/institutional/perspectives/sector-views/bank-loans-loan-dilemma-of-higher-interest-rates

Bank Loans: The Loan Dilemma of Higher Interest Rates

The pros and cons of short-term interest rates going deeper into restrictive territory.

November 10, 2022


This Bank Loans sector report is excerpted from the Fourth Quarter 2022 Fixed-Income Sector Views.

Average prices declined by 0.4 percent in the third quarter, but coupon income helped total returns for the bank loan sector to bounce back with a return of 1.2 percent. This partially reversed the 4.4 percent loss in the second quarter, bringing the Credit Suisse Leveraged Loan Index return to -3.3 percent as of Sept. 30.

Demonstrating that loans are not immune to the Fed’s rate hikes, discount margins tightened 100 basis points from June through mid-August and then widened 100 basis points from mid-August through September as the Fed prepped the market for, and then delivered, its second 75 basis point rate hike at the end of the quarter. Three-year discount margins, the conventional way to express risk premium in loans, ended the quarter at 668 basis points, the 92nd percentile of historical valuations dating back to 1992, and 200 basis points above the historical average. Part of the reason that discount margins are wide versus history is due to the sector’s weakening credit profile (i.e. more single Bs than ever before), but even controlling for ratings, we find risk premiums are wide. As the Fed goes further into restrictive territory, the negative credit impact to loan issuers will worsen as interest payments rise.

Our analysis finds that the median loan interest coverage ratio (the ratio between annual cash flow and interest expense) could fall to less than 3.0x if the fed funds rate rises to 5 percent and earnings growth slows to 5 percent. A near threefold increase in the loan market default rate, from 1.3 percent to 3.5 percent in the next 12 months, is our base case expectation. Looking through the full cycle, we believe defaults could peak around 6-7 percent of the market in 2024 based on the lagged effects of tightening financial conditions and a U.S. recession. This would exceed the COVID peak default rate of 4.6 percent and would be comparable to the 2008 default cycle in terms of length. Since investors typically recover about 60 percent of their loan value in default situations, we estimate the cumulative credit loss rate in loans to be around 4 percent in the next two years. Discount margins at 668 basis points, some of which compensates for limited market liquidity, exceed our loss estimate.

We believe loans remain a compelling place for credit exposure due to attractive yields and discounted prices. We are increasingly selective on new purchases as recession risks rise heading into 2023, and look to make defensive allocation adjustments as the end of this cycle comes more clearly into view.

Bank Loan Interest Coverage Ratios

Interest Coverage for Given Coupon Reference Rate

Our analysis finds that the median loan interest coverage ratio (ratio between annual cash flow and interest expense) could fall to less than 3.0x if the fed funds rate rises to 5 percent and earnings growth slows to 5 percent. A near threefold increase in the loan market default rate, from 1.3 percent to 3.5 percent in the next 12 months, is our base case expectation.

Bank Loan Interest Coverage Ratios

Source: Guggenheim Investments, S&P LCD. Data as of Q2 2022. EBITDA - earnings before interest, taxes, depreciation, and amortization.

—By Christopher Keywork and Maria Giraldo

 
Important Notices and Disclosures

This material is distributed or presented for informational or educational purposes only and should not be considered a recommendation of any particular security, strategy or investment product, or as investing advice of any kind. This material is not provided in a fiduciary capacity, may not be relied upon for or in connection with the making of investment decisions, and does not constitute a solicitation of an offer to buy or sell securities. The content contained herein is not intended to be and should not be construed as legal or tax advice and/or a legal opinion. Always consult a financial, tax and/or legal professional regarding your specific situation.

This material contains opinions of the authors, but not necessarily those of Guggenheim Partners, LLC or its subsidiaries. The opinions contained herein are subject to change without notice. Forward-looking statements, estimates, and certain information contained herein are based upon proprietary and non-proprietary research and other sources. Information contained herein has been obtained from sources believed to be reliable but are not assured as to accuracy. Past performance is not indicative of future results. There is neither representation nor warranty as to the current accuracy of, nor liability for, decisions based on such information.

Investing involves risk. In general, the value of fixed-income securities fall when interest rates rise. High-yield securities present more liquidity and credit risk than investment grade bonds and may be subject to greater volatility. Asset-backed securities, including mortgage-backed securities, may have structures that make their reaction to interest rates and other factors difficult to predict, making their prices volatile and they are subject to liquidity risk. Investments in floating rate senior secured syndicated bank loans and other floating rate securities involve special types of risks, including credit risk, interest rate risk, liquidity risk and prepayment risk. Loans are often below investment grade, may be unrated, and typically offer a fixed or floating interest rate.

Guggenheim Investments represents the following affiliated investment management businesses: Guggenheim Partners Investment Management, LLC, Security Investors, LLC, Guggenheim Funds Distributors, LLC, Guggenheim Funds Investment Advisors, LLC, Guggenheim Partners Advisors, LLC, Guggenheim Corporate Funding, LLC, Guggenheim Partners Europe Limited, Guggenheim Partners Japan Limited, GS GAMMA Advisors, LLC, and Guggenheim Partners India Management.

©2022, Guggenheim Partners, LLC. All Rights Reserved. No part of this document may be reproduced, stored, or transmitted by any means without the express written consent of Guggenheim Partners, LLC.

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VIDEOS AND PODCASTS

2022’s Upside: The Fed Has Put the Income Back in Fixed Income 

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Anne Walsh, Chief Investment Officer for Guggenheim Partners Investment Management, joined Asset TV to discuss macroeconomic conditions, risk, and relative value in the bond market.

Macro Markets Podcast 

Macro Markets Podcast Episode 26: Mortgage-Backed Securities, Structured Credit, Market Liquidity

Karthik Narayanan, Head of Securitized for Guggenheim Investments, discusses value in the residential mortgage-backed securities market and other ABS sectors. Anne Walsh, Chief Investment Officer for Guggenheim Partners Investment Management, answers a listener question on liquidity. Jerry Cai, an economist in our Macroeconomic and Investment Research Group, brings the latest on the labor picture and an update on China.







© Guggenheim Investments. All rights reserved.

Guggenheim Investments represents the following affiliated investment management businesses of Guggenheim Partners, LLC: Guggenheim Partners Investment Management, LLC, Security Investors, LLC, Guggenheim Funds Distributors, LLC, Guggenheim Funds Investment Advisors, LLC, Guggenheim Corporate Funding, LLC, Guggenheim Partners Advisors, LLC, Guggenheim Partners Europe Limited, Guggenheim Partners Japan Limited, GS GAMMA Advisors, LLC, and Guggenheim Partners India Management.