(Bloomberg) -- Investors are pouring money into US leveraged loan funds, fueling some of the biggest gains in credit markets this year, in a high-conviction bet that rates will be slow to fall and junk-rated corporate America will withstand the pressure of elevated borrowing costs.

Leveraged loans have gained 2.52% this year, outpacing junk bonds and investment-grade corporate debt as investors flocked to the sector. The Invesco Senior Loan ETF, the largest passive floating-rate vehicle backed by risky debt, had $2.6 billion of inflows in the past five months alone, the longest streak since at least 2019. 

Even as the Federal Reserve flags its intention to start cutting interest rates this year, continued signs of US economic resilience have led economists and money managers to scale back the timing and extent of any easing, and forge a new consensus that the US economy will avoid a once-feared recession. Benchmark 10-year Treasury yields climbed to a four-month high Tuesday, a day after a report showed expansion in US manufacturing for the first time since 2022.

If things do go awry, senior loans rank high in the pecking order for repayments, insulating investors.

In December, economists on average saw a 50% chance of a recession in the coming year according to a Bloomberg survey. By March, that figure had fallen to 35%. And with inflation proving to be stubbornly high, that’s raised fresh questions about how soon the Fed will start loosening monetary policy.     

“It’s unclear when the Fed does cut rates. So, in the meantime, investors can park their money in this and possibly achieve a higher yield,” said Mohit Bajaj, director of ETFs at WallachBeth Capital. 

Senior loans have one of the highest yields in the debt space, Bajaj said. The $7.3 billion Invesco fund (ticker BKLN), which tracks around 100 of the largest and most liquid senior secured loans, has a yield of about 8.76%, compared with the average junk bond yield of 7.75% as of Monday’s close. It has seen cash come in over 23 of the last 25 weeks. 

The $5.6 billion SPDR Blackstone Senior Loan ETF (SRLN), which has had inflows for four months of out of five, has a yield of 8.82%. Investors pumped a total of $1.3 billion into the ETF during that period.

Double-Edged Sword?

Even as higher yields attract investors to the loan market, they are also putting pressure on companies by boosting their interest expenses. Corporations are earning less relative to their interest expense, and if the trend continues, the market could see more ratings downgrades or worse. 

“Now we may be running into a world where higher interest rates become a double-edged sword for the loan asset class,” said Grant Nachman, co-founder of Shorecliff Asset Management. “As an investor you probably feel good about enjoying higher income across your loan portfolio, but the increased interest burden on borrowers may mean higher defaults and potential loss of principal.”

Borrowers have found ways to gain some breathing room. Intense investor demand for debt has allowed many companies to effectively refinance their loans through repricing, reducing their interest expense by 25 to 50 basis points a year in the process. 

If rates do eventually fall, floating-rate debt can still make sense for investors as senior loans offer competitive yields compared with junk bonds even when rates are falling. Prices for equities and bonds tend to fluctuate more than loan prices, said Shorecliff’s Nachman. And with interest rates at levels not seen in decades, investors can have sufficient income even after some monetary easing, he said. 

Loans would still offer value to investors against other assets, like high-yield bonds, if the economy remained strong and rates fell by 1 percentage point, said Winifred Cisar, global head of strategy at research firm CreditSights.

“Fed cuts could actually support continued loan inflows as the relative value for loans is still pretty attractive,” Cisar said. 

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