The Paradox of Opportunity
What We Are Seeing
Floating-rate loans present a bit of a paradox at the end of 2022. Through mid-November, the asset class outperformed every major equity and bond index by a wide margin. Yet there are good reasons to consider the asset class a cheap buying opportunity in 2023.
The core floating-rate feature of loans was highly attractive in a year when the U.S. Federal Reserve raised rates by 300 basis points. Loans escaped the downside peril of duration, while loan fund distributions nearly doubled from the beginning of 2022.
Investors flocked to loans trading at $98 and yielding 4.5%, based on the Morningstar LSTA Leveraged Loan Index. But now, with loans trading at about $93 and a yield to maturity around 9.4%, buyers are harder to find. Call it the paradox of opportunity.
What We Are Doing
We have always maintained that loans are an asset class exposure that benefits from the thorough due diligence of credit research and active management, especially in this environment.
Our investment team of 40-strong has re-underwritten our portfolio companies, gauging how they may be affected by today's set of risks, like higher input and debt service costs.
As part of this effort, we have resized or in some cases exited positions, where appropriate. Despite the spike in inflation and rising rates over the year, our "watch list" of credits — where we are truly concerned in the near term — remains limited.
What We Are Watching
For investors, the important question is whether the prices and yields on loans are compensating for the heightened recession risks in today's market.
We believe the answer is a solid "yes." In mid-November, loans had an approximate seven-point discount from par. Conservatively assuming that 70% of defaults will be recovered (historically, that number has been 75%), the discount in the market today implies a cumulative 23% default rate ahead.
For context, that figure is almost double the great financial crisis of 2008, and about five times the deep (albeit short) COVID recession. By contrast, the current default rate is below 1%. Though we expect annual levels to rise somewhat, it's clear to us that the market is oversold.
Historically, starting yield has been a good guide to total return. With a floating-rate load yield starting at 9.4% in November 2022, we believe returns that include capital appreciation in excess of coupon income may well be in store.
Bottom line: We'll never "call a bottom," and prices may be unpredictable in the near term. That said, we think loans trading at a deep discount elevates the opportunity for investors. It's a chance for high income, capital appreciation and participation in the rising rates that may lie ahead.
Andrew Sveen, CFA
Head of Floating-Rate Loans
The index performance is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results.
Morningstar LSTA US Leveraged Loan Index is an unmanaged index of the institutional leveraged loan market.