Leveraged Loan Market Update: A Time to Be Selective

The volatility that plagued the leveraged loan markets during the second quarter has continued, leading to a rocky start to the back half of 2022. While spreads still look relatively attractive, greater divergence between credits calls for robust, issuer-specific due diligence and a selective investment approach.

The Morningstar LSTA Leveraged Loan Index saw two months of significant declines in May and June amid volatility that rocked all risk asset classes. This was followed by a strong bounce back in July and August, with solid technical demand from collateralized loan obligations (CLOs) and calmer investor sentiment, notwithstanding some retail outflows.1 In September, however, we again saw strong correlations between the leveraged loan market and other risk assets, including high yield bonds and equities, which have experienced bruising selloffs as a whole on the back of the Fed’s continued hawkish tone. The loan market returned negative 2.27% in September and is now down 3.25% year-to-date.2

At the same time, results from the second-quarter earnings season revealed that fundamentals in the loan market were somewhat better than expected. Revenue and EBITDA growth continued across the broader loan market, with some volatility in sectors such as retail and parts of health care. Earnings growth generally trailed revenue growth, primarily because of inflationary pressures hitting companies’ input and labor costs.

Credit fundamentals have weakened somewhat, but off a solid base

Against this backdrop, we are beginning to see some deterioration in credit quality. The rate of credit rating downgrades relative to upgrades is increasing,3 and defaults are also picking up, with more defaults in August and September than in the rest of the year combined.4 That said, many of the recent defaults affected credits that were previously trading at distressed levels, so they did not come as a surprise, and fundamentals still look decent for the overall market.

Inflation remains a headwind, yet despite the recent uptick in defaults, many issuers have been able to weather higher input and interest costs. The weighted average interest coverage ratio at the end of the second quarter was over 5x on a trailing basis, up significantly from where it was in the early pandemic days of first-quarter 2020, when EBITDA plummeted; however, it had declined to roughly 4x on a three-month basis as of the end of the third quarter.5 (For reference, interest coverage is a financial measure that helps inform investors of an issuer’s ability to pay the interest owed on its debt).

Interest costs had been unnaturally low until recently, given zero or near-zero base rates. However, with short-term rates notably up over the course of this year and continuing to climb, and earnings coming under pressure, we expect interest coverage ratios to keep falling. A report by JP Morgan6 from earlier this year estimated that the portion of the loan market with interest coverage of 1.5x or lower, which is most at risk of default, could increase to 32% with a 400-bp increase in the federal funds rate, a scenario that today may be on the conservative side given current rate forecasts.

The question on many investors’ minds is how long the leveraged loan market can withstand high and rising interest rates before they would become a widespread issue, given the ongoing macro headwinds. While a year of elevated rates may not pose problems for the market as a whole, two or three years could cause significant deterioration in interest coverage ratios, in our view.

Such concerns may explain, in part, the continued retail outflows from leveraged loans despite the rising interest rate environment, when loans would typically look more attractive and experience inflows. The biggest factor in the negative flows, however, is likely contagion from the recent general risk-off sentiment as central banks remain hawkish and recession fears mount.

Key investor takeaways

While we are seeing some deterioration in the loan market as downgrades accelerate and defaults rise, we believe any near-term volatility arising from a slowing economy may allow asset managers to take advantage of increased dispersion in potential issuer returns through selective buying.

At the level of security selection, we favor companies and sectors with recurring revenue streams, which should fare well in a recessionary environment. These include certain technology and software credits. We also see select opportunities in health care. While health care generally does well in low-growth or recessionary conditions, the sector must be approached with caution and careful risk analysis. Some areas of health care, including providers, face regulatory and legislative headwinds, and many segments are grappling with higher labor costs and difficulty finding workers in the current tight labor market. That said, a recessionary environment accompanied by higher unemployment could actually help these segments by increasing competition for jobs and thereby lowering labor costs.

Airlines and some other travel-related segments should also do well with the continued increase in business and leisure travel coming out of the pandemic.

On the flip side, we believe cyclical sectors including retail, automotive, and other consumer discretionary-related segments will continue to face pressures as demand slows. The same holds true for industrials, which may have performed well over the past couple of years but will likely see pockets of weakness going forward. In addition, certain segments of the chemicals sector are experiencing a slowdown in demand while also facing pressure from rising input costs that will weigh on margins.

We are also seeing significant divergence in return potential within sectors, with widely disparate investment prospects even among credits and companies operating within the same lines of business. Disparities in management strength, business models, and competitive dynamics within regions, along with differences in loan terms, underscore why it's critical for asset managers to conduct rigorous issuer-specific due diligence and have a strong understanding of loan documentation.

We believe further volatility lies ahead given the slowing economy and persistent recession fears, conditions that could spell a continued rise in loan defaults. Even so, fundamentals are starting on solid footing overall, credit spreads still look relatively attractive in a historical context, and with base rates at the highest level in years, loans are yielding in the high single digits.  Additionally, despite expectations for higher defaults, loans continue to benefit from their senior position within the capital structure. All told, it's a period in which greater dispersion between credits calls for thoughtful security selection to tap select opportunities.

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