The volatility that plagued the leveraged loan markets during the second quarter of 2022 has continued, leading to a rocky start to the back half of the year. While spreads still look relatively attractive, greater divergence between credits calls for robust, issuer-specific due diligence and a selective investment approach.
The Morningstar LSTA US Leveraged Loan Index saw two months of significant declines in May and June 2022 amid volatility that rocked all risk asset classes. This was followed by a strong bounce back in July and August 2022, with solid technical demand from collateralised loan obligations (CLOs) and calmer investor sentiment, notwithstanding some retail outflows.
In September 2022, however, we again saw strong correlations between the leveraged loan market and other risk assets, including high-yield bonds and equities, which have experienced bruising sell-offs as a whole on the back of the US Federal Reserve’s continued hawkish tone.
The loan market returned negative 2.27% in September and is now down 3.25% year-to-date, according to the Morningstar LSTA US Leveraged Loan Index as of 30 Sept 2022.
At the same time, results from the second-quarter earnings season revealed that fundamentals in the loan market were somewhat better than expected. Growth in revenue and Ebitda (earnings before interest, taxes, depreciation, and amortisation) continued across the broader loan market, with some volatility in sectors such as retail and parts of healthcare. Earnings growth generally trailed revenue growth, primarily because of inflationary pressures hitting companies’ input and labour costs.
Credit fundamentals weakened somewhat, but off a solid base
Against this backdrop, we are beginning to see some deterioration in credit quality.
The rate of credit rating downgrades relative to upgrades is increasing. Defaults are also picking up, with more defaults in August and September than in the rest of the year combined.
That said, many of the recent defaults affected credits that were previously trading at distressed levels, so they did not come as a surprise, and fundamentals still look decent for the overall market.
Inflation remains a headwind, yet despite the recent uptick in defaults, many issuers have been able to weather higher input and interest costs. The weighted average interest coverage ratio at the end of Q2 2022 was over 5x on a trailing basis, up significantly from where it was in the early pandemic days of Q1 2020, when Ebitda plummeted; however, it had declined to roughly 4x on a three-month basis as of the end of the Q3 2022. (For reference, interest coverage is a financial measure that helps inform investors of an issuer’s ability to pay the interest owed on its debt).
Interest costs had been unnaturally low until recently, given zero or near-zero base rates. However, with short-term rates notably up over the course of this year and continuing to climb, and earnings coming under pressure, we expect interest coverage ratios to keep falling.
A report by JP Morgan from earlier this year estimated that the portion of the loan market with interest coverage of 1.5x or lower, which is most at risk of default, could increase to 32% with an increase of 400 basis points in the federal funds rate, a scenario that today may be on the conservative side given current rate forecasts.
The question on many investors’ minds is how long the leveraged loan market can withstand high and rising interest rates before they would become a widespread issue, given the ongoing macro headwinds.
While a year of elevated rates may not pose problems for the market as a whole, two or three years could cause significant deterioration in interest coverage ratios, in our view.
Such concerns may explain, in part, the continued retail outflows from leveraged loans despite the rising interest rate environment, when loans would typically look more attractive and experience inflows.
The biggest factor in the negative flows, however, is likely contagion from the recent general risk-off sentiment as central banks remain hawkish and recession fears mount.
Key investor takeaways
While we are seeing some deterioration in the loan market as downgrades accelerate and defaults rise, we believe any near-term volatility arising from a slowing economy may allow asset managers to take advantage of increased dispersion in potential issuer returns through selective buying.
At the level of security selection, we favour companies and sectors with recurring revenue streams, which should fare well in a recessionary environment. These include certain technology and software credits.
We also see select opportunities in healthcare. While healthcare generally does well in low-growth or recessionary conditions, the sector must be approached with caution and careful risk analysis. Some areas of healthcare — including providers — face regulatory and legislative headwinds, and many segments are grappling with higher labour costs and difficulty finding workers in the current tight labour market. That said, a recessionary environment accompanied by higher unemployment could actually help these segments by increasing competition for jobs and thereby lowering labour costs.
Airlines and some other travel-related segments should also do well with the continued increase in business and leisure travel coming out of the pandemic.
On the flip side, we believe cyclical sectors including retail, automotive, and other consumer discretionary-related segments will continue to face pressures as demand slows.
The same holds true for industrials, which may have performed well over the past couple of years but will likely see pockets of weakness going forward.
In addition, certain segments of the chemicals sector are experiencing a slowdown in demand while also facing pressure from rising input costs that will weigh on margins.
We are also seeing significant divergence in return potential within sectors, with widely disparate investment prospects even among credits and companies operating within the same lines of business.
Disparities in management strength, business models, and competitive dynamics within regions, along with differences in loan terms, underscore why it's critical for asset managers to conduct rigorous issuer-specific due diligence and have a strong understanding of loan documentation.
We believe further volatility lies ahead given the slowing economy and persistent recession fears, conditions that could spell a continued rise in loan defaults.
Even so, fundamentals are starting on solid footing overall, credit spreads still look relatively attractive in a historical context, and with base rates at the highest level in years, loans are yielding in the high single digits.
Additionally, despite expectations for higher defaults, loans continue to benefit from their senior position within the capital structure.
All told, it's a period in which greater dispersion between credits calls for thoughtful security selection to tap select opportunities.
This article was originally published by PineBridge Investments on 20 Oct 2022.
PineBridge Investments is a global asset manager focused on active, high-conviction investing. As of 30 June 2022, the firm managed US$141.1 billion across global asset classes for sophisticated investors around the world.
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