This Rate-Cut Cycle Is Different: Why It Bodes Well for Leveraged Finance

• Our base case is that we are entering a rare non-recessionary rate-cutting cycle that should support the performance of leveraged finance assets over the next 12 months.

• High yield bond defaults appear to have peaked and are expected to decline, while leveraged loan defaults, including liability management exercises (LMEs), should remain near historical averages.

• CLOs are now much more dominant buyers of leveraged loans than in years past, which supports demand and makes loans more resilient from a technical standpoint. CLOs continue to see strong demand given high all-in yields.

• Despite our favorable overall outlook for this cycle, we believe careful credit selection will be a key driver of returns.

Leveraged finance assets have tended to take a hit during rate-cutting cycles, largely because cuts are often accompanied by recessionary environments, which typically lead to a spike in default rates for high yield and leveraged loan issuers.

This time around, however, things look much different. We are entering this rate-cutting cycle at a time when economic growth, while slowing, remains firm, unemployment is relatively low, and the chances of a soft landing are high – an economic picture that remains supportive of leveraged finance, particularly given the health of public corporate credit fundamentals entering this easing cycle.

Past Rate-Cut Cycles Have Coincided With Recessionary Conditions

Source: Federal Reserve Board of Governors, Bureau of Economic Analysis, and Bureau of Labor Statistics as 1 August 2024. https://fred.stlouisfed.org/graph/?g=2hh

We expect default trends, particularly in high yield, to improve against this backdrop rather than deteriorate, as in typical cycles. High yield defaults appear to have peaked already and are expected to decline, while leveraged loan defaults, including liability management exercises (LMEs), should remain near historical averages.

Fed rate cuts are a source of stimulus that will likely improve corporate credit statistics and allow companies, particularly those with significant floating-rate debt, to lower their cost of capital and offset the negative impact of a slowing but non-recessionary macro environment.

While credit spread valuations are currently tight, we expect a narrower band of potential spread widening even under a more pronounced downside recession scenario, and any market dips will likely attract investors as buying opportunities across leveraged finance credit. We see limited potential for price appreciation at current valuations, and returns will be primarily driven by attractive absolute yields.

Leveraged loans and CLOs are positioned to weather this cycle

Investors may be concerned that as the Fed lowers rates, yield and current interest on leveraged loans and CLOs will decline. Yet given the shape of the short end of the yield curve, floating-rate debt will reset from extremely elevated levels relative to fixed-rate debt toward levels that are still very attractive but more in line with historical norms. Furthermore, floating-rate credit spreads are much wider than equivalently rated fixed-rate debt, though potential convexity would be given up in the trade-off.

As the chart shows, as of September 2024, broadly syndicated leveraged loans were yielding around 9.0%-9.5%, with discounted loan spreads in the 420-450 basis point area and one-month SOFR around 4.85% (near the low end of the fed funds target range). As the Fed cuts, base rates will come down, but the decline should mirror the measured pace of such cuts. This suggests that even with a further 150-basis-point drop in the fed funds rate (which would exceed our base case) and a similar decline in SOFR, all-in loan yields should remain above the recent historical average (see dotted line in the chart) if discounted spreads stay rangebound.

Loan Yields Are Likely to Remain Elevated Even as Rates Fall

Source: Pitchbook Factsheet as of 30 September 2024 (Loan YTM represents year-end figure for Morningstar LLI Index); Bloomberg as of 30 September 2024 (fed funds rate represents high end of range; all figures at year-end except for September 2024).

Looking at fundamentals, a key benefit of rate cuts to the leveraged loan market is that a subset of issuers – particularly loan-only capital structures – have experienced constriction in cash flows due to high floating-rate interest service requirements. Falling rates will provide immediate relief, benefiting cash flows and in turn improving the fundamental debt service ratios and outlooks for these issuers.

It’s also critical that CLOs are now much more dominant buyers of leveraged loans than they were even a decade ago, which supports demand and makes loans more resilient from a technical standpoint. CLOs continue to see strong demand given high all-in debt tranche yields, which we expect to persist through year-end. Moreover, in addition to the traditional investor base of insurers, banks, and money managers (among others), the CLO market has also benefited from the growing presence of CLO exchange-traded funds.

High yield is on solid footing

High yield credit quality has been improving, with the market largely shunning new issuance of CCC rated debt, marking a big change from bullish periods of prior decades. While we believe investors should be cautious of triple-C exposures, we expect B and BB rated bonds to perform quite well over this cycle. Moreover, high yield defaults appear to have peaked and are broadly expected to come down over the next year or two.

BB to B Rated Issuers Make Up a Larger Share of the High Yield Bond Market

Source: BofA Global Research High Yield Credit Chartbook as of 30 September 2024.

High Yield Bond Defaults Have Likely Peaked

Source: BofA Global Research (defaults) and NBER (recession periods) as of 30 September 2024.

Fixed-rate high yield bond spreads are compressed relative to comparable loans and CLOs, and market quality has improved as it has become BB-heavy. Because high yield does have some positive convexity with many bonds trading at a discount to par, as the yield curve comes down, the value of that convexity comes closer to being in the money. The result is that even though yields on high yield bonds are currently around a 24-month low, the total yield remains attractive and the standard market convention, yield-to-worst, understates the value of the positive convexity. The combination of more BB issuers, price discounts, and higher base rates relative to the pre-hiking period all contribute to stability for the asset class under a more adverse downside recession scenario.

Moreover, the duration profile of the high yield market is also historically low, which should provide additional stability to the market.

A novel rate-cut cycle

Our base case is that we are entering a rare non-recessionary rate-cutting cycle that augurs well for the performance of leveraged finance assets over the next 12 months. While a hard landing could occur if unforeseen events upend our expectations, we view this as a lower-probability tail risk. We also acknowledge additional policy and geopolitical risks on the horizon, but these factors are more likely to affect industry subsegments and individual issuers rather than having a broad market impact under most scenarios.

Therefore, despite our favorable overall outlook for this cycle, we believe careful credit selection remains a key driver of returns – and that a research-intensive, bottom-up process may best position portfolios to outperform in any environment.