An overlooked area of Wall Street that was previously ignored by investors is now experiencing a surge in popularity.

Higher rates over the past two years were anticipated to have a significant impact on risky corporate borrowers who heavily depend on floating-rate debt. That has not occurred.

In contrast, corporate loans with low ratings have consistently performed better than investment-grade bonds and are now attracting inflows for the first time since 2021. Investors have invested a significant amount of money, $12.2 billion, into mutual and exchange-traded funds that are focused on these loans. According to data from LSEG, there have been outflows totaling $27 billion in 2022 and 2023.

Investors are drawn to the appeal of yields around 9% and the reassuringly low default rates, even as the U.S. economy shows signs of cooling without any immediate threat of a recession.

“Given the current state of the economy, investors are finding a greater sense of security in the loan market,” stated John Lloyd, a portfolio manager at Janus Henderson Investors.

Despite the risky reputation of low-rated corporate loans, they are also known as leveraged loans due to their role in funding private-equity firms’ buyouts of companies.

Since the beginning of the year, the Morningstar LSTA U.S. Leveraged Loan Index has generated a return of 4.6%. This index comprises loans to various companies, such as Uber Technologies and American Airlines, and takes into account both price fluctuations and interest payments. Meanwhile, investment-grade bonds have increased by 0.4%, while junk-rated bonds have experienced a gain of 3.1%.

Over time, experts predict that increased interest rates may have a negative impact on the profitability of high-risk corporate borrowers. This could result in a decline in loan prices and an increase in default rates. Currently, the level of trust that investors have in leveraged loans is evident in the decreasing premium they are requiring above the benchmark overnight rate.

The surge in demand for high-risk corporate debt has led to a surge in loan sales and refinancings by companies such as Peloton Interactive and United Natural Foods. According to PitchBook LCD, businesses with low ratings collectively issued and refinanced $736 billion of speculative-grade loans through June 30. That has increased from under $200 billion for the same period last year.

“The market is wide open,” remarked John Sherman, a portfolio manager at Polen Capital. If you are unable to refinance in this market, it indicates some rather pessimistic aspects regarding the performance of your specific company.

First Eagle Investments, a New York-based money manager, began the year with approximately $1.775 billion in floating-rate debt set to mature in February 2027. With the loan prices experiencing a rally, the firm took advantage of the opportunity to refinance $1.3 billion earlier this year, extending the maturity to March 2029.

Then in the previous month, First Eagle unexpectedly refinanced an additional $300 million, surpassing its original plan.

“We experienced a significant amount of surplus demand,” stated Brian Margulies, the chief financial officer of First Eagle.

In late April, United Natural Foods successfully reduced borrowing costs on $500 million of senior secured debt. The initial range of 5 to 5.25 percentage points was lowered to 4.75 percentage points above the benchmark rate. The food wholesaler set the loan price at the higher end of the initially suggested range, indicating robust demand.

Investors and analysts continue to express concerns regarding leveraged loans, as there is a possibility of lower coupon payments if the Fed decides to cut rates in the coming months. Many experts believe that the loans have a significant risk of default, and the market’s overall quality is declining.

According to Michael Anderson, head of U.S. credit strategy at Citigroup, the proportion of the riskiest corporate loans in the Citi Leveraged Loan Tracker has decreased from 33% at the beginning of the year to 30%. This is a significant drop from 54% in 2015.

“The overall quality of the market is a significant concern,” Anderson expressed. “If we keep losing our top-tier companies, it will alter the market’s composition, resulting in a lower quality overall.”

Defaults are still relatively low compared to the past, but they are gradually increasing. According to PitchBook LCD data, the percentage of defaulted loans in the Morningstar leveraged-loan index has increased from 0.83% at the beginning of last year to 0.92% as of June.

Investors have been showing a strong interest in collateralized loan obligations, which involve the purchase of leveraged loans and their subsequent packaging into securities. However, a significant portion of the activity in the leveraged-loan market has involved companies refinancing their current debt rather than issuing new debt.

According to Marina Lukatsky, global head of credit research at PitchBook LCD, a significant portion of the loan-issuance activity this year, approximately 60%, is dedicated to refinancing.

“There is a significant disparity between the supply and demand for leveraged loans,” Lukatsky remarked.