First Eagle Commentary- Alternative Credit: 2Q23 Review
The higher cost of capital is weighing on borrowers
Summary
- With March’s bank failures seemingly contained, markets refocused their attention on the hawkish rhetoric coming from the Federal Reserve.
While equity market conditions grew relatively placid in the second quarter, interest rates bounced sharply off post-bank failure lows as hawkish Fed rhetoric re-established itself as the dominant driver of sentiment.
The higher cost of capital is weighing on borrowers, and the default rate on broadly syndicated loans is near its long-term average. Rating agencies, meanwhile, continue to downgrade paper at a rapid clip.
Loan supply and demand were both challenged in the quarter. Pronounced volatility and higher interest rates continued to stymie new-loan issuance, while limited M&A activity has disrupted what is usually a reliable pipeline of borrowers. Collateralized loan obligation (CLO) formation ground to a halt, as high loan prices and expensive financing has made investing in these structures less compelling.
- We have been de-risking the portfolio in various ways over recent quarters and expect to remain defensively positioned until greater clarity emerges.
The resulting rise in interest rates during the second quarter, combined with a dearth of new-loan supply, continued to be supportive of the leveraged loan market, which is on track for its best year since the global financial crisis. The Credit Suisse Leveraged Loan Index delivered a total return of 3.1% for the quarter, while the Bloomberg US Corporate High Yield Index was up 1.7% and the Bloomberg US Aggregate Bond Index fell -0.8%.1
As it was last quarter, uncertainty was the primary driver of second quarter activity in the leveraged credit markets. Without greater certainty around a range of issues—monetary policy and the tug of war between recession and inflation perhaps chief among them—it’s difficult to see a significant rebound in transaction volume, and still-tight spreads suggest to us that the incremental reward for additional risk is not terribly compelling.
Higher Cost of Capital Continues to Weigh on Credit Fundamentals
It increasingly has been a tale of two markets in the US, as signals coming from the equity and fixed income markets appear to have fallen further out of sync. Given strong year-to-date returns and volatility at pre-Covid levels, equities appear to be pricing in a soft landing for the economy as the Federal Reserve continues to wage war against inflation. Fixed income markets, however, are flashing warning signs. The yield on two-year Treasuries backed up during the quarter to the 5% level that preceded March’s bank failures, further inverting the yield curve, while measures of interest rate volatility remained elevated.2
While fixed income markets had seemed to coalesce around the “higher for longer” narrative toward the end of the first quarter, mid-March’s bank failures called into question the Fed’s willingness to follow through on this strategy amid such systemic fragility, pulling rates lower across the curve. While this notion dominated market action for the next several weeks, rate sentiment began to shift with the Fed’s May 3 policy meeting. Though the 25 basis point increase, which brought the federal funds rate target to 5–5.25%, was dubbed by some as a “dovish hike” given the messaging that accompanied it, rhetoric from Fed governors in the days and weeks that followed made it clear there was still work to be done in the fight against inflation.
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Disclosures
I/we have no positions in any stocks mentioned, and have no plans to buy any new positions in the stocks mentioned within the next 72 hours. Click for the complete disclosure
