European loans in a sweet spot for higher income

With 2023 more than half over, it seems an appropriate time to take stock and look at the secured loan market performance year-to-date and expectations for the remainder of the year.¹

The mood around loans heading into 2023 was somewhat pessimistic given expectations for a material slowdown in economic activity. This was expected to impact lower rated companies more severely, combined with concerns that rising interest rates would materially impacted loan borrowers’ ability to service their floating rate debt.

Our view was cautious but not negative, as highlighted in the piece we wrote in January 2023 entitled:  ”Loans look-through: a year for income?”. We felt the key driver of return for loans would be the high coupons resulting from the increase in underlying cash rates.

This has indeed been the case and with investors across credit markets becoming less concerned about a hard landing for the global economy, we have seen some modest spread tightening since the start of the year (figure 1).

Whilst investor concerns have abated somewhat, inflation has continued to prove quite sticky and, as a result, central banks have been forced to continue to tighten monetary policy and push up short-term rates (figure 2). Loans as a floating rate asset class have continued to benefit from this.

Attractive yields offer buffer against economic uncertainty

The current yield on the Credit Suisse Western European Leveraged Loan Index (WELLI) rose above 8% at the end of June (figure 3) and, as at 31 August 2023 now sits at 8.4%, a 15-year high.² This yield offers a considerable buffer should the economic outlook decline. It could be argued that with an average loan price of 95.90, the European market is already pricing in some weakness. Excluding the periods covering Covid and the opening of the war in the Ukraine, loans are trading at levels not seen since 2016.

Defaults have risen but are not currently a cause for concern

One of the concerns expressed at the start of the year was that loans were not as well placed to withstand a recessionary period and would experience increasing defaults given the average loan borrower tends to be lower rated. This was a fair observation, and loan defaults have ticked up, albeit from a very low level (figure 5).

We do not see this as an immediate cause for concern and would highlight the fact that two of the main defaults over the last 12 months were cinema chains Cineworld and Vue, businesses that had struggled to recover post Covid. There are a couple of reasons why we feel loan defaults will prove manageable:

• Most issuers in the European loan market are owned by private equity firms. Private equity is sat on a record US$2.5 trillion of dry powder and we would expect them to continue to offer support/liquidity to their portfolio businesses should the need arise.³ We have seen a number of recent examples of this type of behaviour, with EQT recently injecting new equity of €800m into its portfolio company IVC (a veterinary services business) to fund continued growth.
• Something we have highlighted before is that European loans have a lower proportion of CCC-rated issuers than other leverage finance markets. It is here – in this rating band – that we would expect the bulk of defaults to originate from. These are the weaker companies, which are more vulnerable to an economic slowdown.

An attractive asset class for investors seeking higher income

To summarise, we continue to see secured loans as an attractive asset class for those investors looking for higher income. Key reasons for this are as follows:

• The cash yield from the asset class sits at a 15-year high. Whilst cash rates appear close to peaking, there is no suggestion that this hiking cycle will be quickly reversed, suggesting income from this asset class could remain elevated for some time;
• Spreads remain wide versus history and compared to many other fixed income asset classes;
• Loan prices still look slightly depressed versus recent history, offering some capital upside; and
• Default expectations seem manageable at this point.

Footnotes

¹ Year-to-date is as at 31 August 2023.

² The Credit Suisse Western European Leveraged Loan Index (WELLI) is designed to mirror the investable universe of the Western European leveraged loan market. Loans denominated in US$ or Western European currencies are eligible for inclusion in the index, which is rebalanced monthly on the last business day of the month.

³ Source: S&P Global Market Intelligence, 20 July 2023. The global dry powder total as of early July 2023 represented a greater than 11% increase over the December 2022 total of $2.24 trillion, according to S&P Global Market Intelligence and Preqin data.

Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.

High-yield or “junk” bonds involve a greater risk of default and price volatility and can experience sudden and sharp price swings.

Credit Spread is the difference in yield between securities with similar maturity but different credit quality. Widening spreads generally indicate deteriorating creditworthiness of corporate borrowers, and narrowing indicate improving.

Volatility measures risk using the dispersion of returns for a given investment.