Loans: Weighing Yields And Risk
Summary
- The U.S. loan market is off to a strong start in 2023, with the Morningstar LSTA U.S. Leveraged Loan Index returning 3.06% year-to-date through February.
- Overall, Morgan Stanley reported recently that current loan yields are in the 96th percentile of their range since 2002.
- Fundamentally, we believe the loan market remains healthy based on debt leverage and interest coverage.
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By Joe Schurer
Favorable loan market technical, combined with “higher-for-longer” interest rates, could provide an attractive tailwind for leveraged loans.
The U.S. loan market is off to a strong start in 2023, with the Morningstar LSTA U.S. Leveraged Loan Index returning 3.06% year-to-date through February.* The U.S. CLO market generally represents about 70% of loan demand, and brisk CLO formation has helped market dynamics. Thus far, 52 U.S. CLOs have been issued for $22.6 billion, up about 15% year-over-year and their second-highest level (except 2021) since the Global Financial Crisis. Meanwhile, supply has not been ample enough to satisfy loan investor demand as new issue supply related to mergers and acquisitions, which typically fuels the growth of the loan asset class, was only $9.6 billion in the first two months of the year - the slowest pace since 2010. For reference, the institutional leveraged loan market financed $61.7 billion of M&A activity in the first two months of 2022 before market conditions deteriorated. We expect supply to remain light in the near term as continued macroeconomic uncertainty hampers dealmaking, leaving loan investors with little clarity as to when net positive supply will return for the new-issue market.
Despite this rally, we believe loan yields continue to look attractive as the loan markets’ floating base rate has consistently increased, with the one-month Secure Overnight Financing Rate now at 4.72%. Relative to similarly rated high yield bonds, loan yields are appealing, with BB rated loans at 7.9% versus BB bonds at 7.2%, B rated loans at 10.2% versus B bonds at 8.7%, and the overall non-distressed index at 9.4% for loans compared to 7.9% for high yield. Overall, Morgan Stanley (MS) reported recently that current loan yields are in the 96th percentile of their range since 2002.
Fundamentally, we believe the loan market remains healthy based on debt leverage and interest coverage. That said, the sector’s rolling three-month number of downgrades is three times that of upgrades, while its default rate recently exceeded 1% for the first time since June 2021. So, the “higher-for-longer” interest rate environment may make leveraged loans well positioned to deliver above-market yields with durable income generation, but we believe strong credit selection and active management are likely to be vital to manage risk.
* All loan data sourced from PitchBook/LCD except where noted; bond yields sourced from Bloomberg.
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