Investors worried about what might happen should financial conditions lighten should probably give leveraged loan ETFs a wide berth, according to one high-yield bond manager.

A leveraged loan is extended to companies or individuals that already have considerable amounts of debt and/or a poor credit history. Lenders consider leveraged loans to carry a higher risk of default, and as a result a leveraged loan is more costly to the borrower.

There are some hefty leveraged loan ETFs on the market including an $8bn fund from Invesco and another from State Street with an AUM of $3bn.

Now Kames Capital high-yield bond fund manager Mark Benbow says that the wider economic situation could see the flows into the leveraged loan sector reverse.

He points out that at the turn of the millennium there were only 15 ETFs or mutual funds dedicated to the leveraged loan asset class.

This has now ballooned to almost 300 today amid rising interest rate expectations.

"The theory goes that rising interest rates will generally hurt (fixed coupon) bond markets, but leveraged loans (as floating rate instruments) will benefit as central banks unwind balance sheets and increase interest rates," says Benbow.

While the fundamentals for such a theory held true last year, Benbow says the nature of many of the investments in the leveraged loan market means that liquidity is limited - this having a negative impact on products which offer instant redemptions.

"The main holders of leveraged loans remain CLOs (collateralised loan obligations) and investors in CLOs have their money locked-in," Benbow adds.

"They need a secondary buyer of their share of the CLO to redeem their exposure, while ETFs and mutual funds promise instant access to liquidity despite many of the loans rarely trading," he says.

How this scenario unfolds is not yet clear. But Benbow warns that in a worst-case scenario, the chances of recovering capital from failing loans is unlikely given the potential for the likely deterioration in the leverage debt market.

He points out that although loans typically rank higher than bonds in any bankruptcy situation - meaning the recovery rate is higher - the recent evidence points to more than 50% of loans issued having had no junior borrowers to take the first hit.

As a result, Benbow says historic recovery rates of around 75% might well be an over-estimate.

To hammer home the point, he cites evidence from a recent Moody's report which showed that second-line recoveries were expected to fall from 43% to just 14% as many loans are increasingly found at the bottom of capital structures.

"Given the strength of the economy, many of these facts were either not acknowledged or were deemed something to worry about on a rainier day," Benbow says.

"Well, that rainy day could well have arrived as we have seen financial conditions begin to tighten over the last few months, and with this there have been outflows within the leveraged loan asset class."