A clear consensus heading into the final stretch of this tumultuous year is that positioning for leveraged credit remains bearish.
Even with hopes of a seasonal Santa Claus rally, LCD’s quarterly Leveraged Finance Survey shows that the majority still believe the Morningstar LSTA US Leveraged Loan Index has yet to plumb its lows of this cycle, and that the worst of the volatility remains ahead of us.
With markets increasingly hawkish as to what it will take to rein in inflation, and the prospect of higher rates (and soaring debt-refinancing costs) leading to slowing growth and lower earnings, LCD once again surveyed buy-side, sell-side and advisory professionals to gauge sentiment for the leveraged finance year ahead. The full results of the polling, which closed on Sept. 19, are detailed below.
Some of the headlines:
- The majority of respondents believe the U.S. leveraged loan market, per the Morningstar Index, has yet to hit cycle lows;
- The leveraged loan default rate is expected to surpass 1.5% by 3Q23;
- Inflation in a range of 3–3.9% is expected one year from now;
- Loan outflows from retail investors are expected to moderate.
An interactive graphic of the complete survey results can be found here.
The questions, and market responses:
Deteriorating sentiment toward leveraged credit risk is clear to see in loan retail fund flows. The value of assets under management at US ETF and mutual funds has fallen nearly $20 billion since May’s global market selloff, per LCD and Lipper.
With that in mind, LCD asked market professionals about their expectations for retail demand in the leveraged loan asset class. The results show that 42% believe outflows will continue, but that the pace will moderate. Some 24%, meanwhile, think the market could see a return to moderate inflows, and 18% expect outflows to accelerate.
Only 4% believe significant inflows will return to leveraged loans in the fourth quarter.
For a third consecutive quarter, LCD asked respondents whether leveraged credit markets are past the worst of the volatility. In the Q3 reading, 60% believe that the worst of the volatility is still ahead of us. This compares to 56% in the Q2 reading and 35% in the Q1 read.*
Given that outflows are expected to continue and volatility is expected to worsen before stabilizing, respondents unsurprisingly believe secondary market valuations still have a way to fall.
Despite the Morningstar LSTA US Leveraged Loan Index losing 2.56% year-to-date through Sept. 26, 62% of the market believes it has yet to hit its lows of the cycle. The average leveraged loan bid at 91.75 on July 6 was the lowest reading in almost two years. Leveraged loan prices have since partially retraced this year’s losses, to 92.67 (as of Sept. 26), but the market remains well below its 10-year average bid price of 96.40.
That said, one sell-side banker in an open comment option says investors could soon see a buying opportunity. “Spreads and base rates sufficiently shocked the system in the past nine months and as the Fed slowly curtails inflation, more investors will gain confidence in the value of select institutional opportunities, and spreads will tighten.”
For the first time since the market rebounded from the pandemic default wave of 2020, “credit quality risks” jumped in the total of responses for potentially impacting credit portfolios within the next six months. With an option to select up to three choices, credit quality took 18% of the votes, up from 9% in Q2. This comes as companies rated B-minus, for the first time, now make up the largest share of the $1.4 trillion leveraged loan index.
The top-three events seen as most likely to impact credit portfolios in the next six months were unchanged, though in the Q3 read, recession surpassed inflation as most likely to impact credit portfolios, with 22% of all responses (up from 19% in Q2). Falling to second place in Q3, from first place in Q2, potential inflation risks took 20%, from 25% in Q2. Rate environment came in third, at 19%.
On the topic of leveraged buyouts, a buy-side respondent notes the potential for a “material slowdown in fundraising,” citing “the denominator effect impacting LP [Limited Partner] capacity for new private debt commitments.”
To that end, the majority (60%) of respondents once again said they expect leverage multiples of buyouts to decrease.
Given rising interest rates and weakening tolerance for risk, the vast majority of leveraged finance professionals (69%) expect that private equity firms, at the deal level, will increase equity contributions to get buyouts over the finish line.
With rates and inflation 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 are expecting US inflation to correct lower (inflation being the main driver behind the Fed’s current rate-hike policy). The highest share, at 31%, believe inflation will be between 3% and 3.9% by 3Q23. In the Q2 reading, the highest share (35%) expected inflation would be between 4% and 4.9% in 2Q23.
Nevertheless, in the open comment option, one buy-side analyst cautioned: “This is the first confluence of events whereby the appropriate tools are unclear.”
If current market volatility persists, borrowers might turn to private debt over the broadly syndicated market in even greater numbers, sources said, citing the cleaner execution of transactions and relationship-driven nature of the private market. On the pricing front, with funding costs rising in broadly syndicated loans, LCD asked survey participants what degree of spread tightening — in addition to any difference in spread that already might exist, compared to direct deals — might be needed to attract a transaction currently under consideration in the private debt market back to broad syndication.
Of those that opted to respond to the question, 62% said it would need to be enough to bring the syndicated loan spread below that of the private credit loan, while 26% said pricing needed to be in line with private credit loan spreads, meaning like for like, the majority think issuers would choose the option of private credit if spread levels are comparable between the two structures.
For some perspective, the average new-issue spread of buyout-related term loans launched into the broadly syndicated market widened to roughly Sofr+500 in the last six months, versus Sofr+416 in January. At the same time, the new-issue yield-to-maturity, which takes into account the base rate, CSA (if applicable), spread and original issue discount, surged to more than 8%, from under 5%.
Despite recession fears and a stronger US dollar weighing on energy prices, Energy once again came out on top for the sector most likely to outperform, garnering 21% of the votes, edging up from the Q2 and Q1 readings. Energy, returning 2.93% in the year to date through Sept. 23, is one of the few bright spots in the loan index. Healthcare again takes the second-largest share of the votes, at 15%, unchanged from Q2. An interesting jump to third place was seen for the Technology sector, with 15% of responses, versus 10% in Q2.
In this final question, asked every quarter by LCD, responses showed a more negative skew with respect to potential default activity in the Q3 reading, versus the Q2 polling period.
Leveraged finance professionals expect the loan default rate, as measured by the Morningstar LSTA US Leveraged Loan Index, to rise from the ultra-low, Sept. 30 rate of 0.86% (by amount), to 1.50–1.99% by 3Q23. For reference, this would put defaults closer to the 10-year historical average of 1.89%.
At the Q2 reading, participants said they expect the default at 2Q23 to climb to 1–1.49%.
* Note that Q3 survey results are calculated from two choice options, versus four in the 2Q22 survey.
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