Floating-Rate Leveraged Loan Yields Should Remain Attractive Even as Rate Cuts Begin

With US inflation starting to ease and economic growth slowing but still resilient, the Fed is poised to start cutting rates before year-end. And though demand for floating-rate assets is typically driven in part by the direction of short-term interest rates – with lower rates often translating into lower demand – we think this rate-cutting cycle may be different.

The magnitude of interest rate cuts should remain moderate and the pace measured, as the economy remains on relatively stable footing and the Federal Reserve continues to be data dependent. Our expectation is that the federal funds rate stays well above its post-financial-crisis average over the near to medium term.

So what does this mean for the leveraged loan market? In this soft-landing scenario, loan fundamentals should remain stable, with revenue and earnings growth slowing but still positive and default rates remaining near current levels. Loan market technicals are strong, and while they may soften slightly, we expect demand to remain supportive of loan prices.

As the chart shows, broadly syndicated leveraged loans are currently yielding around 9.5%-10%, with discounted loan spreads in the 430-450 basis point area and SOFR around 5.3% (near the low end of the fed funds target range). As the Fed starts cutting, base rates will come down, but the decline should mirror the measured pace of such cuts: Implied forward one- and three-month SOFR are expected to remain near or above 4% over the course of the next 12 months. This suggests that even with a 150-basis-point drop in the fed funds rate 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 remain rangebound.

Loan Yields Are Likely to Remain Elevated Even as Rates Fall

Source: Pitchbook Factsheet as of 30 June 2024 (Loan YTM represents year-end figure for Morningstar LLI Index); Bloomberg as of 23 July 2024 (fed funds rate represents high end of range; all figures at year-end except for June 2024).

The main takeaway for investors is that with loan fundamentals stable against a positive technical backdrop, we expect broadly syndicated loans to continue to offer high-single-digit yields over the near term.

With that said, not all loans are created equal and careful credit selection remains an important driver of returns. Managers with a bottom-up, research-intensive process to selecting credits are best positioned to outperform.