In Brief
- Defaults are expected to modestly rise, but certain issuers have been proactively managing liabilities.
- Although lower policy rates may dampen demand for floating-rate securities, a robust CLO (collateralized loan obligation) market may likely provide more support.
- We remain underweight CCC-rated loans and thematically focused on consumer resiliency, proactive management of liabilities, attractive carry, and selective cyclical exposure.
Recap: Rising Rates Had a Bite, but Macro Resiliency Proved Stronger
Looking Ahead: Less Price Convexity Today but Plenty of Carry
Even with macro resiliency, some credit metrics did deteriorate in 2023 with the flow through of the Fed’s historically aggressive hiking pace to floating-rate liabilities. J.P. Morgan notes interest coverage declined approximately one-turn to 3.2x through Q3 2023, leaving it modestly lower than the pre-pandemic reading. But as a counter, leverage fared better at 4.9x, essentially right in line with the start of 2020. For 2024, we expect CCC defaults to continue to increase modestly, but remain largely in line with the historical average of approximately 3%. However, in continuation of a theme for 2023, we believe issuers and lenders alike will remain proactive by restructuring and re-underwriting liabilities ahead of bankruptcy, but weaker covenants should continue to pressure recoveries. The high yield bond and private credit markets provide alternative avenues of liquidity for loan issuers as the three market segments continue to converge. It is worth noting that the starting relative yield for bank loans compared to high yield bonds, shown in Figure 1, provides an added buffer, which is a positive given that bank loans have historically traded 50-100 bps tight of the high yield bond market.
We expect an easing Fed could have mixed consequences. On one hand, we believe the current pace of easing priced into futures markets is too aggressive, and if we’re right, a walk back of those expectations could create volatility early in the year, particularly in lower-rated issuers. Normally, a decline in policy rates has been associated with lower investor interest in floating-rate exposures, but we believe the demand generated by the significant CLO investor base will prove more meaningful. We expect leverage to remain stable at these higher levels, kept in check by corporate conservatism and larger equity contributions from buyout investors. Challenges include the need for markets to remain open for issuers to address upcoming maturities, as well as a limit on the opportunity set resulting from tighter spreads and lower policy rates. Finally, we expect lower-than-average recoveries to persist, given the phenomenon of repeat default candidates with loan-only structures and the growing CCC segment.
Positioning: Keeping Cyclical and Light in the Tails of the Ratings Spectrum
Figure 1. Yield Differential Partially Explained by Quality Difference — but Still a Pickup in Bank Loans
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Glossary & Index Definitions
ICE BofA U.S. High Yield Constrained Index is a rules-based index consisting of U.S. dollar-denominated, high yield corporate bonds for sale in the U.S. The index is designed to provide a broad representation of the U.S. dollar-denominated, high yield corporate bond market. The index is a modified market value-weighted index with a cap on each issuer of 2%.
Credit Suisse Leveraged Loan index is designed to mirror the investable universe of the U.S. dollar-denominated leveraged loan market.
Spread is the percentage difference in current yields of various classes of fixed-income securities versus Treasury bonds or another benchmark bond measure. A bond spread is often expressed as a difference in percentage points or basis points (which equal one-one hundredth of a percentage point). The option-adjusted spread (OAS) is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is adjusted to take into account an embedded option. Typically, an analyst uses the Treasury securities yield for the risk-free rate.
A basis point is one one-hundredth of a percentage point.
The Federal Reserve (Fed) is the central bank of the United States. The federal funds (fed funds) rate is the target interest rate set by the Fed at which commercial banks borrow and lend their excess reserves to each other overnight.
CLOs (collateralized loan obligations) are securitizations where payments from multiple middle sized and large business loans are pooled together and passed on to different classes of owners in various tranches.
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