Credit assets rebounded in the fourth quarter as improving inflation data sparked hopes that the end of the Fed’s rate-hike cycle may be near.
While leveraged loan market fundamentals have remained relatively resilient in the face of input cost pressures, a higher cost of capital and slowing economic activity, a rising distress ratio suggests trouble may lie ahead. Market technicals continued to be fairly favorable, as a decline in both the supply of and demand for loans kept the market in relative balance.
All-in yields for direct lending have seen a meaningful increase, driven by higher reference rates and larger original issue discounts.
- Given the heightened uncertainty in the market, we continue to be thoughtful about loan structuring. In such an environment, asset-based lending structures may represent a particularly attractive opportunity to put capital to work.
Credit assets rebounded in the fourth quarter as improving inflation data sparked hopes that the end of the Federal Reserve’s rate-hike cycle was near.
The broadly syndicated loan market, as reflected by the Credit Suisse Leveraged Loan Index, delivered a total return of 2.33% in the quarter and -1.06% for full-year 2022, compared with the Bloomberg US Corporate High Yield Index’s performance of 4.2% and -11.2%, respectively.1 Leveraged loan market fundamentals have remained relatively resilient in the face of input cost pressures, a higher cost of capital and slowing economic activity. Loan defaults by volume—a backward-looking indicator—pulled back in the fourth quarter and currently remainswell below historical norms. Meanwhile, market technicals were fairly favorable during 2022, as the supply of and demand for loans declined to keep the market in relative balance.
Current economic trends suggest issuance is likely to remain muted in 2023. The slowing economy should weigh on the enterprise value of companies while their cost of capital remains elevated, resulting in lower leverage ratios on new deals. Given the heightened uncertainty in the market, we continue to be thoughtful about loan structuring; notably, asset-based lending (ABL) structures may represent an opportunity to put capital to work for an attractive risk-adjusted return over the long term.
Market Fundamentals Hanging on
Markets in the fourth quarter embraced the idea that easing inflation and slowing economic growth would enable the Fed to conclude its tightening cycle at some point in the first half of 2023. Indeed, the 50 basis point hike announced in December was a deceleration from the 75 basis point pace that characterized the four hikes since June, and the 4.25–4.50% range at which the fed funds rate ended 2022 was well within shouting distance of the Fed’s current terminal rate forecast of around 5.1%. While Fed Chair Powell has taken pains to convey his intention to keep rates higher for longer, markets appeared not to be buying the rhetoric. Pricing in the futures markets suggests that while the fed funds rate may reach 5% or so in 2023, policy will at some point before the end of the year pivot toward rate cuts as economic growth continues to wane.2
Leveraged loan market fundamentals have remained relatively resilient in the face of input cost pressures, a higher cost of capital and slowing economic activity. A lot of this is likely due to borrower behavior in the cheap-money period following the outbreak of Covid-19. The vast majority refinanced debt at low rates, and some likely employed derivatives techniques like hedges and swaps to mitigate the impact of rising rates and extend the maturity of their debt loads. The maturity walls for this year and next are quite manageable as a result, and a variety of credit metrics remain well supported. For example, weighted average leverage is back to pre-pandemic levels and interest coverage remains ample. This number can shift quickly and dramatically as rates rise, however, and there can be significant differentiation across industries and among individual borrowers. Those with pricing power and the ability to pass along higher costs onto their customers should be better positioned to defend EBITDA levels and margins, as will companies with reasonable inventory levels.
Loan defaults by volume—a backward-looking indicator—pulled back in the fourth quarter and currently remains well below historical norms. This may belie trouble ahead, however, as the distress ratio—a forward-looking indicator that reflects loans trading for less than 80 cents on the dollar—ended the year at 7.4%, up from 5.8% at the end of the third quarter.3 Ratings agencies, meanwhile, appear to be taking a rather pessimistic view of credit performance going forward; credit actions turned negative midyear, and downgrades outpaced upgrades by nearly three to one by year-end.4 Lower ratings curb the demand for loans, particularly among the collateralized loan obligations (CLOs) that serve as their primary buyer, as the CLO structure is highly sensitive to the regula-tory limitations of their investor base (insurance companies, banks and asset managers). All told, a bias toward downgrades typically results in greater price volatility, fewer new issuance and refinancing challenges.
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