Leveraged Finance Asset Allocation Insights: Issuer Selection Is Key as Loans’ Edge Over High Yield Moderates

• We currently favor floating-rate asset classes (bank loans and CLO debt tranches) relative to fixed-rate asset classes (such as high yield bonds) but believe those trends will largely equalize over the remainder of the year. Spread differentials still support bank loans over high yield.

• With a larger portion of the loan market trading above par, however, repricing activity has increased, and we are more neutral with respect to our asset mix between high yield and loans. We are instead focused on issuer selection and are actively participating in new issues in both markets.

• We’re currently finding value in the following areas: In high yield, the CCC and below segment shows elevated dispersion, as measured by the proportion of bonds with spread levels more than 400 basis points above or below average index spreads; loan yields are still in the 9%-10% range, which is attractive on a risk-adjusted basis, with superior relative value in the B-flat and B+ rating segments; and in CLOs, given tighter valuations and risks that are tilted to the downside, we remain positioned higher in the capital stack overall, with more selective exposure to A and BBB credits.

• We still expect the Fed to cut interest rates in the second half, and while we believe this will initially spur a rally, at that point portfolio positioning will depend on which side of the Fed’s dual mandate is more prominent: Was it a policy adjustment, or a defense against deteriorating employment trends?

US inflation was unexpectedly strong in the first quarter, leading to prolonged higher interest rates and halting the rally in risk assets. Real domestic final sales also remained robust due to firm income growth, supported by government employment and easier financial conditions following the Fed’s fourth-quarter policy shift. This helped sustain strong service consumption even as excess savings declined.

These demand factors are likely to diminish as the year goes on, however. Notably, the reacceleration of inflation is only partly due to strong demand, while supply-side strength appears more enduring. Manufacturing is now showing signs of recovery, as goods inventories have cleared, ending the rolling recession that started in early 2023.

January's inflation surge was largely due to challenging seasonal adjustments. Overall, the inflation increase in the first quarter seemed less connected to domestic inflationary pressures, which are not expected to persist. In April, consumer price inflation moderated. Core Consumer Price Index (CPI) inflation rose by the expected 0.3%, with the annual figure dropping from 3.8% to 3.6%, the lowest level in three years. Although April’s inflation figures are still above the Fed's targets, they are moving in the right direction after previous setbacks. We still expect to see the first Fed rate cut in the second half of this year, but further cooling in the labor market is likely needed for this to happen.

Meanwhile, April retail sales were disappointing, with the biggest decline seen in online sales, which had been a bright spot in prior months. The next move for the Fed is clearly cuts, and while believe this will initially spur a rally, at that point portfolio positioning will depend on which side of the Fed’s dual mandate is more prominent: Was it a policy adjustment, or a defense against deteriorating employment trends?

This has been a strong earnings season for leveraged credit, with many more companies beating than missing EBITDA expectations. We have seen a rally so far this month in both the high yield and leveraged loan markets. High yield has outperformed given the rally in Treasury rates.

From here, we favor floating-rate asset classes (bank loans and CLO debt tranches) relative to fixed-rate asset classes (such as high yield bonds) but believe those trends will largely equalize over the remainder of the year. Spread differentials still support bank loans over high yield. However, with a larger portion of the loan market trading above par, repricing activity has increased, and we are more neutral with respect to our asset mix between high yield and loans. We are instead focused on issuer selection and are actively participating in new issues in both markets.

Key Data

Source: Bloomberg as of 20 May 2024. High yield represented by the Bloomberg US Corporate High Yield Index, spread is OAS and yield is yield-to-worst. Leveraged loans represented by the Credit Suisse Leveraged Loan Index, spread is discount margin 3-year and yield is yield-to-maturity. CLO represented by the JPM Post-Crisis CLOIE, spread is discount margin to worst and yield is yield-to-worst.

High Yield Bonds

The resilient macro outlook continues to support our expectation for a modest increase (but no spike) in defaults. From a bottom-up perspective, first-quarter earnings results suggest solid fundamentals, with increasing consumer credit stress offset by strong employment trends. Normalization of supply chains is largely complete in the US. Fundamental strength in credit metrics appears to have peaked but from relatively high starting levels, and we believe this strength will persist despite a more restrictive monetary backdrop.

From a valuation standpoint, average spreads at the index level continue to be at the tighter end of our fair-value range. For most issuers, the market is pricing in a soft- to no-landing scenario, with little material probability of a hard landing. However, the lowest-quality segment (CCC rated and below) is bifurcated, with many issuers cut off from new capital in both the private and public markets. Their balance sheets require significant improvement, with half the segment experiencing negative free cash flow and debt-to-enterprise value ratios of 85% or higher. Many of these issuers are already engaged in liability management exercises (or are rumored to be). As a result, we favor a selective approach to CCC and lower-rated issues.

Nonetheless, while spreads are toward the tighter end of our fair valuation range, with higher all-in yields, a lower average dollar price, and solid issuer fundamentals, we believe the high yield market presents an attractive total return option for longer-term investors.

The CCC and below segment shows elevated dispersion, as measured by the proportion of bonds with spread levels more than 400 basis points above or below average index spreads. This historically has not been the case when index spreads are trading relatively tight. The first chart below shows the level of dispersion relative to all monthly time periods since 1998. The second chart focuses on time periods when the index OAS was trading at or inside of 350 basis points. On the second chart, the y-axis indicates the option-adjusted spread on the Bloomberg US High Yield Index, while the x-axis shows the proportion of CCC rated bonds trading more than 400 basis points outside of average index spread levels, with the darker blue dots indicating observations from December 2023-April 2024. Typically, when overall index spreads are tight, dispersion among CCC rated issuers is relatively low. However, this is currently not the case. Again, the elevated dispersion underscores the need for a highly selective approach.

For CCC Issues, We Favor a Highly Selective Approach

Source: ICE BofA as of 30 April 2024.

Source: OAS is from Bloomberg as of 30 April 2024; dispersion of CCC rated bonds is from ICE BofA as of 30 April 2024.

Leveraged Loans

Leveraged loans should continue to perform well over the next six to 12 months as issuer fundamentals benefit from the resilient economic backdrop and technicals provide support for loan prices. For investors, a higher-for-longer rate environment should keep loan yields well above the historical average.

Earnings season for loan issuers is underway, and broadly speaking, results are pointing to a continuation of revenue and EBITDA growth. However, loan performance is still bifurcated. Issuers with over-leveraged balance sheets or that are facing shifting secular trends are seeing their loan prices gap down in response to disappointing results.

Defaults and distressed exchanges picked up slightly in April, but absent a broader economic downturn, this activity will likely remain concentrated among weaker credits that do not have access to traditional capital markets. For loans trading below 80, a typical threshold for distress in the loan market, the weighted average bid price has continued to trend lower, highlighting both the difficult operating environment for these issuers and expectations for lower recoveries. In contrast, the average bid price for the broader loan market has trended higher year to date, with approximately 65% of the Morningstar Leveraged Loan Index trading at par or higher as of 16 May 2024.

The Weighted Average Bid Price Is Trending Lower for Distressed Loans

Average bid price: loans below 80

Source: Morningstar as of 16 May 2024.

The technical backdrop for loans remains strong, with no signs that supply/demand dynamics will shift in the near term. Demand for loans continues to outpace new issue supply. Net loan supply will remain limited as elevated financing costs continue to sideline mergers/acquisitions and leveraged buyouts. Loan issuers are still focused on liability management, with opportunistic transaction activity including repricings and refinancings setting a record pace year to date. In terms of demand, collateralized loan obligation (CLO) formation remains steady; April was the second-busiest month for CLO issuance in roughly two-and-a-half years. CLO issuance continues to be supported by tighter CLO liability spreads as well as healthy demand for the asset class. Retail loan funds, another source of demand for leveraged loans, have also seen net inflows accelerate in recent weeks.

With much of the loan market trading near par in the current environment, bottom-up credit selection based on a credit research-intensive process will remain paramount. However, loan yields are still in the 9%-10% range, which is attractive on a risk-adjusted basis, with superior relative value in the B-flat and B+ rating segments. In addition, interest rate futures are pricing in less than two 25-basis-point rate cuts from the Federal Reserve in 2024, which would leave base rates just below 5% and keep loan yields elevated on a historical basis for the next several quarters.

CLOs

CLO new issuance has continued at a record pace as managers take advantage of tighter liability spreads, with AAA secondary spreads at the tightest levels since April 2022. CLO prices in the secondary market have increased dramatically so far this year, with the average price of AAA to A rated CLO paper now trading above par. Loan prices are also elevated, with over 60% of the loan market now trading above par. Amid tight spreads and high asset prices, refinancing and reset volumes have continued at a torrid pace, with $56.1 billion pricing through April, already exceeding the volume in four of the past five full years.

Although the potential universe of refi/reset candidates has shrunk materially given the level of activity already this year, should the loan and CLO markets continue to rally, we would expect to see more portfolios benefit from the significant redemption optionality in CLOs. However, given the dispersion we’re seeing in the loan market, certain CLO portfolios holding weaker credits, particularly deals that are out of their reinvestment periods, could eventually experience impairments to the lowest-rated debt tranches, even if the majority of the loan market continues to rally. As a result, vintage, portfolio, and manager selection remains key.

Demand has kept pace despite the strong overall supply, with investors largely looking past tight spreads and continuing to seek out high all-in yields provided by CLOs, which we expect to remain at attractive levels given more muted rate-cut expectations. Demand for new paper has also been bolstered by investors who need to reinvest proceeds from amortizing, called, refinanced, or reset deals. The rapid increase in the size of the CLO ETF market was another tailwind, growing from roughly $2 billion at the start of 2023 to over $11 billion today. This has led to even tighter spreads and should limit the potential for any extreme near-term spread widening in a downside scenario.

Overall, we expect CLO spreads to trade in a range for the next three to six months given the supportive technical backdrop, and we view spreads and yields as attractive in most market scenarios over the next 12 months. Given tighter valuations and risks that are tilted to the downside, we remain positioned higher in the capital stack overall, with more selective exposure to A and BBB credits. Should prices increase further above par for A and BBB credits, we would expect to begin derisking portfolios, looking for opportunities to once again add exposure to lower mezzanine tranches once spreads begin to widen.

Average Price of AAA to A Rated Tranches Rose Above Par for the First Time Since June 2018

CLO average price by rating

Source: JP Morgan CLOIE Index as of 16 May 2024.