(Bloomberg) -- The US leveraged loan market, as yet unruffled by the shift to a higher-for-longer view on interest rates, may soon join in the pain being felt in other asset classes. 

The floating-rate investments, which typically lag behind other assets, have delivered returns of 2.69% so far this year. But some borrowers in the market, often highly leveraged companies owned by private equity firms, are likely to see a cooling in demand as forecasts for a Federal Reserve rate cut are pushed further into the future.

That reality was reaffirmed again Thursday when New York Federal Reserve President John Williams said he doesn’t feel any urgency to lower interest rates. While it’s not his baseline expectation to raise interest rates again, Williams said it’s possible if the economic data warrants it. 

The loan market has been buffeted by unexpected shifts in lending risk in the past. In a high-profile case two years ago, a group of banks had provided financing for Elon Musk’s buyout of Twitter, the company he renamed X, only to have the $12.5 billion debt package remain on their books when the Fed raised rates and prospective investors balked.

“I don’t think the loan market is immune. It is a risk asset class and there’s some level of correlation to risk assets,” said Frank Ossino, portfolio manager at Newfleet Asset Management. “Right now at least the loan market is holding in a lot better than equities and better than high yield because the volatility is primarily rate centric.”

The high interest payments loans currently provide offer a cushion against the volatility, Ossino said. Case in point: Despite rate shocks and geopolitical events in the last week, the loan market’s total return remained positive due entirely to the strong current income.

Junk bond average spreads have widened to a two-month high of 329 basis points from 292 basis points last week, when a hotter-than-expected March Consumer Price Index reading caused yields to climb. The S&P 500 Index is down more than 2% since the inflation report.

The current higher rate environment is putting pressure on corporate balance sheets, and debt interest coverage has been deteriorating. Adding to the stress is that leveraged loan borrowers haven’t hedged effectively in the past. 

“The analysis pivots increasingly to who has the rate hedge on, who has the pricing power to maintain margin, who has been cost cutting, who has runway and liquidity,” said Ossino. “Those conversations will pick up to make sure the CCC and B- rated credit you own will make it in that environment.” 

Demand Remains

For now, borrowers continue to find demand, though lenders are taking the precaution of sounding out investors before bringing a loan deal, including those at the riskiest end of the rating scale.

KKR & Co.-backed Global Medical Response Inc. on Wednesday launched a $3.56 billion amend-and-extend transaction after securing support from more than 80% of bond and loan holders, according to people familiar with the matter. The existing first-lien loans carry a CCC+ rating and are priced at 425 basis points above the benchmark rate, according to data compiled by Bloomberg. 

The overall financing also featured $600 million in new senior secured notes and $948 million in payment-in-kind preferred equity, they said. 

JPMorgan Chase & Co. on Tuesday launched a $500 million leveraged loan to support a refinancing by United Natural Food Inc., after gauging interest from prospective lenders. The company was downgraded last month to B3 from B2 by Moody’s Ratings. 

And secondary market loan prices still remain above 96 cents on the dollar after slightly softening. Those high prices have allowed borrowers to reprice their loans, shaving 25 to 50 basis points from their margins. 

Loan demand has been supported by collateralized loan obligation managers, who are seeking new assets to fund their liabilities. New-issue CLOs have increased 53% to $37.4 billion compared with last year, according to data compiled by Bloomberg. 

Read more: Leveraged Loan Rally Builds on High-for-Longer Rates: Macro View

(Adds comments from John Williams in third paragraph and comments from Frank Ossino in sixth paragraph.)

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