Editor's note: This article was recently published by LCD, the leading outlet for analysis and data on the leveraged-loan market. PitchBook has deepened its private market coverage through parent company Morningstar's acquisition of LCD, which was completed last month. Read more about PitchBook and LCD joining forces.

There's very little the first half of 2022 hasn't thrown at investors: chaotic market action, plunging risk valuations, Russia's war on Ukraine, rising recessionary risk, and the Federal Reserve's aggressive rate hikes, to name a few challenges.

While cheaper valuations after a brutal quarter for returns could provide a silver lining, LCD's Leveraged Finance Survey of buy-side, sell-side and advisory professionals shows the majority are still bracing for an even rougher road ahead.

Some of the headlines:

• Share of respondents forecasting recession skyrockets

• Leverage multiples of buyouts set to decline

• The worst of the volatility is yet to come

• Default rate to remain well below historical average

Even with the cheapening of valuations, LCD's survey finds market watchers are not necessarily viewing this as a buying opportunity. In fact, the majority of respondents believe the worst is yet to come.
 
The survey from June 17 to 27 shows a dramatic deterioration in sentiment among LCD's polling base, with 56% responding that the worst of the volatility is still ahead. This compares to 35% in the first-quarter reading.

"Interest rate increases will exacerbate the market turmoil leading to less—and more challenging—credit availability," a respondent at an advisory firm noted in a request for comment option.
 
On the topic of rate increases, a potential positive from LCD's survey is that market pros are expecting inflation to correct lower (inflation being the main driver behind the Fed's current rate-hike policy). Some 35% believe inflation will be between 4% and 4.9%, and 28% say it will be between 3% and 3.9% a year from now. Only 16% think inflation will be between 5% and 5.9%, and 13% see inflation above 6%.

Though a much more moderate rate of inflation is generally expected than the 8.6% CPI increase recorded in the 12 months through May (a near-40-year high), for the Federal Reserve, inflation running in excess of 4% makes unleashing its monetary toolkit a difficult proposition should a recession unfold.

To that end, more than half of respondents see at least a 75% chance of a U.S. recession in the next 12 months. In another clear deterioration of sentiment, at the first-quarter poll, only 9% saw a 75% (or higher) chance of recession.

A quarter of respondents expect inflation to be the biggest driver of credit portfolio performance, nearly unchanged from 22% in the first quarter and 21% in the fourth quarter of 2021.
 
Recession, at 19% of all responses, was the second most-cited factor to impact portfolio performance, and the rate environment, in third place, received 17% of the responses.

With headwinds of inflation, rising rates and escalating funding costs persisting into the second quarter, and with oil prices maintaining a support level above $100, the top two sectors that market pros expect to outperform in the debt markets over the next six months were unchanged. Aggregated results from LCD's polling put energy once again at the top spot, at 20% of responses. Amid defensive positioning and growing fears of a hard landing, healthcare again came in second, with 15% of the votes.
 
With inflationary pressure and higher oil prices impacting the cost of goods and, in turn, household disposable income, once again consumer discretionary was deemed least likely to outperform, polling results show.

Changing tack, with private equity-backed M&A a lifeblood of leveraged finance issuance, LCD asked institutional investors whether they are likely to allocate more, less or the same amount of capital to private equity funds in the third quarter. Only 24% of buy-side respondents said their firms are likely to allocate more to PE funds, while 32% said they would allocate less.
 
Nearly half, at 44%, said they are maintaining their allocations. This is as PE funds remain supported by a near-record $731 billion of dry powder at year-end 2021, according to PitchBook.

With that in mind, a sell-side respondent wrote in: "[There is] too much capital looking to be put to work in PE that will drive supply," adding that "there is attractive yield potential in relative terms [for investors] in floating rate structures."

Driving private equity deal flow for the remainder of 2022, according to LCD's polling base, will be dry powder levels, economic drivers (encompassing recession/inflation/funding costs) and sector-specific trends.
 
In the face of rising funding costs, "many existing portfolio companies refinanced at attractive rates in 2021," one buy-sider writes. "Some sponsors proactively refinanced with fixed-rate debt or are hedging to achieve a fixed rate to insulate from the rising rate environment."

The recent shift higher in funding costs following the Fed's move away from its near-zero interest rate policy will of course impact the underlying investment environment for PE.

With risk tolerance clearly diminishing (as shown in the dramatic slowdown of leveraged loan and high-yield bond issuance), the vast majority of leveraged finance professionals (73%) expect that private equity firms will increase equity contributions to get deals over the finish line.
 
On the plus side for debt funding, "high-yield is in a tough spot with rates, but leveraged loans should recover once we find some level of support in the broader market," a sell-side respondent comments.

Typically, a median leverage ratio of 6x or greater in leveraged lending has attracted regulatory scrutiny. According to LCD, leverage levels supporting buyouts in 2022 have matched the high of 5.9x recorded in 2021 and 2019. Respondents, however, expect the tide to change, with 75% now believing that leverage levels for new deals will decrease. In the first-quarter survey, only 38% thought a decline in leverage levels would be in the cards.
 
While sentiment has clearly declined, especially with respect to volatile market conditions and even recessionary pressure in the year ahead, the good news is that the pain of defaults is not expected to be a trouble spot for some time yet.

Leveraged finance professionals expect the loan default rate, as measured by the S&P/LSTA Leveraged Loan Index, to rise from a near-record low of 0.21% in May to between 1% and 1.49% a year from now. Note that this still sits well below the long-term average of 2.77%.
 
The primary reason, as already noted, is the relative lack of maturities coming due, with issuers having taken full advantage of low benchmark rates in 2021 to refinance debt.

Per LCD, the volume of loans due in 2022-2024 was just $138.6 billion, against a backdrop of about $1.4 trillion in outstanding loan paper.

Nevertheless, this debt remains a concern for the longer term. "Cheap financing and no covenants combined with challenged EBITDA and net profit will keep a zombie pool of companies that are just trying to make it for the next 3-5 years," a buy-side respondent commented.

On that note, with the bear market cycle upon us, the massive growth of private credit—and any impact during a downturn—will largely take place away from public view. This was a concern noted by many respondents in the open comment section.

Comments range from private credit being less transparent and not rated by credit rating agencies, to expectations that "[p]rivate lenders will increasingly replace syndicated loans, especially second liens."

Another weighs in: "Private lending dry power and appetite—or the ability for deals to get done without the banks underwriting" will impact broadly syndicated loans.

To wrap up, respondents see potentially better times ahead with respect to inflation, and defaults are not a worry for the 12-month horizon. On the other hand, headwinds of (still high) inflation, rising rates, tightening financial conditions and a slowing economy are still driving what is expected to remain a volatile market.

Featured image by Spencer Platt/Getty Images

This article originally appeared on PitchBook News