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At this point in the new year, we’re cautiously optimistic on the US bank loans asset class. While we see continued macroeconomic headwinds, we believe bank loans will likely rebound from last year’s negative total returns.
Why? Bank loans may offer an attractive level of income. They have coupons above 8% and prices in the low-90s, which provides capital appreciation potential. However, we don’t think now is the time to stretch for yield given weakening fundamentals amid the uncertain macroeconomic backdrop.
We believe approaching the bank loan market with a neutral to moderately defensive risk posture, with a strong emphasis on credit selection, is prudent given the macroeconomic environment. In our view, this approach has the potential to deliver attractive total and benchmark relative returns over the next 12 months.
At the time of writing, our base case is a mild global recession beginning toward the second half of this year. However, we believe the risk of a “rolling” recession — one where different sectors of the economy suffer downturns at different times — has increased. This would likely be more severe and could pose a stiffer headwind for bank loan issuers.
Last year, in an attempt to curb inflation, the US Federal Reserve (Fed) initiated an interest-rate hiking cycle that’s brought the US yield curve to its flattest point since the 1980s. Historically, an inverted US yield curve has preceded recession, supporting our view of slowing US economic growth in 2023.
While the pace of inflation has decelerated recently, it remains unclear where inflation will settle and the path of the Fed’s tightening cycle. On the plus side, credit growth, excess savings depletion, labor gains, and housing wealth all boosted consumers’ spending in 2022. The labor market remains tight and wage stickiness will likely be an important factor in the Fed’s decision making in 2023. Nevertheless, we don’t believe the true cumulative effects of tighter policy on consumers will take hold until mid-2023.
Bottom line: The macroeconomic landscape remains challenging and we expect global growth to continue to slow in 2023.
Today, bank loan issuer fundamentals are good. Corporate liquidity profiles are solid and credit profiles remain better than pre-pandemic levels, with strong interest-coverage ratios.
However, fundamentals are likely to weaken over the next six – 12 months as lagged policy effects work their way through the bottom-up economy. We anticipate continued pressure on lower-quality issuer profit margins, as higher costs might not be as easily passed on to a flagging consumer sector in 2023.
Bank loan issuer margins were compressed in 2022 partially due to higher financing costs amid rising short-term interest rates. Despite these trends bank loan issuer defaults remained low. As of 2022 year end, the bank loan market’s trailing 12-month par-weighted default rate was 0.7%.1
By the end of 2023, we expect defaults to be closer to 3% – 4% as a result of the deteriorating macroeconomic environment and weakening issuer fundamentals. However, we believe there are several factors that could temper the default experience, making for a relatively benign year overall. These include:
That being said, we’re more concerned with downgrade activity in 2023, which we expect to tick up as fundamentals weaken. Given the large collateralized loan obligation (CLO) demand for higher-quality loans, heavier-than-normal downgrade activity can put technical pressure on newly downgraded bank loans. As a result of this and the normalization of default rates from near historical lows, security selection will be increasingly important in the next 12 – 24 months.
As the Fed raised short-term rates in 2022, bank loan coupons increased significantly. Bank loan spreads also widened last year in sympathy with broader risk assets. As of 2022 year end, the bank loan market had a coupon of 8.14% and a three-year discount margin of 652 basis points, the 91st percentile of historical observations, according to the Credit Suisse Leveraged Loan Index.
While we believe the interest-rate hiking cycle is winding down, bank loans remain the potential beneficiary of persisting higher rates in the form of attractive income potential. Additionally, prices are in the low-90s, suggesting the possibility of price appreciation. Against this backdrop, we believe now may be an attractive entry point to gain bank loan exposure.
Amid broad macroeconomic uncertainty and considering where we stand in the credit cycle, we believe an optimal approach to the asset class could be a neutral to moderately defensive risk posture coupled with a strong emphasis on securities selection.
Current valuations, with both an attractive current income plus capital appreciation potential, offer compelling risk-adjusted return opportunities. With a disciplined approach, we believe bank loans may be able to deliver attractive total returns in 2023.
1Source: Morningstar/LSTA, 31 December 2022.
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