- Given the heightened uncertainty in the market, we continue to consider credit structuring. In such an environment, asset-based credit structures can be a particularly attractive way to deploy capital.
Credit assets rallied in the fourth quarter as improving inflation data raised hopes that the end of the Federal Reserve’s rate-hiking cycle was near.
The broadly syndicated loan market, as reflected by the Credit Suisse Leveraged Loan Index, delivered a total return of 2.33% for the quarter and -1.06% for the full year 2022 compared to the performance of the Bloomberg US Corporate High Yield Index of 4.2% and -11.2%.1 The fundamentals of the leveraged loan market have remained relatively resilient amid cost pressures on inputs, higher capital costs and a slowdown in economic activity. Loan defaults by volume – a backward-looking indicator – declined in the fourth quarter and currently remain well below historical norms. Meanwhile, market technicals were quite benign in 2022 as credit supply and demand declined to keep the market in relative balance.
Current economic trends indicate that emissions are likely to remain subdued in 2023. The slowing economy is likely to weigh on corporate enterprise value while their cost of capital remains high, resulting in lower leverage ratios for new business. Given the heightened uncertainty in the market, we continue to consider credit structuring; Asset Based Lending (ABL) structures in particular can present an opportunity to deploy capital for an attractive risk-adjusted return over the long term.
Market fundamentals attached
Markets embraced the idea in the fourth quarter that easing inflation and slowing economic growth would allow the Fed to complete its tightening cycle sometime in the first half of 2023. Indeed, the 50 basis point hike announced in December was a slowdown from the 75 basis point basis point pace that marked the four rate hikes since June and the 4.25-4.50% range in which the fed funds rate ended 2022. was within shouting range of the Fed’s current final rate forecast of around 5.1%. While Fed Chair Powell has struggled to articulate his intention to keep rates higher for longer, markets didn’t seem to buy the rhetoric. Futures market pricing suggests that while the fed funds rate could reach around 5% in 2023, policy will shift to rate cuts sometime before the end of the year as economic growth continues to slow.2
The fundamentals of the leveraged loan market have remained relatively resilient given cost pressures on inputs, higher costs of capital and the slowdown in economic activity. Much of this is likely due to the behavior of borrowers in the easy money era following the Covid-19 outbreak. The vast majority refinanced debt at low interest rates, and some likely used derivative techniques such as hedging and swaps to mitigate the effects of rising interest rates and extend the life of their debt burden. As a result, maturity barriers for this year and next are quite manageable and a variety of credit metrics remain well supported. For example, weighted average leverage is back to pre-pandemic levels and interest coverage is still adequate. However, this number can shift rapidly and dramatically as interest rates rise, and there can be significant variation across industries and between individual borrowers. Those with pricing power and the ability to pass higher costs on to their customers should be better positioned to defend EBITDA levels and margins, as should companies with decent inventory levels.
Loan defaults by volume – a backward-looking indicator – declined in the fourth quarter and currently remain well below historical norms. However, that could mask upcoming troubles, as the distress ratio — a forward-looking indicator that reflects loans trading for less than 80 cents on the dollar — ended the year at 7.4%, up from 5.8% at the end of the third quarterly Meanwhile, 3 rating agencies seem to have a rather pessimistic assessment of future credit developments; Credit action turned negative mid-year and downgrades outpaced upgrades by almost three to one by year-end.4 Lower ratings are dampening demand for credit, particularly for collateralized loan obligations (CLOs), which serve as the main buyers, as is the case with the CLO -The structure of the case is very sensitive to the regulatory constraints of its investor base (insurance companies, banks and wealth managers). All in all, a trend towards downgrades usually leads to greater price volatility, less new issuance and funding problems.
Read more here.
Comments are closed.