The first signs to watch out for companies hit by interest rate hikes are those with leveraged loans.
An MLIV Pulse survey among 291 investors saw the majority saying leveraged loans are like a canary in a coal mine. This indicates the quality of credit among corporates is getting worse.
A sign of leveraged loans being in trouble is the shift in the credit cycle. This year, most of the time, it seemed reasonable to buy loans on floating rates as they gave higher yields when the central bank tightened the monetary policy. The loan prices, even after falling, gave a rising yield that left investors down by only 0.9% compared to double-digit declines in other markets.On the other hand, corporate balance sheets, including those of junk-rated companies, remained strong.
Credit Cracks for Leveraged Loans
Some investors are reducing credit risk exposure as companies look more likely to default. The MLIV survey saw 28% of respondents expect defaults to rise significantly if the interest rates in the US peak at around 5%. The US market is expecting the Federal Reserve to stop hiking rates around the 5% levels as seen in the futures of Fed Funds. 63% of the respondents see defaults surge if the rate goes above 5%.
Ironically, the problem now is because of the floating rates, which made the loans attractive to investors earlier. It is now forcing indebted corporates to pay higher interest on loan repayment. Many investors expect stagflation in 2023 to weigh on corporate revenues. Money managers would bet on long-term investment-grade bonds in anticipation of interest rates falling.
There is not enough data on leveraged loans to tell how they are performing during recessions, as the leveraged loan market in the US is only a couple of decades old. Debt fell drastically during the global financial crisis in 2008 and the covid -19 pandemic. In the 2001 recession, the returns were zero or negative for the leveraged loan index of Morningstar LSTA US.
According to Matt Mish, strategist at UBS, the default rates for leveraged loans can go up to 9% if the Fed continues with its tighter credit conditions as more indebted companies will be affected.
Many investors who purchased loans at the beginning of the year faced pressure after the Russian-Ukraine war broke out, leading to global concerns over energy prices and economic growth. The US leveraged loans were trading at 99 cents vis a vis the dollar in January, which has now dropped to 93 cents.
The FTX collapse has also shaken the crypto market and exposed the lack of due diligence and aggressive risk-taking among venture capital firms. Around 94% of the respondents to the MLIC Pulse survey feel that more blow-up will follow the FTX bankruptcy as years of easy credit availability is now turning into a challenging market environment.
More FTX Type Fiascos!
Frank Ossino, loan sector head with Newfleet Asset Management, says that a vulnerable credit environment will mean investors will be more diligent while doing their homework. 2023 looks particularly interesting for investment-grade bonds, as leveraged loans look less appealing to investors.
