Despite economic uncertainty and rising defaults, we believe leveraged credit in the U.S. continues to offer attractive return potential, supported by compelling yields, a favorable technical backdrop and steady demand.
Resilient performance in 2023
Despite initial concerns of a U.S. recession, global financial markets showed resilience in 2023. A backdrop of fiscal support, steady corporate earnings and positive investor sentiment led to strong performance in risk assets, including leveraged credit. High carry and healthy market technicals outweighed fundamental concerns, resulting in double-digit returns for senior loans and high yield bonds.
Favorable supply and demand dynamics
We expect the leveraged credit market to continue benefiting from a favorable technical backdrop in 2024. Net issuance remains low, while demand continues at a steady clip. Refinancing activity will likely be the primary driver of supply, with a potential uptick in mergers and acquisitions (M&A) activity. However, the market may face challenges as collateralized loan obligations (CLOs) exit their reinvestment period and refinancing needs increase.
Fundamentals and defaults
With policy rates likely at peak levels and a decelerating corporate earnings environment, fundamentals in leveraged credit faced growing pressure in 2023. Leverage and interest coverage metrics exhibited negative trends, and defaults and downgrades increased. While defaults are expected to tick higher, the majority of borrowers should continue to meet their debt obligations. Downgrade activity is likely to decelerate, but certain sectors, such as healthcare and telecom, may face continued challenges.
We anticipate late-cycle dynamics will continue to drive a wide dispersion of outcomes and an uptick in defaults. The resulting relative-value opportunities will provide an environment ripe for credit pickers. For example, although we expect challenging dynamics to continue for sectors such as healthcare, software, telecom, media and communications, we also see opportunities associated with TV broadcasters, surgical centers, energy and insurance brokers.
Despite the potential for increased defaults and challenges in certain sectors, leveraged credit in the U.S. remains attractive in 2024. Compelling yields, a supportive technical backdrop, and steady demand should continue to provide attractive returns. Active credit selection will be crucial in navigating the market, and while risks exist, the overall outlook for leveraged credit remains positive.
A note about risk
Principal risks for senior loans: All investing involves risks of fluctuating prices and the uncertainties of rates of return and yield. Voya’s senior loan strategies invest primarily in below investment grade, floating rate senior loans (also known as “high yield” or “junk” instruments), which are subject to greater levels of liquidity, credit and other risks than are investment grade instruments. There is a limited secondary market for floating rate loans, which may limit a strategy’s ability to sell a loan in a timely fashion or at a favorable price. If a loan is illiquid, the value of the loan may be negatively impacted and the manager may not be able to sell the loan in order to meet redemption needs or other portfolio cash requirements. The value of loans in the portfolio could be negatively impacted by adverse economic or market conditions and by the failure of borrowers to repay principal or interest. A decrease in demand for loans may adversely affect the value of the portfolio’s investments, causing the portfolio’s net asset value to fall. Because of the limited market for floating rate senior loans, it may be difficult to value loans in the portfolio on a daily basis. The actual price the portfolio receives upon the sale of a loan could differ significantly from the value assigned to it in the portfolio. The portfolio may invest in foreign instruments, which may present increased market, liquidity, currency, interest rate, political, information and other risks. These risks may be greater in the case of emerging market loans. Although interest rates for floating rate senior loans typically reset periodically, changes in market interest rates may impact the valuation of loans in the portfolio. In the case of early prepayment of loans in the portfolio, the portfolio may realize proceeds from the repayment that are less than the valuation assigned to the loan by the portfolio. In the case of extensions of payment periods by borrowers on loans in the portfolio, the valuation of the loans may be reduced. The portfolio may also invest in other investment companies and will pay a proportional share of the expenses of the other investment company.
Principal risks for high yield bonds: All investing involves risks of fluctuating prices and the uncertainties of rates and return and yield inherent in investing. High-yield securities, or “junk bonds,” are rated lower than investment grade bonds because there is a greater possibility that the issuer may be unable to make interest and principal payments on those securities. As interest rates rise, bond prices may fall, reducing the value of the portfolio’s share price. Debt securities with longer durations tend to be more sensitive to interest rate changes than debt securities with shorter durations. Other risks of the portfolio include, but are not limited to, credit risk, other investment companies’ risks, price volatility risk, the inability to sell securities and securities lending risks.