As a year that has relentlessly whipsawed investors comes to a close, we are approaching 2021 with optimism about opportunities for above-average returns in the credit markets.
Markets rebounded quickly from the Covid-related dislocations in early spring, reflecting powerful monetary and fiscal actions, confidence that the virus could be beaten by behavioral changes and science (including testing and vaccines), and investors’ execution of the “buy the dip” playbook from past market disruptions. Also critical to the leveraged loan markets was a continued worldwide surplus of capital paired with investors’ willingness (or need) to take on investment risk in a low to negative interest rate environment. These trends manifested in the rapid availability of high-yielding rescue financings offering attractive yield and positive convexity.
Looking out over the next 12 months, leveraged loan prices look attractive and offer favorable return potential given the risks we see ahead. We expect loans to yield about 4% to 5%1 over the next year – a compelling prospect given the general context of low to negative interest rates globally. Moreover, credit market defaults have surprised to the downside versus dire forecasts in March and April, and they remain concentrated in two sectors – energy and retail – that were already badly hobbled going into the pandemic. Rescue refinancings have been a big factor in the better-than-expected default rates and are an area to watch going forward. In this environment, credit selection will remain critical.
We expect 10 key trends to drive the leveraged loan markets in 2021:
Increased institutional demand for credit. With interest rates worldwide likely to remain at low to negative levels for at least the next two years, the spreads on offer in the loan market look particularly attractive, especially given default trends to date. With spreads of 520 basis points (bps) for a single-B credit,2 equivalent to about 600% of five-year US Treasury yields, risk premiums (credit spreads) in this market continue to be compelling. Furthermore, we expect to see additional demand from non-US investors due to reduced hedging costs and their net yield focus on spreads rather than underlying base rates.
As of 31 October 2020. Sources: three-year discounted spreads, LCDcomps.com “SPLSTA LLI Factsheet.” 10-year Treasury yield, Bloomberg. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any views represent the opinion of the investment manager and are subject to change.
A brisk pace of CLO formation. Collateralized loan obligations (CLOs) own about 60% of the leveraged loan market,3 so trends in this area are crucial. After sputtering to a halt early in the pandemic, CLO issuance has recovered to about 70% of its 2019 pace and is expected to continue at a brisk clip through at least year-end.4 CLOs proved to be durable investments in 2008-2009 (despite significant price volatility for holders) and are likely even better able to weather the credit stress ahead. Our confidence is driven both by vehicle structures that benefit from lessons learned in the Great Recession, as well as CLO managers’ willingness to diversify portfolios more broadly and take earlier but smaller losses in troubled sectors, while avoiding the most problematic areas of energy and retail. Moreover, CLOs allow investors to choose their desired level of risk, from near-zero credit risk in the AAA tranches to equity-like risk in the lowest tranches. This is a particularly attractive quality given widely divergent views on the likely duration and intensity of Covid-19’s impact on the economy, a key source of risk.
Swings in market discipline. The trend toward far looser, covenant-lite credit agreements, which can open up loan holders to aggressive issuer behavior, is well documented. When credit markets plunged in March, loan investors publicly bemoaned the lack of market discipline over the past two to three years. And as generally happens when credit markets contract, many participants saw the value in tighter loan terms for issuers in the first months of the recovery. More recently, however, looser terms are creeping in again. These range from the covenant-lite structures we’ve seen since 2009 to a more troubling return toward terms that give issuers significant latitude to pay large dividends, or even to move key assets away from the lending group’s security interests. Loan managers will be watching this closely.
Potential for more aggressive lender behavior. More and larger pools of opportunistic debt capital are now active in the market. While some of this capital was raised in traditional distressed-debt offerings, much of it is a natural offshoot of the entry of hedge funds and traditional equity sponsors into the loan market. This capital has been deployed in many instances to rescue – at a price – companies that otherwise would have gone into default. At other times, however, capital has been deployed coercively, leaving loan managers with little option but to accept weakened covenants or haircuts to their holdings. Staying ahead of these situations will be crucial to avoiding trading or structuring losses.
Companies’ performance after rescue financings. As noted above, many companies executed rescue financings to build liquidity and buy time to get through Covid-driven lockdowns. While those moves kept the default rate well below earlier estimates, they have also saddled companies with enough debt to raise questions about their continued viability. This will be a key area to watch next year and underscores the importance of credit selection.
The shift from beta to alpha opportunities. With the significant rally since March, when beta opportunities abounded, loan investors now must pivot to security selection. While significant upside is theoretically available, with loan prices averaging about 93 and spreads far exceeding historical levels,5 the path to attractive returns may well be bumpy: navigating the uncertain economy ahead will require skill, experience, and discipline.
Post-election changes to economic and foreign policy. A Biden administration combined with a divided Congress could usher in policy shifts affecting both near-term fiscal stimulus and longer-term macroeconomic conditions. These changes may be most noticeable with respect to foreign policy engagement, which would have far-reaching implications for trade (especially vis-à-vis China, but also Europe) and also for specific industry segments, most notably energy and health care. The magnitude of these changes, while not yet known, could be pronounced and have a significant impact across the loan market.
The pandemic’s continued macro impact. Covid-19 has the potential to keep the global economy on its back foot well into next year. As of this writing, the resurgence in coronavirus cases is again threatening to slow the worldwide economic recovery. That said, early findings showing at least 90% efficacy for more than one of the leading vaccine contenders, along with progress toward more and better testing and treatments, offer reasons for cautious optimism. However it unfolds, the pandemic’s trajectory will be a key driver of the macro environment and credit conditions for loans in 2021.
Rating agency actions. Given the importance of the CLO bid for loans, and the inability of most CLOs to purchase loans rated B3/B- or below, loan prices will also be heavily influenced by the actions of the rating agencies. The agencies downgraded a broad swath of the loan market in late spring, and while rating actions have slowed dramatically since May, it remains to be seen whether another mass downgrade is to come – especially if rising Covid cases precipitate further lockdowns.
Data is rolling 3-months as of 23 September 2020. Source: S&P/LSTA Leveraged Loan Index, LCD, an offering of S&P Global Market Intelligence. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any views represent the opinion of the investment manager and are subject to change.
A larger and more liquid loan market. The leveraged loan market now totals approximately $1.2 trillion, twice the size of the 2008 market.6 Loan investors thus have far more options when constructing and maintaining diversified portfolios and in avoiding sectors that might carry Covid-related or other structural risk. The market’s growth, and its maturity into an asset class attractive to a significantly larger number of institutional investors, has boosted its liquidity significantly. In general, the larger half of the loan market trades with bid-ask spreads inside 75 bps. (It’s worth noting, however, that liquidity in both loan and high yield markets tends to shrink considerably in times of systemic stress.)
As we look toward 2021, we believe leveraged loans will continue to be compelling to investors amid persistent low to negative interest rates globally, with attractive prices and favorable return potential given a manageable level of defaults to date. But ongoing uncertainties and significant differences in the impact of the pandemic and shutdowns among sectors and individual companies mean that active credit selection will be paramount.
Our focus has long been on the more broadly syndicated part of the $1 trillion-plus loan market, and we believe liquidity remains critical. More-liquid assets allow for greater flexibility to trade quickly as trends shift. Finding and tapping the right opportunities in volatile markets requires significant experience in stressed and distressed markets and is essential to navigating the unpredictable market conditions ahead.
For more PineBridge views on what to expect across economies and asset classes in 2021, visit our 2021 Outlook page.
1 Source: PineBridge Investments calculations, as of 18 November 2020.
2 Source: LCDcomps.com, “LLI Discounted Spreads,” as of 30 October 2020.
3 Source: JP Morgan North America Credit Research, as of 9 November 2020.
4 Source: LCDcomps.com “CLO Historical Stats,” as of 31 October 2020.
5 Source: LCDcomps.com, "SPLSTA Factsheet," as of 31 October 2020.
6 Source: LCDcomps.com, “SPLSTA Factsheet,” as of 31 October 2020.
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