Leveraged Finance Asset Allocation Insights: Bank Loans Ride the Tide in Rates

Fundamentals: With inflation pressuring the near-term macroeconomic outlook and financial conditions tightening, the fundamental outlook for loans has become more uncertain. Earnings volatility will likely increase, and a combination of higher input costs, lower consumer demand, and rising interest costs will negatively pressure cash flows and likely lead to higher defaults in the medium term. That said, last-12-month default rates remain low at 0.21% as of May month-end,4 and although we expect defaults to rise, we continue to believe they will stay below the long-term historical average of roughly 3%.

Valuations: Spreads continue to move wider. The spread-to-maturity of the S&P/LSTA Leveraged Loan Index is now at 501 (as of 14 June 2022), versus 466 and 404 in mid-May and mid-April, respectively. Although uncertainty surrounding the economic outlook has increased, loan valuations have become more attractive, and investors are being more adequately compensated for taking such risk.

Technicals: Primary activity has slowed significantly, and the few transactions that have come to market are coming at larger discounts. CLO demand for loans remains steady, as the number of print-and-sprint transactions has increased, although retail outflows have been a partial offset. With recent market volatility, the weighted average bid for the S&P/LSTA Leveraged Loan Index has declined 121 basis points (bps) from 17 May 2022 to 14 June 2022. The higher-risk components of the market have come under the greatest pressure, with the average bid of CCC rated loans down 335 bps, while the average prices for BB and single-B loans have declined 90 bps and 128 bps, respectively.5

Fundamentals: Earnings revisions are on the way. Expect to see continued challenges in financials, health care, utilities, and restaurants, as well as cost input pressures in industrials. Consumer confidence and forward inflation expectations have retraced to generational lows, and CEO surveys are trending negative. However, while fundamental trends are clearly negative, financial metrics remain solid, with leverage trending back to longer-term averages. We expect default rates to remain low throughout 2022. But given tighter financial conditions and a more active Fed, the question is how high they will rise. At worst, we believe they will revert to their long-term average.

Valuations: Financial conditions continue to tighten more rapidly, weighing on risk sentiment. This caused a blow-off decline in US Treasury prices and equities, as option-adjusted spreads (OAS) on the Bloomberg US Corporate High Yield Bond Index moved back to the top of the 400-500 bps range (at 480 as of 13 June 2022). Fundamentally, fair value OAS is about 350-400 bps due to solid fundamentals and our 2%-3% default rate forecast. We see value at 480 OAS, although with few upside catalysts given the global macro backdrop. With the market’s implied default rate in the 4% area, we calculate attractive high-single-digit next-12-month returns bottom up, but it’s going to take equity stability and more clarity on financial conditions to realize that.

Technicals: High yield (HY) was attracting a trickle of inflows before the massive equity drawdown; we expect material outflows going forward. Year to date (YTD), outflows total $32 billion. The primary market has picked up in the last few months but continues to be very light, with the YTD total just $72 billion and issuance down 74% from 2021. Technicals, while generally negative, continue to gap both ways, with size buyers active on dips. Call it neutral, while transaction costs are high. (Technicals based on JP Morgan Securities data as of 10 June 2022.)

Fundamentals: Credit risks remain benign for US leveraged loans as loan default rates in the US remained at roughly 0.2%.6 CLO fundamentals remain constructive. That said, we are starting to see downgrades. Loans priced below 80 increased to 2.0% from 1.6% last month but remain well below the five-year average of 3.5%.7 Despite the continued sell-off in June and anticipation of 2023 default rates increasing to 1.75% for US loans and to 1.50% for HY, default rates in 2022 should remain below historical averages.

Valuations: BBBs are at 400 to 600, BBs at 750 to 950, and single-Bs at 1,050 to 1,400. BBB rated CLOs are fair to cheap compared to HY at 440 OAS and BB rated leveraged loans at 390. BB rated CLOs are trading wide of single-B HY at 470 and leveraged loans at 575 on an OAS basis. The three-month cross-currency Japan yen/ US dollar basis (now using three-month SOFR) is approximately -32 bps as of 13 June 2022, up about 3 bps over the month, making US dollar assets remain relatively expensive to hedge for Japanese investors. (Valuations based on JP Morgan and S&P/ LCD data as of 15 June 2022.)

Technicals: Selling of investment grade (IG) CLOs, as tracked by bids wanted in competition (BWIC) and FINRA’s Trace system, has declined since a peak in March but remains elevated. Market volatility has led to more print-and-sprint deals, which take advantage of discount prices in the leveraged loan market. We expect lower BWIC and primary volumes for the next few months until markets stabilize and spreads tighten. Because of the relative cheapness of CLO tranches compared to other credit across the capital stack, we anticipate an increase in investor bids in the secondary market.

Fundamentals: Eurozone PMI data is pointing to a potentially severe production downturn as the manufacturing sector continues to suffer the headwinds of supply shortages, elevated inflationary pressures, and weakening demand.8 The eurozone economy is looking increasingly dependent on the service sector to sustain growth in the coming months. A survey of future output expectations is signaling further weaknesses ahead, most notably for business investment spending. We continue to see a mixed earnings trend, with consumer durables and food and beverage being most impacted by input cost inflation. There are tentative signs of supply chain pressures easing, which could be a silver lining to the dark clouds in the macro outlook.

Valuations: From a historical perspective, loans look cheap when put in context of the distress ratio. At the end of May, the discounted spread over three years on the S&P/LSTA European Leveraged Loan Index surged to 639 bps while the distressed ratio remained close to its historical low of 1.5%. The three-year discounted spread reached that level during the pandemic (August 2020), when the distressed ratio was at 5.1%, and in June 2013, when the distressed ratio was at 8.5%. (Valuations based on S&P/ LSTA data as of 31 May 2022.)

Technicals: May was the softest post-pandemic month in market technicals, with the buy/sell inquiry ratio as low as 1:20 on some days. The loan market appears to be shedding some of its outperformance versus the European HY market. Performance in June was helped by incoming repayments that were cautiously redeployed in higher-quality loans. For the most part, investors remained on the sidelines in anticipation of the reopening of the new-issue market. There appear to be no detectable signs of large-scale forced selling despite the absence of a solution for underwater CLO warehouses.

Fundamentals: Eurozone PMI data is pointing to a potentially severe production downturn as the manufacturing sector continues to suffer the headwinds of supply shortages, elevated inflationary pressures, and weakening demand.9 The eurozone economy is looking increasingly dependent on the service sector to sustain growth in the coming months. A survey of future output expectations is signaling further weaknesses ahead, most notably for business investment spending. We continue to see a mixed-earnings trend, with consumer durables and food and beverage being most impacted by input cost inflation. There are tentative signs of supply chain pressures easing, which could be a silver lining to the dark clouds in the macro outlook.

Valuations: Euro-denominated HY spreads may look more attractive given the prospect of “more flexibility” in the deployment of European Central Bank (ECB) policy. However, this may be necessary to compensate for the inherent risks in the region with regard to the energy crisis and an uneven eurozone economy. Five- to seven-year BB rated paper could be the sweet spot.

Technicals: Liquidity continues to be low and skewed to the better offerings in lower-rated issuance. There is no evidence of managers deploying cash despite reports of small inflows in recent weeks.

Fundamentals: : European leveraged loan default rates remained at about 0.6%, and the percentage of loans trading below 80 increased to 1.5% in May from 0.8%.10 That said, the continued market sell-off in June has increased those percentages given the conflict in Ukraine and China’s zero-Covid policy. The probability of a recession in Europe continues to increase, and we see a commensurate increase in default rates as a result.

Valuations: BBBs are at 475 to 550, BBs at 700 to 900, and single-Bs at 1,100 to 1,300. BBB rated CLOs are cheap relative to BB HY at 365 and leveraged loans, while BB rated CLOs are cheap relative to European HY at 435 and leveraged loans. The benefit that European CLOs receive from a Euribor floor of zero, which adds about zero to 35 bps to the spread of CLOs, depends on their weighted-average life (WAL). US buyers find single-A and BBB tranches most attractive. (Valuations data based on JP Morgan and S&P/LCD data as of 15 June 2022.)

Technicals: While market sentiment has improved slightly in Europe, uncertainty given the Ukraine conflict and the increased probability of a recession still loom. The thin buying base for European AAAs in the primary market has been a headwind for European print-and-sprint deals. Until clearing levels are found, it will remain challenging for European tranches to find take-up from local investors.

Fundamentals: After assessing the impact of inflation in each region, we concluded that overall margins and leverage are unlikely to change materially into year-end given the sector breakdown and ability to pass on costs. JP Morgan improved its full-year 2022 outlook with total debt of 2.2x (down from 2.4x) and net debt of 1.2x (from 1.3x) due to a 10% upward move in EBITDA, flat gross debt, and a +4% move in net debt (JP Morgan as of 15 June 2022).

Valuations: In June, CEMBI BD spreads tightened 16 bps, with HY (narrower by 14 bps) marginally underperforming IG (narrower by 18 bps). We adjusted our short-term scores higher as spreads have outperformed, narrowing 30 bps in IG and HY in developed markets. The drivers were the Middle East and Latin America in IG, and Non-China Asia in HY. This is probably a reflection of the liquidity lag and partly the local investor bases, but we thought it was worth moving the score to reflect the relative tightening. Within the EM asset class and over the longer term, we remain constructive. We see value opportunities given sovereign-driven risk events and the strong corporate fundamentals and outlook. (Valuations based on JP Morgan data as of 14 June 2022.)

Technicals: We maintained our technical scores this month on a continuation of the same theme, namely lower supply and accumulated cash. YTD supply of $150 billion is down 48% year-over-year. YTD net financing is down $77 billion. With $32 billion in scheduled cash inflows this month and $35 billion in July, net financing is likely to go lower. (Technicals based on JP Morgan data as of 13 June 2022.)