2. Bank loan fundamentals: Jeff Heuer
The bank loan market is coming off a period of historically strong credit performance, including default rates of less than 1%, according to Leveraged Commentary & Data. My view is that defaults will increase from current low levels closer to their historical average range of 3% – 4%, peaking over the coming 12 – 18 months. Even within the context of potentially higher defaults, there are three reasons I think the current credit cycle is healthy:
- Broadly speaking, fundamentals across the sector are starting from a strong place;
- Many issuers have been able to successfully “pass through” persistent inflation; and
- Most defaults are triggered by liquidity problems, an area where many issuers are in good standing today.
Taken together, I expect there to be heightened spread volatility as the market digests the path of future defaults, but the absolute level of likely defaults appears manageable and consistent with historical default cycles in which the CLO asset class has performed well.
3. Bank loan spreads: Dave Marshak
Bank loan investors are generally compensated for default risk through correspondingly higher credit spreads and an illiquidity premium. Bank loan spreads ended September at 665 bps, in the 86% percentile historically.2 To put that in the context of expected defaults, this level of spreads implies a five-year cumulative default rate of 49%, which is almost twice as high as the worst five-year default experience since 1990 (27%).
In my view, market illiquidity is driving spreads and income to draconian levels, creating what I anticipate will be a favorable environment for capital deployment in the loan market over the next 12 – 18 months. This may present opportunities for skilled credit selection to potentially drive enhanced returns.