The context
Leveraged loans and CLOs (which package up a portfolio of loans) were a great source of return for active credit investors in 2023, given their floating-rate nature against a backdrop of rising rates. Furthermore, loan spreads have lagged the recent rally in credit markets to create compelling valuations. But the backdrop that helped loan investors harmed loan borrowers, which feel the pain of rate rises relatively early.
As a result – and despite surprising macroeconomic resilience supporting corporate fundamentals overall – pockets of the loan market appear to be suffering. Since mid-2022, a fall in interest coverage levels* is a key reason why loan downgrades by rating agencies have consistently outpaced upgrades. In 2023, the overall ratio of upgrades to downgrades was 0.5x in the US loan market – much worse than the 1.3x seen in the US high-yield market. As the chart shows, rating trends were weaker at the lower-rated end of the market.
The CLO market has also seen these downgrades feed through to riskier tranches, but overall downgrade rates remain low. This is thanks to the in-built structural protection in CLOs, with diversified underlying portfolios helping to limit idiosyncratic risk. Further support comes from favourable deleveraging dynamics in the CLO market, as managers are increasingly returning cash to investors (as discussed here).
*JP Morgan recently estimated that 9% of loans borrowers had interest coverage levels (EBITDA/interest expense) below 1x in 3Q 23, and 37% had coverage between 1x and 2x. This compares to 8% and 14% at the end of 2021.
The conclusion
While valuations of CLOs and loans look broadly attractive, investors need to take care to limit exposure to a deteriorating tail of the market. The less-impacted CLO market remains an appealing route to access leveraged loan exposure; as we discussed in a previous Picture This, we particularly like short-maturity CLOs, which are benefiting from a deleveraging tailwind. However, investors shouldn’t write off leveraged loans completely; parts of the market remain compelling – here, we think high-quality, short-dated loans continue to offer attractive yields with limited credit risk.
