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The Landscape for Leveraged Loans
Insight • June 16, 2023
4 min. Read

The Landscape for Leveraged Loans

Positive trends may continue to provide support for the asset class in the second half of 2023.
In Brief
  • Attractive yields, strong interest-coverage ratios, and healthy issuer fundamentals are generally supportive of the asset class.
  • Elevated coupon payments and a possible higher-for-longer rate regime are potential challenges.
  • We continue to closely monitor signs of credit stress as financial conditions tighten and maintain an up-in-liquidity and up-in-quality bias.

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Leveraged loans have had a resilient start to the year in the wake of lingering recession concerns. Performance has been strong, returning just over 4% through May and outperforming other fixed-income sectors such as high yield, investment-grade and government-related bonds. Several factors have provided a boost for the asset class, particularly its attractive starting yield of over 10%, which has generated solid carry to offset gyrations in spread movements. Additionally, technical factors have been supportive. Net demand (primarily CLO creation) has outpaced supply as new issue markets have been relatively benign, and many issuers have been tapping the high yield markets to refinance outstanding loans.

Looking ahead, we believe there are several factors that make the loan market an appealing asset class. Bank loans currently offer more relative value compared to other credit-sensitive sectors, with credit spreads (as measured by discount margins) closer to recession averages compared to spreads on high yield bonds (Figure 1). While this may imply that markets are expecting more credit issues in the loan market than the high yield market, it also creates a more attractive entry point into the asset class as potential distress is priced in. Credit metrics for loan issuers also remain on relatively solid footing heading into a more challenging economic backdrop. Despite showing early signs of erosion, interest coverage is at healthy levels, hovering around multi-year highs and above pre-pandemic levels. Furthermore, leverage has remained largely in check. Loan markets also continue to benefit from a fairly extended maturity wall, with just under 4% of total leveraged loans outstanding set to mature by the end of 2024, thus creating a more manageable environment for issuers to address upcoming due dates. Lastly, we view CLO dynamics as an area of opportunity given their susceptibility to downgrade risk. As CLO vehicles are generally capped on their allocation to lower-quality credits, they may be forced sellers if portfolio loans are downgraded, which may present an attractive opportunity as technical pressures lead to pricing dislocations. In the past, extended downgrade cycles, such as in the COVID-19 and GFC periods, have presented compelling entry points for loan investors.

Figure 1. Loan Yield Around Post-Global Financial Crisis Highs with a Historic Yield Pickup versus High Yield

Yield to three-year average life on the Credit Suisse Leveraged Loan Index and the yield-to-worst (YTW) on the ICE BofA U.S. High Yield Index, May 31, 2002-May 31, 2023
Figure 1. Loan Yield Around Post-Global Financial Crisis Highs with a Historic Yield Pickup versus High Yield
Source: Credit Suisse and ICE Data Indices, LLC. Data as of 05/31/2023. Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett.

Positioning and Risk Stance

Our risk posture within our bank loan portfolios remains modestly defensive. We acknowledge that loan performance may be challenged, particularly if Federal Reserve (Fed) policy supports a higher-for-longer rate regime. This could be a headwind for loan issuers, who have already seen debt service costs double over the course of the last 12 months, although coverage ratios remain strong. Therefore, we believe it’s vital to watch for broader signs of rising credit stress, given tighter financial conditions and more stringent access to capital. It is our view that tail risks remain elevated, and a lack of investor conviction in the asset class could stress liquidity, which would be magnified if economic growth continues to be subdued, and inflation persists. Liquidity management is a paramount focus for us, and we have maintained our up-in-liquidity posture within the portfolio. We also believe that strong security selection is necessary in the second half of the year, as downgrades and default risks climb, entailing the need to avoid deteriorating credits amid higher dispersion in performance.

However, we have added back modest risk, with valuations returning to recent lows. As in our high yield strategy, we continue to broadly favor higher-rated credit bands while holding an underweight to CCC credit. We believe that credits in lower-quality credit bands present more vulnerability given their heightened sensitivity to recessionary periods. We have selectively increased exposure to Single B loans that should offer attractive carry and used tighter BB and softer CCC credits as a source of funds. From a sector perspective, we are holding overweights in Aerospace and Leisure/Gaming, which have benefited from resilient consumer spending on travel services. The portfolio also remains overweight Energy, albeit at lower levels as a result of continued headwinds from commodity prices, U.S. recessionary concerns, and a slower-than-anticipated pace of China’s reopening activity.

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Glossary & Index Definitions

Credit Spread is the spread between Treasury securities and non-Treasury securities that are identical in all respects except for quality rating.

Yield Curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The most frequently reported yield curve compares the three-month, two-year, five-year and 30-year U.S. Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth.

The U.S. 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.

The Credit Suisse Leveraged Loan Index is designed to mirror the investable universe of the U.S. dollar-denominated leveraged loan market.

The ICE BofA U.S. High Yield Constrained Index tracks the performance of U.S dollar denominated below investment grade corporate debt publicly issued in the US domestic market. Qualifying securities must have a below investment grade rating (based on an average of Moody’s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, at least one-year remaining term to final maturity as of the rebalancing date, a fixed coupon schedule and a minimum amount outstanding of $250 million.

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