The Market-Beating Investment That’s Defying Wall Street Skeptics

Since the start of last year through Friday, loans backed by companies including PetSmart and Uber Technologies in the Morningstar LSTA U.S. Leveraged Loan Index delivered a return of 9.3%, buoyed by higher interest rates and a resilient economy. Investment-grade bonds lost 13% in that time, counting price changes and interest payments, while the S&P 500 lost 3.9%.

Few investments have been as maligned as leveraged loans, the low-rated debt often used to fund private-equity company buyouts. When the Federal Reserve started aggressively raising rates last year, many analysts warned that these loans were vulnerable because their rates rise and fall with those set by the central bank.

Higher rates, these analysts warned, would squeeze loan borrowers by saddling them with larger interest payments and tipping the economy into a recession, thereby depressing corporate revenue. Individual investors pulled billions of dollars out of loan funds starting around mid-2022.

So far, the skeptics have been mistaken. The economy has remained strong, helping issuers withstand rising interest costs and keep cash flowing to investors. Meanwhile, prices of bonds with ultralow fixed rates have tumbled, amplifying the advantage of floating-rate debt.

“A lot of the fearmongering, I get it…but let’s also give a little bit of credit when it’s due," said George Goudelias, a senior portfolio manager and head of leveraged finance at Seix Investment Advisors LLC.

Companies have taken additional steps to mitigate rising interest costs, including cutting expenses, reducing debt and hedging interest-rate exposure.

Asurion, a privately owned company based in Nashville, Tenn., that insures and repairs cellphones, curbed continuing expenses last year by paying down more than $600 million in debt and laying off roughly 1,000 employees, according to reports by Moody’s Investors Service and the Nashville Business Journal. The moves came after it lost a contract with Sprint following T-Mobile‘s takeover of the wireless carrier.

One of the loan market’s largest borrowers, Asurion has also maintained a hedging program to lock in fixed rates on nearly all of its more than $12 billion in floating-rate loans. That program is expected to save the company on average more than $300 million a year over the next several years, according to a person familiar with the matter.

Not many companies have been as vigilant as Asurion in hedging their interest-rate exposure, according to investors. But there are other examples. North American companies owned by the private-equity firm Bain Capital have hedges in place that have saved them roughly $600 million and are currently valued at $900 million to $1 billion based on future expected savings, according to a person familiar with the matter. Details about Bain’s hedging strategy were reported earlier this year by Bloomberg.

Investors and analysts still have concerns about leverage loans. Companies across the market are generating less cash, thanks to surging interest costs. Some companies that have avoided bankruptcy remain highly vulnerable to a default, especially if a downturn finally arrives.

“We haven’t seen that many companies go from cash-flow positive to cash-flow negative, so we’re still OK, but absolutely, we’ve seen that degradation of free cash," said John Sherman, a portfolio manager at Polen Capital.

Defaults, though still modest, have been rising.

The share by dollar amount of the Morningstar LSTA U.S. Leveraged Loan Index that has defaulted in the past 12 months had increased to 1.55% as of August—just below the 10-year average—from 0.18% in April of last year, according to PitchBook LCD data. Those figures count events such as missed coupon payments and bankruptcy filings but exclude so-called distressed exchanges, when companies purchase debt below its face value.

Individual investors have pulled about $13 billion this year from mutual funds and exchange-traded funds that focus on buying leveraged loans, according to Refinitiv Lipper.

Still, companies have generally made progress in addressing financial challenges, using a variety of means to remove the kind of near-term debt maturities that can tip them into bankruptcy.

As of Aug. 15, companies had refinanced, paid down or extended some $45 billion of loans that were previously due to mature in 2024. That has left about $27 billion remaining of the $75 billion that was outstanding at the start of the year, according to PitchBook LCD data. Since then, the software company Finastra was able to obtain a new loan with which it will pay down roughly $4 billion of loans due in 2024.

Drew Sweeney, a loan-portfolio manager at TCW Group, said he felt good enough about the economic outlook to buy loans with extra-low, triple-C ratings, seeing their prices as attractive partly because many loan buyers can hold only a limited amount of them.

“I think we’ll see default rates push higher," he said, “but I don’t think we’re looking at default rates that are at levels that are terribly concerning."

Write to Sam Goldfarb at sam.goldfarb@wsj.com