The loan market experienced a volatile May and June this year, with total returns of -2.5 percent and -2.1 percent, respectively—their worst monthly performances since March 2020. For the second quarter bank loans were down 4.3 percent in total return, bringing year-to-date returns to -4.4 percent. We continue to see opportunities in loans, but with the Fed set to raise short-term interest rates into restrictive territory, we are closely watching how this affects issuers.
Loan issuers kicked off 2022 on strong footing, fundamentally speaking, with median interest coverage ratios around 4.7x. Rate hikes are likely to erode interest coverage as coupon payments increase. If short-term rates rise to 3.5 percent, we estimate that median coverage would fall from 4.7x to 3.0x assuming no earnings growth, a harsh assumption given public loan issuer earnings were up 15 percent year over year in the first quarter. A 3x interest coverage ratio would still be viewed as healthy for a single issuer, but it hides peripheral stress if this is the index median. History shows that when the loan market median interest coverage is near 3x, about 10 percent of loans had coverage of less than 1.5x and approximately 37 percent had coverage between 1.5x–2.9x. As interest coverage fades, net positive credit rating migration will turn increasingly negative. The second quarter was the first three-month period where downgrades outpaced upgrades since January 2021.
For several reasons, including issuance trends and the economics of collateralized loan obligations, the leveraged loan market has seen a dramatic increase in loans rated just one notch above CCC+ since 2018. Historical data show that the three-year cumulative default probability of a B- loan and CCC+ loan is the same at 9 percent, but it increases to 19 percent for CCC-rated loans. That jump in default probability is the reason why these loans tend to see prices drop substantially at the end of cycles. This concentration in lower B-rated issuers presents a risk to the sector as recession probability rises.
Our portfolios are defensively positioned, and we have been focusing on staying up in quality. Higher-rated loans have outperformed lower-quality year to date, leaving our portfolios in what we believe to be a good position to look for relative value in the secondary market. We regard opportunities in discretionary and/or cyclical overlevered businesses with caution given the heightened risk of recession.
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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.
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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.