Barring a deep, prolonged recession, we expect leveraged borrowers to successfully navigate the late cycle backdrop given relatively healthy fundamentals.
We believe many of the issues that confronted the leveraged credit markets in 2022 will persist into 2023, though we hope to see resolution of certain issues as the credit cycle matures. Notable macro themes for 2023 include slower global growth with heightened potential for recession, decelerating inflation, less aggressive and less synchronous central bank policies, lower interest-rate volatility and continuing geopolitical risks.
As the end of the hiking cycle nears, we expect central bank policies to diverge globally, driven by regional differences in growth and inflation. We believe the European Central Bank will prioritize growth, since energy, the primary driver of inflation, is outside its control. Generally, we believe interest rate volatility will recede as central banks move beyond peak hawkishness, although higher rates will linger globally. As a result, markets will pivot from pricing interest rate risk to pricing fundamental risk, potentially with recessions scattered around the globe.
The prominent themes shaping our return expectations for 2023 are higher starting yields balanced against growing fundamental concerns. We believe that, barring a deep and prolonged recession and meaningful escalation of the war in Ukraine, leveraged credit should deliver positive returns.
Review of 2022
By many accounts, 2022 was a tumultuous year. More than two years since the start of a global pandemic, economies and markets faced the aftermath of monetary and fiscal policies aimed at taming the dovish overshoot from prior years. Inflation swelled globally to levels not seen in decades, geopolitical shocks created an energy crisis, central bank policy exhibited peak hawkishness and global bond yields spiked.
Certainly, the macro backdrop looked supportive at the start of the year. In the United States and Europe, solid corporate earnings, excess consumer savings, robust labor markets, tourism and reopening tailwinds created favorable environments for risk assets. Inflation proved to be more than transitory, however, as it accelerated from core products into services and was further amplified by commodity price increases after Russia’s invasion of Ukraine. This geopolitical crisis disrupted flows of natural gas flows to key economies across Europe, leading to fears of energy scarcities and soaring prices. As inflation quickly accelerated, policies that bolstered markets in 2020 and 2021 became a headwind, and central banks were forced to play catch-up. The US Federal Reserve increased its policy rate by than 350 basis points (bp) from the start of the year ― the fastest pace of monetary policy tightening in history. The European Central Bank (ECB) delivered a cumulative rate increase of 250 bp, and the Bank of England (BOE) reacted similarly.
This unforeseen aggressiveness in global central bank policy resulted in market volatility, with no shortage of debates about the size of rate hikes and terminal rates. The yield on 10-year US Treasury notes increased by more than 300 bp, creating a massive reset in financial asset valuations and upending a prolonged period of low yields and excess liquidity. Meanwhile, 10-year yields on British gilts jumped to their highest level in more than a decade, while 10-year yields on German bunds turned positive for the first time in years.
Nearly all European risk assets felt the pain, but duration-sensitive assets bore the brunt of it. Looking at Exhibit 1, European equities lost 12.76% and European government bonds lost 17.17%; investment grade, high yield bonds and emerging market debt also experienced steep declines. Floating-rate senior loans fared better than other broad asset classes, closing out the year at -3.06%. Negative market sentiment and interest rate sensitivity drove performance in 2022, while corporate fundamentals did not weigh as much on valuations, particularly in the first half of the year.
As of 12/31/22. Source: LCD, Bloomberg. European government bonds are represented by the Bloomberg Euro-Aggregate Treasury index. Emerging market debt is represented by the Bloomberg Emerging Markets USD Aggregate index. European investment grade bonds are represented by the Bloomberg Pan-Euro Corporate index. The STOXX Europe 600 index represents European equities. European high yield bonds are represented by the Bloomberg Pan-European High Yield index. European Loans are represented by the Morningstar European Leveraged Loan ex-currency index. See disclosures for index definitions. Investors cannot invest directly in an index.
Spotlight on leveraged credit
While there were many similar themes across the senior loan and high yield bond markets, the floating-rate characteristics of the loan market versus the fixed characteristics of the high yield market explained much of their total-return differences in 2022. As central banks reacted aggressively and bond yields rose, performance in high yield suffered. While loans were shielded from the volatile rate movements, the worsening macro outlook combined with rising geopolitical risks undoubtedly affected performance. The average bid price of the Morningstar European Leveraged Loan Index (ELLI) started the year above 98.5 and decreased to the low-90s (and even into the high-80s on numerous occasions) due to growing concerns of a recession in the Eurozone. As a result, sharp market value declines more than offset the increased coupon “carry” due to rising Euribor rates.
Borrowers faced an increasingly difficult economic backdrop, which put both technical and fundamental factors under pressure and caused performance dispersion at the rating and sector levels. Unsurprisingly, these growing fears resulted in a clear bias towards higherquality paper. As reflected in Exhibit 2, performance for CCC-rated loans was second lowest to only the global financial crisis, while the outperformance of BB rated loans relative to B rated loans (which account for the bulk of ELLI outstandings) was the highest since 2008. Although a similar theme was evident in high yield, the level of dispersion between ratings was far less pronounced, particularly between BB and B rated bonds where the return discrepancy was less than 70 bp.
As of 12/31/22. Source: LCD, Bloomberg. European high yield bonds are represented by the Bloomberg Pan-European High Yield index. European Loans are represented by the Morningstar European Leveraged Loan ex-currency index. Investors cannot invest directly in an index.
Supply and demand
European new issue formation in 2022 was constrained by broad uncertainty and volatility. Following a record €112 billion of new issue loans launched in 2021, institutional loan issuance totaled just €35 billion, the lowest since 2012, during Europe’s sovereign debt crisis. The notable slowdown was partly driven by a dearth of opportunistic transactions such as refinancing and dividend recapitalizations, both of which were prevalent in 2021. Additionally, given the challenging conditions, banks tapped into the private credit markets to address some of the new issue pipeline deals instead of syndicating them in the leveraged loan primary markets. As if loan market conditions weren’t difficult enough, the high yield market fared even worse, with only €22.3 billion of new issuance in 2022, the lowest figure since 2008. Heightened market volatility, limited demand for the asset class given inflation and rising rates, higher funding costs and pushed-out maturities stemming from 2021’s historic refinancing wave kept most issuers on the sidelines.
We expect capital market activity to recover in 2023, but with volumes below recent trends.
For 2023, we are forecasting a recovery in capital market activity but lower overall volumes relative to recent historical trends. We do believe refinancings have some room to grow, however, particularly in the high yield bond market as issuers look to lock in fixed rate financings amid fears of further rate volatility into 2024. With just 9% and 14% of loan and high yield markets set to mature in the next two years, we don’t foresee a strong catalyst to drive refi activity much higher. We project gross issuance volumes to reach levels of €60–70 billion in both markets in 2023, with most of the volume launching in the second half of the year, assuming a clearer economic outlook (Exhibit 3).
As of 12/31/22. Source: LCD.
On the investor demand side, European collateralized loan obligation (CLOs) ― the primary buyers of European loans ― helped provide a stable bid for the asset class. Despite the challenging backdrop, total origination amounted to a respectable €26.2 billion. Despite widening liabilities due in part to the LDI-driven sell-off by UK pension funds, a thin investor base for AAA-rated CLO tranches and muted new issue loan supply, managers found creative solutions to ink deals, such as tapping into the secondary loan market to build portfolios via “print-and-sprint” transactions and issuing shorter-dated or static structures. Meanwhile, demand for high-yield bonds faltered due to reduced appetite for duration sensitive assets. Retail fund flows, as tracked by Emerging Portfolio Fund Research, Inc., were negative during the year.
We expect AAA new issue spreads to remain wide for European new issue CLOs in 2023. Recently, the overall global CLO, AAA investor base has been constrained due to the reluctance of US banks to invest, given their heightened need for improving capital ratios. At the same time, higher hedging costs and currency volatility have dampened Japanese interest. Nonetheless, we believe the new-issue market will remain adequate for much of the year, with the primary driver of new deal formation being the use of structural levers that are afforded to well established managers. We project CLO issuance to be nearly in line with 2022 at around €25 billion (Exhibit 4). Upside drivers could emerge if we see improvement in the macro environment, tighter CLO liabilities and a notable uptick in loan supply.
As of 21/31/22. Source: LCD.
On the other hand, investor appetite for high yield likely will remain challenged given the prospects of rising rates and a recessionary environment across Europe. While all-in yields look compelling, the ability to earn increased yields across higher rated areas of fixed income likely will limit demand for below investment grade credit.
Defaults and fundamentals
Following a period of strong growth and balance sheet improvement, issuer fundamentals started to show signs of weakness during 2022. While default rates remained near historic lows in both the loan and high yield bond markets, other distressed metrics — such as loans trading below 80 percent of par, high-yield bonds with an OAS of 1000 bp or more — increased notably.
Looking at 2023, we expect fundamentals to continue to worsen in the loan market. The cumulative effects of higher rates and slower growth should begin to weigh on highly leveraged balance sheets, eroding interest coverage ratios. As a result, we expect default rates to increase to 2–3% for both loans and high yield (Exhibit 5). Despite the slightly better average rating profile of the high yield market versus the loan market, it is offset by different sector compositions, particularly the greater exposure in the high yield market to sectors that could be more vulnerable in the current environment.
We expect loan and high yield defaults to increase toward their historical average ranges of 2–3%.
Apart from defaults, we expect downgrade activity to pose more challenges in 2023. Rating agencies are focused on issuers with deteriorating credit metrics, including margin pressure from higher input prices, increased financing costs due to rising interest rates and lower consumer spending due to the drawdown of excess savings. Nevertheless, we do not envision a repeat of 2020 when the agencies took aggressive, widespread action based on unprecedented macro shocks.
As of 12/31/22. Source: LCD (loans), BofA Global Research (high yield). Loan data represented by the Morningstar European Leveraged Loan index, trailing 12-month default rate by par amount. High yield bond default data represent the trailing 12-month par-weighted default rate.
Sector views and market opportunities
In 2022, sectors that benefited from tourism tailwinds and defensive/stable-oriented sectors outperformed. By contrast, industries that experienced weakened demand, margin compression and the inability to pass through price increases underperformed. Automotive, construction and paper and packaging also experienced growth headwinds as a result of more careful corporate spending, increased margin pressures and more downgrades. This was in large part due to combinations of macro/sector challenges and idiosyncratic execution issues.
Looking at 2023, sectors that remain relatively resilient in the current environment are healthcare/pharmaceuticals and telecommunications/cable, where demand is stable and the ability to pass through the impact of inflation exists. We believe the more challenging sectors are those reliant upon discretionary consumer spending (retail) and those where the impact of rising rates is more profound (building materials).
We believe higher quality loans will continue to outperform in the near term should macro conditions remain challenged (Exhibit 6). Given high carry and significant price convexity, however, we think B-rated loans are positioned for some relative value opportunities, but careful selection is warranted. As downgrade risks mount, weaker loans rated B minus and B3 may come under additional pressures. CCC-rated loans are likely to stay under stress until more clarity emerges on central bank policy, the inflation outlook, the Russia/Ukraine crisis and the severity of any recessions that emerge.
In high-yield bonds, valuations appear reasonable and spreads are currently pricing in only a mild recession (Exhibit 7). An up-in quality tilt could benefit the asset class in 2023, given longer duration and less credit risk compared to the riskier parts of the market, while B-rated bonds remain a cohort where credit selection is key. CCC-rated bonds will remain highly sensitive to any major macro drivers in either direction, and to company-specific developments. Similarly, we expect secured bonds to outperform unsecured bonds given prospects for widening spreads and an expected uptick in default activity.
As of 12/31/22. Source: LCD.
As of 12/31/22. Source: Bloomberg.
The constraining effects on industrial activity of rationed energy supply and high prices will force the Eurozone into recession in the first half of 2023. Although inflation has peaked, the cost of goods, labor and financing remain highly elevated. We do not expect European inflation to abate in the medium term, as low unemployment and government subsidies to reduce energy costs should continue to support consumer spending. As the end of the hiking cycle nears, we expect central bank policies to diverge globally, driven by regional differences in growth and inflation. We believe the European Central Bank will prioritize growth, since energy, the primary driver of inflation, is outside its control. Generally, we believe interest rate volatility will recede as central banks move beyond peak hawkishness, although higher rates will linger globally. As a result, markets will pivot from pricing interest rate risk to pricing fundamental risk, potentially with recessions scattered around the globe.
For 2023, we forecast leveraged credit potential returns in the range of 4–6%.
The prominent themes shaping our return expectations for 2023 are higher starting yields balanced against growing fundamental concerns. While there can be no guarantees of future performance, we believe that, barring a deep and prolonged recession and meaningful escalation of the war in Ukraine, leveraged credit should deliver positive returns. For floating-rate loans, we forecast a potential return in the range of 4–6%; we expect the improved carry will be able to cushion modest declines in loan prices and increased credit losses. We think the high yield market will perform in a comparable fashion. In the absence of material spread widening, the market should benefit from a modest decrease in rate volatility and an improving technical backdrop. Of course, both estimates are subject to an array of factors that could shift expectations considerably. Risks remain skewed to the downside and clarity on outcomes is still elusive.