The leveraged loan trading market has been on a tear this year — the Morningstar LSTA US Leveraged Loan Index has achieved equity-like returns in 2023 as interest rates have soared to levels not seen since before the Global Financial Crisis. On the flip side, this performance is supported by a languishing new-issue market which, in running at 14-year lows, has taken a back seat to secured funding in the high-yield market and increasingly, private credit.
In light of the impressive secondary market rally, and with borrower companies increasingly turning to private credit to finance transactions that in the past would have been done in the syndicated loan market, LCD asked a roster of buyside, sellside and advisory accounts for their view on what to expect going forward. Will fund allocations targeting leveraged credit favor private credit, or broadly syndicated markets? Will credit conditions tighten, or ease?
Some of the headlines:
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Inflation is not expected to fall below the 2% Fed target in the year ahead;
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Leveraged credit fund allocations are expected to favor private credit;
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Leveraged loans are projected to outperform high yield in Q4;
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The loan default rate is expected to fall between 2.50-2.99% a year from now.
See also our interactive graphic of the survey results.
In terms of credit conditions for leveraged companies funding via broadly syndicated loans and high-yield bonds in 4Q23, 36% of respondents said they expect credit conditions to be unchanged, 34% said they expect a moderate easing of credit conditions, and 25% saw a moderate tightening in the final leg of 2023.
Sentiment here has shifted. In the Q2 reading, nearly half (48%) of survey respondents saw a moderate tightening of credit conditions for leveraged companies funding via broadly syndicated loans and high-yield bonds in the second half of 2023.
In a new survey question, respondents were asked, in the year ahead, whether they expect fund allocations targeting leveraged credit to favor broadly syndicated loans and high-yield bonds over private credit, or vice versa.
Perhaps unsurprisingly, given that private credit has been taking market share from the broadly syndicated loan market at an accelerated pace over the past several years, an overwhelming majority, at 82%, believe fund allocations targeting leveraged credit will favor private credit over broadly syndicated loans and bonds. The results indicate that the trend (as LCD data shows) of private credit transactions financing loans that in the past would have been done in the syndicated loan market — including refinancings and buyout deals — will continue to accelerate in the year ahead.
Nevertheless, as one loan underwriter commented, “Banks hit the brakes in [the first half of the year] and [will now] have pressure to add assets so volume will increase, credit conditions will loosen, and leverage will creep up.”
Amid what has been a stellar year for leveraged loans in the secondary market, a significant majority believe floating-rate loans will outperform high-yield bonds in the fourth quarter.
At the time of polling, the year-to date return of the Morningstar LSTA US Leveraged Loan Index had crossed an impressive threshold, topping 10%. It has been the strongest year for the asset class since 2009, when the leveraged loan market was recovering from the steep losses of the Global Financial Crisis. High-yield bonds, by comparison, had returned 6.45% as of Sept. 22.
Leveraged loan returns have surged as interest rates climbed to levels not seen since before the GFC, contributing to significant interest returns for the floating-rate asset class, and as the limited new-issue supply has supported secondary prices.
In terms of survey results, 70% said leveraged loans would continue to outperform high-yield bonds in the fourth quarter, up from 52% in the Q2 read.
In another new question this quarter, LCD asked respondents which ratings bracket in leveraged loans will outperform in Q4. Results were evenly split between double-B rated loans (45%), and single-B rated loans (43%). Only 11% said triple-C rated loans would outperform. This would be a reversal of recent trends. Triple-C rated loans, which account for roughly 7% of the index, were up 2.01% in August, the fifth consecutive monthly gain. In the year to date this cohort has gained 13.23%, putting it far ahead of double-B and single B sub-indices, and reversing the 12.24% loss in 2022.
Respondents remained steadfast in their view on market volatility, with 55% believing that the worst of the volatility is ahead of us, in line with 57% in the Q2 reading, but down from 80% in Q1.
As for when Fed policy makers will begin cutting rates, 45% of survey respondents said the Fed would not cut rates until the third quarter of 2024. In the Q2 reading, 55% said the Fed would not cut rates until at least the second quarter of 2024.
Regarding leverage multiples for buyouts, 55% of respondents said leverage will remain at similar levels in the fourth quarter. A year ago, 60% of respondents said they expected leverage multiples of buyouts to decrease.
Despite an improving macro backdrop, with expectations growing for a soft landing and lower inflation, and despite rallying secondary market valuations, respondents remain wary of deteriorating fundamentals impacting credit portfolios. Results show survey participants, in equal measure at 20%, believe defaults & restructurings and the rate environment will most likely impact credit portfolios in the next six months. Downgrades and rising funding costs followed, each at 11%.
In the Q2 survey, defaults and restructurings was the top answer, at 20%, after receiving just 5% of votes in the Q1 survey. The rate environment took second billing in Q2, at 15% of the total votes.
To gauge expectations on the technical landscape in the quarter ahead, LCD asked market professionals their views regarding retail demand for leveraged loans.
The results showed significant improvement in sentiment, with 50% expecting moderate inflows to return in the fourth quarter.
In the Q2 survey, 47% said they expected outflows would moderate in the third quarter, and 28% expected moderate inflows to return. As it turned out, a modest $91 million inflow to ETF and loan mutual funds in August broke a 15-month streak of net withdrawals from the asset class, with the pace of withdrawals easing throughout the quarter, according to Morningstar data.
Reflecting expectations for the return of market volatility, 61% said they believe the Morningstar LSTA US Leveraged Loan Index has not hit its lows of the cycle.
Regarding inflation, the majority (55%) of respondents expect it to be 3.0-3.9% a year from now. Almost 32% think inflation could fall to 2.0-2.9%.
No respondents said they expected inflation to fall below the Federal Reserve’s 2% inflation target.
Polling shows Technology and Healthcare — two sectors with an outsized index share and share of distressed loans — also took the most votes for sectors that would most likely outperform in the next six months, with a respective 16% and 14% of responses.
Finally, with leveraged loan default rates rising roughly 100 bps over the last 12 months, LCD once again asked respondents where they think the default rate will be one year from now. Their 12-month forward forecast for leveraged loan defaults was unchanged from the Q2 survey, at between 2.5% and 2.99%. At the 2.75% midpoint, this would push the loan default rate slightly above its 2.70% historical average.
At the end of August, the default rate by amount of the Morningstar LSTA US Leveraged Loan index dipped 20 bps, to 1.55%, from 1.75% in July.
Featured image by Marco Bottigelli/Getty Images
This article originally appeared on PitchBook News
