Jeff Boswell

Ninety One’s Multi-Asset Credit team explains how loans have lagged the recent rally in credit markets to create compelling valuations but warns investors to take care to limit exposure to an increasingly vulnerable segment of the mark.

The loan market looks relatively cheap, but higher rates are taking their toll and driving downgrades in the lower-quality segments. To limit exposure to downgrade risk, look to higher-quality loans or CLOs.

The context

Leveraged loans and CLOs (which package up a portfolio of loans) were a great source of return for active credit investors in 2023, given their floating-rate nature against a backdrop of rising rates. Furthermore, loan spreads have lagged the recent rally in credit markets to create compelling valuations. But the backdrop that helped loan investors harmed loan borrowers, which feel the pain of rate rises relatively early. As a result – and despite surprising macroeconomic resilience supporting corporate fundamentals overall – pockets of the loan market appear to be suffering.

Jeff Boswell, Head of Alternative Credit, Ninety One: “Since mid-2022, a fall in interest coverage levels^[1] is a key reason why loan downgrades by rating agencies have consistently outpaced upgrades. In 2023, the overall ratio of upgrades to downgrades was 0.5x in the US loan market – much worse than the 1.3x seen in the US high-yield market. As the chart shows, rating trends were weaker at the lower-rated end of the market.”

The CLO market has also seen these downgrades feed through to riskier tranches, but overall downgrade rates remain low. This is thanks to the in-built structural protection in CLOs, with diversified underlying portfolios helping to limit idiosyncratic risk. Further support comes from favourable deleveraging dynamics in the CLO market, as managers are increasingly returning cash to investors.

The conclusion

While valuations of CLOs and loans look broadly attractive, but Boswell warns that investors need to take care to limit exposure to a deteriorating tail of the market.

Boswell adds: “The less-impacted CLO market remains an appealing route to access leveraged loan exposure; we particularly like short-maturity CLOs, which are benefiting from a deleveraging tailwind. However, investors shouldn’t write off leveraged loans completely; parts of the market remain compelling – here, we think high-quality, short-dated loans continue to offer attractive yields with limited credit risk.”

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Notes:
[1] JP Morgan recently estimated that 9% of loans borrowers had interest coverage levels (EBITDA/interest expense) below 1x in 3Q 23, and 37% had coverage between 1x and 2x. This compares to 8% and 14% at the end of 2021.

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Jeff Boswell

While the third quarter began on a positive note, with a less hawkish tone from the US Federal Reserve stoking hopes of an imminent end to the rate-hiking cycle, a more volatile backdrop ensued. Markets ultimately priced in a ‘higher for longer’ interest-rate outlook, with the yield on 10-year US Treasuries rising to end the quarter 73bps higher at 4.57%.

Jeff Boswell, Head of Alternative Credit, Ninety One: “Global credit markets were buffeted by the large moves seen in sovereign bond yields in the third quarter, especially higher-duration assets. But significant divergence was evident in credit markets – both between regions and across asset classes – showcasing the rich diversity of global credit investment universe. The US investment-grade (IG) market clearly bore the brunt of the sell-off in government bonds; here, yields rose to 6.1% at quarter end – a level only seen a few times over the past 20 years. But not all credit markets fared so badly, and pockets of strength could be found in less mainstream markets.

“By way of example, collateralised loan obligations (CLOs) CLOs delivered strong total returns in Q3. Floating-rate coupons helped shield the asset class from the surge in risk-free rates, while tightening credit spreads further helped drive outperformance relative to other fixed income asset classes.”

Figure 1. US Collateralised Loan Obligation returns vs. comparable markets

Source: Ninety One, ICE Data Indices (for corporate bonds) and JP Morgan (for loans and CLOs). 30 September 2023.

At the top of the capital structure, AAA rated CLOs (USD) returned 2.4% in Q3, compared with a loss of 2.7% posted by US investment-grade corporate bonds. BBB rated CLOs returned 5.8%, compared with 0.5% for the US high-yield market and 3.3% for US loans. Euro CLOs also performed well relative to comparable corporate credit markets. There was an increase in CLO call activity in the quarter, with CLO equity holders in a number of deals opting to sell the underlying loans, repay the CLO debt and recoup the residual portfolio value. This is a trend is expected to continue over the next few months, which should be supportive of valuations of short-maturity CLO bonds.

Robust relative performance also continued in a closely related market – loans. US and European loans delivered returns of +3.3% and +4.1% respectively in the period, comfortably outpacing the US high-yield market. This brings US and European year-to-date loan returns to an impressive +10.0% and +11.5% respectively.  Boswell stated: “The technical backdrop for loans remains supportive, with subdued net new loan supply – due to a substantial majority of activity being refinancings/repricing orientated – meeting healthy demand, as the pace of CLO formation picked up notably in September and retail loan flows improved.”

The corporate hybrid (perps) and bank capital markets also posted a solid quarter. The former was helped by stable spreads and relatively high starting all-in yields, while the bank capital (or contingent convertibles) market comfortably outperforming comparable asset classes such as high yield over the quarter.

Boswell concluded: “Encouragingly, we have seen a continuation of most bank-capital issuers calling their bonds in 2023. Furthermore, stronger issuers continue to benefit from access to the market, with several new deals pricing and being relatively well received. Even so, we continue to see elevated risk premia in the sector, even relative to lower-rated asset classes such as high yield.  While we expect the sector to continue to recover, we currently prefer higher quality banks and instruments, where we think extension risk is still mispriced.”

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