Widening Senior Loan Spreads Offer Value

Jeffrey Bakalar

Jeffrey Bakalar

Group Head and Chief Investment Officer, Senior Loans

Dan Norman

Dan Norman

Group Head and Senior Managing Director, Senior Loans

Despite increasing credit risk and uncertainty, we believe that loans will continue to dampen portfolio volatility this year, much as the asset class did in 2018.

Loans are offering attractive value

Loan credit spreads are above long-term averages and widening for higher-risk credits. Combined with mid-term expectations of relatively modest default and loss rates, value appears quite strong, especially in view of the discount created by last December’s technical sell-off. In terms of value relative to high yield bonds, bond spreads and yield opportunities have also been pushed higher due to the year-end volatility.

However, a dearth of new issuance throughout much of 2018, which has only recently abated, together with the now widespread assumption that duration risk is moot at best, is causing spread compression in both high yield and investment grade bonds. As a result, we’ve seen some tipping of the relative value equation in favor of loans as coupons edge higher.

The default-rate outlook is creeping higher but remains manageable

Our outlook for defaults is inching higher as the current cycle moves through its late stages. We do not see a high risk of a rapid, material compression of earnings and cash flow in the leveraged corporate market. Lenders are more likely to undergo a gradual slowing of growth in earnings and cash flow rather than a sharp drop.

More highly leveraged issuers with ratings of weak single B or lower may be increasingly at risk, but most better-rated issuers are still able to comfortably service debt and reinvest in their business through internally generated cash flow.

Issuer-level data remain key

With regard to relevant leading indicators, we watch global and U.S. GDP as well as Fed indicators, of course, but the most important signals come from issuer-level data and management insights, some of which is not publicly accessible. Thus far, they are signaling a modest tapering of exceptionally strong recent growth trends and a slight uptick in cautiousness regarding expectations for earnings and capital spending. None of these messages, at this point, are sufficiently broad in scope to signal a material increase in systemic risk.

Any significant change to the default-rate outlook would probably be precipitated by one or more of the following contingencies:

  • An unexpected reversal of the Fed’s most recent dovish pivot;
  • An abrupt and significant market-wide shift in issuers’ earnings guidance;
  • An exogenous, systemic shock that paralyzes capital markets and disrupts lending.

Credit risk across sectors seems reasonably balanced

On a sector basis, credit risk across sectors seems reasonably balanced, with a few smaller-exposure exceptions such as legacy telecom, legacy oil/gas and retail. Any widespread wave of defaults would require a material macro disruption, and, again, would most negatively impact the most leveraged issuers within those sectors.

The largest sectors – business services, technology and healthcare – may be the most likely candidates simply based on their relative positions within the investable universe. However, we do not see on the horizon any sector set up to repeat the experience of development technology (2001), specialized real estate (2009), oil/gas/mining (2015) or brick/mortar retail (2016).

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