This year’s rapid shift in market conditions and the macro-economic environment has changed the playbook for leveraged companies that have long funded against ultra-low benchmark rates. Moving into 2023, tougher financial conditions will, at best, require that companies pay more to raise or refinance debt. For the less solvent, prohibitive funding costs or a shunning of risk will heighten focus on the implications of ratings downgrades and credit losses.
As market players convalesce from the volatility of 2022, LCD asked a roster of buyside, sellside and advisory professionals for a view on the year ahead. When will institutional loan default rates exceed the historical average? Will high yield outperform leveraged loans? What will most likely impact credit portfolios? Has the Morningstar LSTA US Leveraged Loan Index hit its lows of the cycle? These are just a few of questions asked.
Some key takeaways:
- High-yield bonds seen outperforming leveraged loans;
- Significant majority believe the loan index has yet to hit cycle lows;
- Market watchers peg high-yield spreads wider;
- Loan default rate will remain below historical averages in 2023.
An interactive graphic of the survey results can be found here.
The default cycle of the 2020 pandemic is only just in the rearview mirror, but attention is turning, once again, to weakening corporate fundamentals and whether heightened liquidity needs will push the market into a full-scale default cycle.
In this survey, given between Dec. 1 and Dec. 9, LCD asked market professionals where they expect the US loan default rate (by amount) to be at the end of 2023.
LCD’s polling shows a median expectation that the loan default rate (as measured by the Morningstar LSTA US Leveraged Loan Index) will finish 2023 between 2% and 2.49%.
This compares to a default rate of 0.73% at the end of November.
One buyside analyst noted that “downgrades and triple-C bucket implications [with respect to CLOs] will be more consequential than actual defaults.”
Certainly, while the landscape for credit defaults is back on the radar, respondents expect defaults to be kept in check in 2023 since some of the excesses were flushed out in the 2020 default cycle. More importantly, respondents cite the heady pace of refinancings in 2021 and early 2022 that pushed out debt maturities and provided a stronger starting point for corporates to service their debt in the face of a slowing economy.
The overriding feedback from survey respondents on the topic of defaults is that the covenant-lite structure will (artificially) keep default rates low, though it’s the length of any default wave, rather than the spike, that would be of greater concern.
LCD’s polling shows 61% of market professionals expect the default rate of leveraged loans to reach the historical average of 2.73% (by amount) by the end of 2024. Some 30% said this would happen between 2025 and 2026.
“Leveraged loan documentation structure has been tightening but it is significantly weaker than historical average,” opined a buyside investor. “That is why we are below historical default rates. The true metric to track will be the loan recovery rate, which is expected to be lower due to weaker lender protections.”
Indeed, LCD’s analysis of S&P Global’s LossStats database has shown covenant-lite term loan facilities recover less than traditional term loans with maintenance covenants. Covenant-lite first-lien term loans issued after 2009 recovered 66% of par, versus 73% for all first-lien term loans.
Ultimately, the credit quality of leveraged loans, many of which are low single-B credits, may present an opportunity for distressed portfolios in time, but with the twelve-month default rate expected to be below historical averages, a full-scale credit default cycle is not a concern.
As a buyside investor put it, “liability management transactions may keep the default rate artificially low, [though they] still have a negative impact on returns and the market.”
To that end, LCD asked respondents which asset class would outperform, leveraged loans or high yield bonds.
By a low conviction of 55%, respondents expect high-yield bonds to outperform leveraged loans in the first half of 2023.
More risk, of course, typically means more outsized moves in times of volatility. High-yield bonds, as tracked by the Morningstar US High-Yield Bond TR USD Index, have lost 9% this year through Dec. 13, versus a loss of just 0.8% for loans in the Morningstar LSTA US Leveraged Loan Index.
Though market watchers expect high-yield bonds to outperform leveraged loans, 65% believe high-yield spreads will widen in the first half of 2023.
Speaking of volatility, LCD once again asked respondents whether they thought the worst of the volatility is behind us, or still to come. A clear majority, at 61%, say the worst of the volatility is still ahead. This is nearly unchanged from 60% in the third-quarter reading, but is less favorable than the second-quarter and first-quarter totals of 56% and 35%, respectively.
In terms of what will drive the markets, recession again takes the top spot, at 19%; the rate environment moves from third to second place, at 17%; and inflation falls from second to third place, at 14%. Those three have dominated the last three surveys.
More broadly, deteriorating sentiment was clearly evident in the flow of retail funds in 2022. The value of holdings at US leveraged loan funds fell by a total of $35.17 billion in the six months from May through October, according to Morningstar fund flow data and LCD.
With that in mind, LCD asked market professionals about their expectations for retail demand in the leveraged loan asset class. The results show that 36% believe outflows will moderate. This compares to 42% in the Q3 reading.
Meanwhile, 32% believe moderate inflows will return. This compares to 24% in the prior quarter.
Only 2% believe significant inflows will return to leveraged loans in the first half of 2023.
Despite the Morningstar LSTA US Leveraged Loan Index bouncing back by nearly 100 bps from its intra-year low of 91.75, 70% of respondents think the loan market has not yet plumbed the lows of this cycle. Sentiment around valuations in the loan market have deteriorated from the Q3 reading, when 62% said the index had yet to hit its low mark.
Next, LCD surveyed sentiment for the buyout landscape in 2023. In an open comment, a sellside broker points out that “there is significant capital on both the equity and debt side sitting on the sidelines,” but nevertheless, “either leverage levels need to rise, or enterprise values fall to help things loosen up.”
Per LCD’s polling, 75% of respondents once again said they expect leverage multiples of buyouts to decrease. This compares to 60% in the third-quarter survey.
Either way, “the high cost of capital is going to make it difficult for leverage to increase much from current levels,” the broker notes.
While enterprise value expectations from sellers may well need to come down, equity contributions might need to increase to get deals across the finish line. A vast majority of respondents (82%), when asked their expectations for average equity contributions in 1H23, said contributions for leveraged buyouts would need to increase. This is up from 73% in the second quarter.
Turning to private credit, even with the recent decline in activity, the asset class is still outpacing syndicated loan transaction volume, especially where riskier LBO loans are concerned, LCD data shows.
Respondents, citing the speed and certainty of execution relative to public markets, direct lending’s dry powder, and a lack of appetite at banks to underwrite risk, expect the shift to private credit to continue. Seventy-three percent believe pricing in the private credit markets will be competitive with terms available in the syndicated loan and public bond markets over the next six months, though “a sizeable liquidity premium is required for direct lenders,” per one buyside analyst.
With inflation still in the top three of events seen as most likely impacting credit portfolio performance, LCD again asked where market professionals expect inflation to be a year from now.
A potential positive here is that market pros expect US inflation to correct lower (inflation being the main driver behind the Fed’s current rate-hike policy), and the fourth quarter reading was more modest than in the last survey. Thirty-eight percent pegged inflation at 4.0-4.9% one year from now, and 35% expect inflation at 3.0-3.9%. Fewer expect inflation to be in the 5.0-5.9% range, with 19% of the Q4 votes, versus 27% in Q3.
Finally, with headwinds of recession fears, inflation, and escalating funding costs persisting into year-end, results to polling show that market professionals expect defensive sectors to outperform in the debt markets over the next six months.
Energy again took the top spot, at 15%. Utilities and Consumer staples tied with 14%, and Healthcare took fourth position, at 13%. Just 3% chose Consumer discretionary.
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