Our Macroeconomic and Investment Research Group expects a Fed easing cycle to start this year, which could impact the loan market in two ways. First, our view suggests that loan coupons could decline to 8.1 percent by year-end from the current level of 9.5 percent, keeping all else constant. We still view this as attractive, as prior to 2022, the last time coupons were near 8 percent was in 2008 when spreads were significantly wider. Second, an easing cycle helps lower interest expense for issuers, which will benefit interest coverage ratios. Assuming unchanged earnings, the median single B loan borrower could see their interest coverage ratio increase from 3.2x to 4.3x (with some lag) if the Fed lowers rates to 4.0 percent by the end of 2024, and even more if the easing cycle continues into 2025. We expect more distribution around the median interest coverage figure as some loan borrowers will struggle to adapt to interest rates remaining above 10-year average levels. Already, Pitchbook LCD’s figures show that the share of the market with coverage between 1.5x–2.99x has increased to 34 percent. But this high-level sensitivity exercise helps depict how strategies focused on well-positioned borrowers could benefit.
Attractive coupon return of 9.8 percent in 2023 plus a recovery in average loan prices brought the annual return of the Credit Suisse Leveraged Loan Index to 13 percent, the best annual performance since 2009. We believe the continued lack of market supply could support prices this year, which are averaging 95 percent of par.
Net supply in the primary market, often driven by leveraged buyout (LBO) activity, is likely to remain muted given the level of rates and the market’s limited appetite for high leverage. Most of the supply this year will likely be refinancing activity as loan issuers address maturities. Already in January, refinancing represented 75 percent of total volume.
We continue to find opportunities in loans given that yields and coupons are still attractive, and expect that loan prices could rally further. The backdrop is likely to result in more bifurcation and dispersion in the loan universe, which supports evaluating relative value opportunities on an issuer-by-issuer basis. An elevated degree of caution is warranted given the lagged effect of higher interest rates, highlighting the importance of re-underwriting key positions in industries that have been hurt by inflation and tight labor market dynamics and avoiding structures with unsustainable leverage.
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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, including the possible loss of principal. In general, the value of a fixed-income security falls when interest rates rise and rises when interest rates fall. Longer term bonds are more sensitive to interest rate changes and subject to greater volatility than those with shorter maturities. During periods of declining rates, the interest rates on floating rate securities generally reset downward and their value is unlikely to rise to the same extent as comparable fixed rate securities. High yield and unrated debt securities are at a greater risk of default than investment grade bonds and may be less liquid, which may increase volatility. Investors in asset-backed securities, including mortgage-backed securities and collateralized loan obligations (“CLOs”), generally receive payments that are part interest and part return of principal. These payments may vary based on the rate loans are repaid. Some asset-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 and valuation risk. CLOs bear similar risks to investing in loans directly, such as credit, interest rate, counterparty, prepayment, liquidity, and valuation risks. Loans are often below investment grade, may be unrated, and typically offer a fixed or floating interest rate.
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