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Despite some negative press about the bank loan market, we maintain a more constructive view. Critics have highlighted perceived weaker quality among bank loans, predicting a heavy default environment. They’ve also argued that lower interest rates could be on the horizon, which paired with lower coupons, could impact bank loan investors negatively.
We, on the other hand, believe that today’s valuations compensate investors for the heightened default risk. Further, we agree that declining rates would impact bank loan coupons, but we don’t view this as a risk until 2024 at the earliest, if at all in the next 12 – 18 months.
With the Morningstar/LSTA Leveraged Loan Index at an average price of US$94.2 as of June 30, we believe loan prices imply a significantly worse economic outcome than we expect over the next 12 – 18 months. While we acknowledge the weaker credit quality of the asset class relative to previous cycles, the current roughly six-point discount in bank loan prices already reflects the market’s expectations for heightened defaults and losses. In fact, a price of US$94.2 implies a default experience equal to the worst-ever trailing 12-month default experience for the loan market.1 We think this is an unlikely outcome and the loan market has more than priced in an economic slowdown already.
Additionally, with a 5.00% –5.25% federal funds rate, banks tightening lending conditions, and one of the most inverted Treasury curves in history, it’s a tough environment to bet on capital appreciation. As a result, we believe that focusing on income, which can act as a buffer in more volatile markets and significantly help drive total returns, could be prudent.
As of June 30, the Morningstar/LSTA Leveraged Loan market had a yield to maturity of 10.4%. This represents an attractive level of income, but one that also offers meaningful downside protection. For example, to offset that high level of income, the loan market would need to experience a default environment more than twice as great as the highest 12-month default rate in loan market history, or dollar prices would need to fall to global financial crisis or COVID pandemic-type levels. In our view, this type of event is unlikely, and we believe that investors could be well served by the high current income of loans and the downside protection they afford.
We believe many market participants are overestimating the negative impact of declining rates on bank loan coupons. On June 14, the US Federal Reserve (Fed) paused its interest-rate-hiking cycle, keeping the federal funds rate at 5.00% – 5.25%, but at the time of writing, no rate cuts are priced in for the balance of 2023.
As Figure 1 shows, the median dot on the Fed “dot plot” calls for two more rate hikes in 2023 and maybe only about 100 basis points of cuts in all of 2024. However, the estimates for when the Fed will begin cutting rates have been pushed out on more than one occasion, and we believe it’s increasingly probable that the first rate cut could be more than 12 months away. With a double-digit yield to maturity, we see attractive levels of income being paid out in the loan market today. If rates do come down in 2024, we would expect a gradual decline.
Additionally, as we saw in 2001 and 2007, any future interest-rate cuts would likely suggest that the Fed has pushed too hard and tight credit conditions have impacted jobs and earnings. As Figure 2 illustrates, in the last two recessionary rate-cutting regimes, bank loans have outperformed the S&P 500 Index in the six months, 12 months, and 24 months after the first interest-rate cut. While today, that first cut is likely far off, this is an important nuance that we believe the market is underappreciating. Historically, in periods of recessionary rate cuts, bank loan income has outperformed the capital depreciation experienced in the equity markets.
In our view, the bank loan asset class presents a compelling opportunity at present. Current valuations are attractive and bank loans could potentially provide some downside protection relative to other risk assets over the next 12 months.
With double-digit yields and trading at a roughly six-point discount to par, we believe bank loans may offer attractive levels of income and have priced in an overly bearish macroeconomic view. What’s more, fears of interest-rate cuts appear overstated given recent guidance from the Fed. However, when the Fed does eventually cut rates, we believe the income from bank loans may help cushion the blow of a declining earnings environment and blunt the drawdown relative to equities.
1 Average ultimate recovery rate for term loans between 1987 and 2022 was 71.7% and highest trailing 12-month issuer-weighted speculative-grade default rate for US loans was 12.03%, in November 2009. Assuming defaulted loans get the average ultimate recovery rate of 71.7% and all non-defaulted loans trade at 97.25, the Morningstar Leveraged Loan Index average price of US$94.2 implies a default rate of 12% (12% × 0.717 + 88% × 0.9725 = 94.2).
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