Junk-Loan Rally Cuts Company Borrowing Costs

Companies issuing new loans, including web-hosting firm

GoDaddy Inc.

GDDY 3.29%

and racetrack operator

Churchill Downs Inc.,

are taking advantage of the demand, raising a record of $110 billion during the first two months of the year. Other borrowers, such as consulting firm AlixPartners LLP and software company Kofax Inc., have pursued more opportunistic loan deals intended to pay a dividend to shareholders.

The rally is notable after loans rebounded from the pandemic more slowly than other assets last year. Now, with junk-bond yields still hovering around 4.5%—below their pre-pandemic record lows—investors are turning to leveraged loans because their interest payments increase with short-term rates.

Unlike junk bonds, leveraged loans often also are backed by a portion of the company’s assets, providing additional collateral.

The yield on the benchmark 10-year Treasury note recently climbed above 1.6% to its highest levels since the pandemic began, powered by investors’ expectations for vaccine- and stimulus-fueled rebounds in growth and inflation.

While more than $8.8 billion was flowing into U.S. mutual and exchange-traded funds that buy loans in 2021, as of March 4, according to Refinitive Lipper, investors were pulling $3.7 billion from comparable junk-bond funds during the same period. Though junk bonds still pay out a higher average yield, loans are more senior in the capital structure, putting investors closer to the front of the line to get paid in the event of a bankruptcy. Loans are also often backed by a portion of the company’s assets, providing additional collateral.

“If you think inflation is coming or rates are going to rise, you’re going to want to move up in the capital structure,” said Keith Berlin, director of global fixed income and credit at FEG Investment Advisors.

Loans have returned over 1.8% in 2021, counting price changes and interest payments, ahead of the roughly 0.4% return on high-yield bonds and 10-year Treasurys’ minus-5.2%. Loans rated triple-C, one of the lowest credit rungs before default, have led the rally, returning more than 5.7% to investors during the same period.

Many investors look to the loan market as a barometer of credit conditions, since deals tend to involve debt-laden companies with low credit ratings—a combination that tends to deter lending when people get nervous about the future.

One reason the loan market recovered more slowly than bonds was because the biggest buyers, who bundle the loans into so-called collateralized loan obligations, got caught up in last year’s credit crunch. Many large borrowers in the loan market didn’t qualify for support from the Federal Reserve and instead had to work with lenders to renegotiate or amend loan terms.

This year, CLOs are off to a hot start, with issuers selling more than $58 billion during the first two months of the year, according to data compiled by

Barclays

PLC, the biggest start to any year since at least 2013. Analysts expect CLO creation to grow from last year’s volumes, providing another steady source of loan demand.

Some companies have taken advantage of the recent rally to cut interest costs, which can lead to upgrades and rising loan prices. Some have improved the terms of their loans. That has sparked worries that leveraged loans also now offer investors dwindling contractual protections against default and rising levels of debt relative to corporate earnings, possibly impeding borrowers’ ability to pay back their debts.

Loans generally don’t prohibit borrowers from paying back debt more quickly than expected, allowing them to take advantage of investor demand to refinance debt—a move that can limit investors’ returns. Around 60% of the $110 billion of loans sold during January and February have been used to refinance or reprice existing debt.

Loans backing a dividend payment to shareholders, often private-equity firms, totaled $6.58 billion as of Feb. 9, the most during any comparable period since 2017 and the second-highest tally in data going back to 2010.

As more retail money flows into the market, pushing up prices, institutional investors are increasingly challenged to find loans with long-term potential, said David Moffitt, co-head of U.S. credit management at Investcorp.

“Things seem to be priced to perfection,” he said.

Corrections & Amplifications
A graphic that accompanied this article incorrectly quoted average leveraged loan prices in dollars instead of cents on the dollar. The graphic has been updated. (Corrected on March 15)

Write to Sebastian Pellejero at sebastian.pellejero@wsj.com