Riding the curve with leveraged loans…read more to learn why
Broadly syndicated loans are an asset class worthy of serious consideration for credit portfolios. Yields in the loan market are among the highest in the last twenty years. At the index level, fundamentals including operating margins and leverage metrics have improved to pre-pandemic levels.1 Spreads (discount margins or “DMs”) for performing issuers reasonably compensate investors for credit risk. Unlike fixed rate bonds, loan coupons are on average higher in today’s market than their calculated yields even with average prices below par as calculated yields assume that the rate curve will be realized. Coupons are floating rate, indexed to term SOFR and reset monthly or quarterly. This advantages loan investors with optionality as to the pace and direction of Federal Reserve interest rate decisions. A well underwritten, high-quality portfolio of broadly syndicated leveraged loans can add high, stable carry, and diversification to corporate credit allocations.
Leveraged loans comprise $1.4 Trillion of the $3.5 Trillion leveraged corporate lending market, alongside high yield bonds and private credit, and there is increasing evidence of convergence.2 Bond-for-loan refinancings are common totaling $47.6 Billion in 2023 and $18.5 Billion YTD through February 2024.3 Secured high yield bond issuance has increased.4 Private credit refinanced nearly $25 Billion of lower-rated broadly syndicated leveraged loans in 2023.5 Private equity sponsors now often dual-track financing activity in the leveraged loan and private credit markets to obtain the best terms.
Historically, loans experience low volatility and high risk-adjusted returns.6 This is due in part to the fact that they are floating rate instruments and due to their unique and differentiated market structure.
Floating rate coupons insulate loans from interest rate duration and provide investors optionality regarding the pace and direction of future Fed rate decisions. A well underwritten portfolio of performing loans should experience price stability and continue to carry well through a Fed easing cycle.
Also contributing to low volatility is market structure. Collateralized loan obligations (CLOs) represent about 70% of the loan market. Like closed-end funds, CLOs are actively managed and are not exposed to investor outflows. CLOs tend to be opportunistic during times of market weakness—adding stability to the market.
This unique market structure can give rise to inefficiencies and arbitrage conditions that can translate into alpha opportunities for the astute investor.
While robust demand currently supports repricing and refinancing activity, loans offer investors enhanced carry for similar, sometimes identical, credit risk versus other leveraged credit markets.7 Credit investors stand to benefit from an actively managed, well-underwritten allocation to leveraged loans.