Market expectations for the terminal fed funds rate for this cycle settled around 5 percent between October 2022 and January 2023 after a few encouraging Consumer Price Index reports, which caused the sector to rally. The Credit Suisse Leveraged Loan Index delivered a total return of 2.3 percent in the fourth quarter, bringing the annual return to -1.1 percent. Investors are cautiously optimistic about the end of the hiking cycle, with a Fed pause and rate cuts baked into futures market pricing starting in the second half of 2023.
Despite recent inflows into bank loan-focused strategies, investors remain concerned about the potential lagged impact of higher short-term rates and a deteriorating macroeconomic environment on loan issuers. Fueling these concerns is the accelerated pace of credit rating downgrades that occurred as economic projections moved lower. S&P LCD reports that 277 U.S. institutional loans were downgraded in 2022 versus 164 upgraded, the worst 12-month trailing ratio since April 2021. December saw 30 downgrades versus just seven upgrades.
Bank loans from nearly all sectors suffered rating changes in 2022, including industrials, consumer discretionary, healthcare, communication services, and technology, each with more than 20 downgrades. The two sectors somewhat spared were materials and energy, with only six and three downgrades each, respectively. Industry concentrations explain some of the trend, but a big factor is the unique macroeconomic tailwinds and headwinds that each industry faces. Revenue underperformance, margin pressure brought on by higher costs, and near-term risk of a liquidity squeeze were all frequently cited by S&P analysts. Rating outlooks provide a warning sign that more rating cuts may come. In the index, 164 loan issuers have a negative outlook by S&P while just 51 have a positive outlook. Sectors like retail and consumer goods appear most at risk, which corroborates the macro trend in consumer preferences for services spending over goods.
While the negative rating migration trend is likely to continue, we see opportunity in select sectors and issuers that offer some element of safety. We favor issuers with contracted revenue streams, senior secured first lien positions with modest leverage, players with strong market share, and issuers with adequate liquidity over the next 12 months. Investors will need to tread carefully, but opportunities exist given leveraged loans’ cheapness relative to history, with discount margins in the 50th percentile of historical observations, and yields the most attractive in the past decade.
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