The leveraged loan market has staged a strong rally as consensus that a recovery is just around the corner becomes more entrenched, prompting investors to look further and further down the ratings spectrum in a bid to boost returns.

Loans rated triple-C recorded an 18.31% gain in May to return 43% so far this quarter, according to the S&P/LSTA Leveraged Loan Index. That’s the best month ever, according to Standard & Poor’s LCD unit and well ahead of loans from borrowers rated single and double B. Single- and double-B rated loans gained 7.4% and 2.93% last month, respectively, with returns of 20% and 9.5% so far this quarter. This is in stark contrast to the first three months of the year when BB-rated loans returned 13.5% and loans from triple-C-rated borrowers returned a negative 7.6%.

“In June 2007, leveraged loans were priced as though no loan would default, but at the end of last year they were priced as though every one would default. Now some normalcy has returned,” said Steven Miller, managing director of S&P’s LCD. With the S&P/LSTA index returning 26.63% year-to-date, leveraged loans have outperformed most other asset classes this year. But they might not have rallied so furiously without the help of the junk bond market, which has
returned with a vengeance.

More and more junk-rated borrowers have been turning to the bond market this year to refinance billions of dollars of leveraged loans maturing through 2014.

Issuance of junk bonds has soared even as the market prepared itself for Monday’s chapter 11 bankruptcy filing from General Motors Corp. This has helped cut the stock of leveraged loans and put money back into the market, giving loan investors a stream of cash to put to work.

Indeed, proceeds from about 60% of high-yield bond sales in 2009 have been used to pay down bank debt and this has already helped reduce the amount of outstanding loans to $575 billion, according to Miller.

“If the high-yield market remains strong, the loan market has further to run and it can get back to business,” Miller said. “We can get to a more normal situation where the loan market is printing $200 billion a year in new issuance…” he said.

The rising prices and the prospect of excellent returns will continue to lure investors and may even encourage managers of collateralized loan obligations, structured product that pool high-risk loans sold by junk-rated companies, to return.

But for that to happen, investors have to keep believing that the banking system will heal and that the economy will improve. “…and these things have to continue to be true for the loan market to continue its rally,” Miller said.