By Lynn Adler and Jonathan Schwarzberg

NEW YORK (Reuters) - Floating-rate leveraged loans issued to highly indebted US companies are seeing the highest total returns in four years, propelled by a secondary loan price surge since February when prices dropped to four-year lows.

Rallying oil prices and reduced recession fears sparked the upswing in returns. Now expectations of rising U.S. interest rates are propelling demand for the high-yielding assets far beyond available supply.

The result is the biggest spike in total return since the financial crisis, based on the S&P/LSTA Leveraged Loan Index.

Total returns for leveraged loans hit a four-year high of 8.82% this year through November 29, compared with -0.69% in 2015, the index shows.

“A return of this magnitude cannot occur without a preceding sell-off,” said Joseph Lynch, senior portfolio manager, non-investment grade credit, at Neuberger Berman. “The market-value decline last year provided the potential for price appreciation this year.”

The last time there was a greater increase was when returns slumped to -29.1% in 2008 before rebounding to return 51.6% in 2009, according to the index.

The asset class appears headed for ongoing strength in 2017, as investors reach for yields that will rise as the Federal Reserve raises interest rates, providing more of a hedge than fixed-rate bonds, and with new political leadership promising better conditions for business.

“What we’ve seen in bank loan funds in the past couple of weeks is directly tied to the Federal Reserve telegraphing that they’re going to raise rates in December,” said Pat Keon, research analyst at Thomson Reuters Lipper.” “We’ve seen the inflows explode.”

Net inflows into loans in each of the past five months total about US$6.5bn, according to Thomson Reuters Lipper.

President-elect Donald Trump’s tax cutting and infrastructure spending plans could boost inflation and interest rates, further stoking demand for floating-rate exposure. 

The Fed indicated on November 23 that the US economy was gathering enough steam to warrant a rate hike soon. The next policy meeting is December 13-14.

In anticipation, retail investors have been pouring money into bank loan mutual and exchange traded funds since the middle of the year. Inflows in the past two weeks have escalated to highs last seen more than three years ago.

Issuance by Collateralized Loan Obligation (CLO) funds, the biggest buyers of leveraged loans, has also heated up as the year progressed.

A long-awaited series of Fed rate hikes is now seen starting on December 14, which will lead demand to continue outstripping supply in the US$860bn leveraged loan market.

High volatility and uncertainty about the US elections, Fed rate plans and the UK’s vote to exit the European Union curbed loan volume for much of the year, driving bids higher for available new issuance and secondary loans.

The US$683bn of completed US leveraged loan deals is just 3% above the same period last year, according to Thomson Reuters LPC.

“Loan performance will continue to stabilize next year, reflecting our expectation for moderate economic growth and declining default rates," Moody's associate managing director Min Xu said in a statement. Moody’s expects “a conducive economic environment and a broader investor base” to keep CLO issuance in 2017 comparable to this year.

Despite a slow start, CLO volume has reached US$64bn this year after US$98.6bn in full-year 2015, according to Thomson Reuters LPC Collateral.

HERDING

Cautious optimism as the market awaits policy details of the new US administration may temper the pace of loan fund buying, but a reverse is unlikely, investors and analysts said.

Flows tend to be one directional, with a herd mentality, Thomson Reuters Lipper data show.

Before net inflows of US$6.5bn in the last five months reversed, the market saw outflows in 22 of 27 months between April 2014 and June 2016, for around US$60bn.

Most recently, the US$1.12bn of inflows in the week ending November 23 was the highest since US$1.32bn in September 2013. That boosted the year so far to US$42m of net inflows after a loss of US$21.57bn in full-year 2015.

“If the Fed keeps saying, 'yes, we're going to keep raising rates,' I would expect to see consistent, steady inflows,” said Keon. “The loan sector is kind of underbought.”

TRUMP RULES

While there is a clear consensus that leveraged loans will keep gaining favor, potential sweeping regulatory changes under the new administration make sector analysis increasingly vital for investors.

“I think there’s going to be more and more transactions, but there are a number of unknowns that people are trying to figure out,” said Neil Wessan, group head and managing director of CIT Capital Markets. “Until we start seeing some real policy coming out of Washington, things will continue along cautiously optimistic.”

Healthcare, energy, banks and manufacturing are just some of the segments subject to policy shifts and investor reassessment.

Affordable Care Act changes could boost pharmaceutical pricing power, while cutting hospital stays by leaving more people uninsured, for example.

“We were more concerned about pharma pre-election, and now we’re not as concerned. We were not overly concerned about hospitals pre-election and now we see that subsector more at risk,” said Lynch. “These are probably the two sectors that have been most impacted in the near term by the unexpected election outcome that resulted in Republican control of the House, Senate and the Presidency.”

(Reporting by Lynn Adler and Jonathan Schwarzberg; Editing by Michelle Sierra and Tessa Walsh)