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 continuinggeopolitical risks.
A material reduction of the US inflation rate should allow the US Federal Reserve to pause its rate hikes. Unless the US dips into a deep recession, we don’t expect a rate cut until the labor market rebalances and inflation shows signs of settling below 3%. As we progress toward what may be the end of the interest-rate hiking cycle, we expect interest rate volatility to recede as global central banks move beyond peak hawkishness ― although higher rates will linger, driven by regional differences in growth and inflation. Markets will pivot from pricing interest rate risk to pricing fundamental risk, potentially with recessions scattered around the globe.
Given the risk of a weaker earnings environment, we expect ratings downgrades and defaults to increase. Over the near term, we believe higher-quality leveraged credits will continue to outperform lower-quality should macro conditions remain challenged. Considering high starting all-in yields, we believe leveraged credit still offers fairly attractive relative value; given the late-cycle backdrop, however, we see the need for careful credit selection and monitoring.
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, solid corporate earnings, excess consumer savings and a robust labor market created a favorable environment 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. As a result, what was favorable for markets in 2020 and 2021 quickly became a headwind; the Fed and other central banks were forced to play catch-up. The fed funds rate increased by more than 350 basis points (bp) from the start of the year ― the fastest pace of monetary policy tightening in history.
This unforeseen aggressiveness in Fed 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. Nearly all risk assets felt the pain, but duration-sensitive assets bore the brunt of it. Looking at Exhibit 1, equities lost 18.11%. US Treasuries were deeply in the red at –12.46%, which was not constructive for fixed-rate corporate credits, including both investment grade and high yield bonds. Given the rapid increase in Libor/SOFR base rates, floatingrate senior loans did well relative to other asset classes, finishing the year only slightly in the red at –0.6%. 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: Source: LCD, Bloomberg. Equities are represented by the S&P 500 index and by the Nasdaq Composite index. US Treasuries are represented by the Bloomberg US Treasury index. Investment grade (IG) bonds are represented by the Bloomberg US Corporate index. High yield bonds (HY) are represented by the Bloomberg US Corporate High Yield index. Loans represented by the Morningstar LSTA US Leveraged Loan index. 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. To start the year, loans benefited from increased demand as investors anticipated a meaningful rise in short-term interest rates. By contrast, demand for high-yield bonds quickly diminished. As the Fed and other central banks signaled their plans to tame inflation at any cost, bond yields jumped, leading to some of the worst total return declines on record for the high yield bond market.
For loans, the average bid of the index started the year above the 98.5 mark, leaving little opportunity for market value appreciation. As volatility picked up and technical factors weakened, the loans moved lower along with other asset classes but at a fraction of the pace of other assets. Still, loan bids dropped to the low-90s and hovered around those levels for the better part of the year, while the coupon component of total return helped offset some of the market value declines. Thanks to the floating rate nature of loans, the US loan market fared notably better than the high yield bond market in 2022.
US loans’ floating rate features helped them outperform high yield bonds in 2022.
That said, the environment for loans was far from rosy, with a myriad of challenges developing along the way. Borrowers faced an increasingly difficult economic backdrop, putting both technical and fundamental factors under pressure, and causing performance dispersion at the rating and sector level. Initially, technical factors drove secondary trading levels, with investors concerned about inflation and whether companies could successfully pass price increases through to consumers. Once it became evident that the Fed would hike aggressively, uncertainty started to mount around earnings growth and higher financing costs, and investors began to weigh the implications on issuer fundamentals.
The capital structures of borrowers that reported earnings misses came under pressure, and their loans traded off. The performance of CCC-rated loans (Exhibit 2) was the third worst on record; and the performance gap between BB-rated and B-rated loans was the widest since 2008. At an even more granular level, returns for loans rated B+ and B- were more than five percentage points apart, at 1.96% and –3.23%, respectively. Returns for the B- cohort particularly were influenced by heightened downgrade risk in a market with a large and growing base of collateralized loan obligation (CLO) buyers, who have structural limits on the permissible concentration of CCC holdings.
The high yield market was similar, showing preference for higher-rated cohorts but more nuanced as shorter-duration profiles generally outperformed. The outperformance of B-rated bonds was largely due to lower duration compared to BB-rated bonds. CCC-rated bonds disproportionately came under pressure in the latter part of the year, given the heightened focus on fundamentals.
As of 12/31/22. Source: LCD, Bloomberg. High yield bonds (HY) represented by the Bloomberg US Corporate High Yield index. Loans represented by the Morningstar LSTA US Leveraged Loan index. Investors cannot invest directly in an index.
Many of the issues that affected markets in 2022 will persist into 2023, but we hope to see some resolution as the credit cycle matures.
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 recession potential, deceleration from peak inflation levels, less aggressive and less synchronous central bank policies, lower rate volatility and continuing geopolitical risks. While macro news will have an impact on technical factors, fundamentals likely will be a bigger story. A weaker earnings environment raises the prospects of more downgrades and defaults and continued ratings and sector dispersion among weaker credit profiles, particularly among loans. Some of the downside potential already is reflected in current valuations, e.g., loan prices in the low 90s and high yield option-adjusted spreads (OAS) around 470 bp. Considering high starting all-in yields, we believe leveraged credit still offers fairly attractive relative value, but given the late-cycle backdrop, acknowledge the need for careful credit selection and monitoring.
Supply and demand
New issue formation in 2022 was constrained by broad uncertainty and volatility. Following a high-water mark of $615 billion in 2021, total institutional loan issuance was just $225 billion ― the lowest since 2011 and well below the post-global financial crisis average of $355 billion. The pullback was exacerbated by a handful of large deals that were shelved during syndication, leaving the underwritten loans on bank balance sheets. In general, the difficult economic backdrop, higher financing costs and notable declines in secondary trading levels were not supportive for the syndication of new loans.
For 2023, we expect issuance to improve but expect another light year in deal flow compared to recent historical standards. Informing our view is a continuation of below-trend merger and acquisition (M&A) activity due to the rising cost of debt (although private equity cash coffers remain robust), greater selectivity of large corporate and investment banks toward underwriting large deals and lower investor appetite for loans amidst other attractive yield opportunities in fixed income. Therefore, we don’t envision a strong catalyst to drive new loan activity meaningfully higher in 2023. Our forecast for gross issuance is around $250–300 billion, with most of the volume launching in the second half of the year, assuming a clearer economic outlook.
As part of that gross issuance estimate, we note that refinancing activity should increase somewhat, due in part to the loan market’s need to transition fully away from Libor by Libor’s cessation date of June 30, 2023. Since only about one-fifth of the market has transitioned so far, there will be heightened urgency for issuers to meet the deadline. While many issuers have fallback language embedded in their credit agreements, those who don’t will require refinancing transactions. We think a relatively orderly transition will ensue ― market participants have been preparing well in advance of Libor’s cessation date ― but we expect to see refinancing volumes increase as the deadline approaches.
Turning to high yield, full-year issuance was a lackluster $102.0 billion given limited acquisition-related financing ― a stark reversal from the prior year’s record $465.5 billion and the lowest gross annual figure since 2008 (Exhibit 3). Subdued issuance and an increase of issuing company upgrades to investment grade status decreased the size of the high yield market to $1.4 trillion as represented by the Bloomberg High Yield index , aligning it with the $1.4 trillion leveraged loan market.
We look for modest increases of leveraged credit issuance in 2023.
Looking ahead in 2023, greater clarity as to the path of rates ― including a potential Fed pause ― could bode well for high yield issuance, prompting issuers look to lock in fixed rate financings amid fears of rate volatility extending into 2024. Another tailwind is the potential for a notable uptick in bond-for-loan refinancings. As the Libor transition deadline approaches for the loan market, borrowers may find funding costs in the high yield bond market to be more attractive. Although we expect “refi” activity to increase, it is unlikely to be significant: we believe borrowers will be able to stay on the sidelines a little longer due to pushed-out maturities, with less than $120 billion expected to mature in the next two years (Exhibit 4), and reasonable liquidity on balance sheets. Overall, we forecast $160200 billion of high yield supply in 2023.
As of 12/31/22. Source: LCD.
Source: S&P/LCD and BofA Global Research, as of 12/31/21. The loan market is represented by the S&P/LSTA Leveraged Loan index, the high yield bond market is represented by BofA/ML High Yield Corporate index. Default rates are by par amount. Investors cannot invest directly in an index.
Pivoting to investor demand, interest in leveraged loans was highly mixed in 2022. CLOs were the dominant drivers of loan demand, with total origination of approximately $129 billion. While lower than 2021’s record figure of $187 billion, it was still the second highest full-year tally in the history of the asset class. With widening liabilities across the entire debt stack and sparse new issue loan supply, managers found creative solutions to ink deals, such as tapping into the secondary loan market to build portfolios via “print-andsprint” transactions and issuing shorter-dated or static structures. In other words, the weak primary market did not materially impact the ability of seasoned managers to execute transactions, with many deals being a byproduct of PO-driven arbitrage (“principal only,” i.e., driven by price convexity), which works when loan prices soften considerably, a prevailing market dynamic for a large part of the year.
In the first half of 2023, we expect spreads to remain well wide of 200 bp for new-issue, AAA-rated CLO tranches. The overall CLO AAA investor base has been constrained recently due to the reluctance of US banks to invest, given their heightened need for improving capital ratios. Additionally, the bid from Japanese investors has been pressured because of higher hedging costs and a stronger US dollar. What’s more, new issue CLO paper will face stiffer competition from a relative value perspective ― a function of wider spreads in the secondary CLO market and other securitized products. The shift in market sentiment has come at the expense of smaller managers as well-seasoned and larger managers have gained market share.
These trends likely will continue into 2023, as we expect CLO formation to remain primarily available to only select managers and via the use of structural/economics levers: e.g., static structures with one-year non-call periods and three-year reinvestment periods versus traditional two-year non-call and five-year reinvestment periods. We expect gross CLO issuance levels to be around $90–100 billion. Downside risks to our forecast include the challenging backdrop for AAA investors, constrained new issue supply for loans, potential for an improvement in secondary loan prices for stronger-rated issuers (limiting opportunistic deals) and increased difficulty for managers sourcing equity capital amidst a recessionary environment. Upside drivers could emerge if we see an improvement in the macro environment, tighter CLO liabilities and a notable uptick in loan supply.
The other measurable sources of demand for loans ― mutual funds and ETFs ― experienced net outflows for the year (Exhibit 5). Macro uncertainties and general investor unease, together with a more competitive yield opportunity set, outweighed any demand tailwind from the strong rise in short-term rates, which historically has been a positive driver of retail flows. After a net inflow of $24.5 billion through the first four months of the year, monthly redemption activity averaged close to $5 billion for the balance of the year, resulting in a net outflow of $13.5 billion. For 2023, late-cycle dynamics will likely continue to weigh on retail investor appetite for below-investment grade risk assets, particularly given attractive yield opportunities across the higher quality parts of fixed income. Therefore, we think retail flows are likely to remain net negative in 2023.
Retail investors also exited high yield bonds in 2022, as they became increasingly bearish on credit risk and more sensitive to duration. The latter should be less a concern for 2023, assuming rate volatility subsides. Therefore, we expect interest in the asset class to improve, barring a deep and prolonged recession.
Latest available data as of 12/31/22 (CLO issuance, loan fund flows), 11/30/22 (HY fund flows). Source: LCD, Lipper FMI, Morningstar.
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 and the percentage of CCC-rated paper ― increased notably.
Voya projects loan and high yield defaults to increase toward their historical average ranges of 2–3%.
For the loan market, the ratio of downgrades to upgrades widened, as the cumulative effects of higher interest rates and increasing margin pressure began to weigh on highly leveraged balance sheets. All things considered, we expect most issuers to successfully navigate the higher-for-longer rate environment and the anticipated economic downturn, as 2023 and 2024 loan maturities remain manageable (less than $100 billion total is set to mature in 2023 and 2024). Nonetheless, a handful of loan issuers with unsustainable capital structures likely will be unable to refinance. Therefore, we project loan index default rates to increase closer to the historical average range of 2–3% (Exhibit 6).
We forecast a similar range for the high yield bond market, where the prevalence of fallen angels over the past few years has skewed the ratings profile upward, though the market still holds a much higher concentration in CCC-rated companies. Leveraged credit markets may not see a peak in defaults for the current cycle until 2024, as fundamental challenges grow and maturities begin to approach. In general, default activity should be tempered in the near term by the relatively healthy fundamentals of most borrowers. For reference, average interest coverage ratios closed out 2022 at 6.0x and 5.8x for loans (public filers) and high yield, respectively. Leverage was manageable at 5.0x and 3.7x for loans and high yield, respectively.
Distressed exchanges are likely to remain a popular solution for troubled borrowers. This has been a prevalent theme in previous high yield default cycles, but is now a growing phenomenon in the loan market, where late cycle credit events could be more skewed toward restructuring and liability-management exercises rather than traditional bankruptcy f ilings. This trend has been precipitated by sponsors and private equity firms being more inclined of late to opportunistically take advantage of embedded structural flexibilities in credit documents and inject super priority financing, to the potential detriment of existing lenders. LCD does not capture distressed exchanges in its trailing default statistics; as a result, the true level of credit stress in the loan market likely will be somewhat understated.
As of 12/31/22. Source: LCD (loans), BofA Global Research (high yield). Loans: Trailing 12-month default rate as a percentage of par amounts. High yield: Trailing 12-month par-weighted default rates.
Apart from defaults, we expect downgrade activities to pose a bigger challenge 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. Nonetheless, we do not envision a repeat of 2020, in which the agencies took aggressive, widespread action based on unprecedented macro shocks.
Sector views and market opportunities
In 2022, commodity-linked and defensive industries were sector standouts. In contrast, healthcare and tech/software-oriented sectors were clear underperformers. Healthcare and tech/software together represent more than 20% of the loan market and have seen growth headwinds from stricter scrutiny of corporate spending (technology), increased margin pressures and more downgrades. These headwinds are largely due to a combination of macro and sector challenges with idiosyncratic execution issues. In the technology space ― much of which is centered around software providers in the loan market ― credit profiles with elevated leverage, thinning liquidity and poor earnings quality came under pressure and saw decreased trading levels. Certain healthcare subsectors faced continued wage and inflation pressures that eroded margins, while top lines were impacted by volume deceleration. We expect these trends to continue in 2023.
More broadly, we are cautious on cyclical sectors as well as those reliant upon discretionary consumer spending. Both have exhibited softening trends as price increases (key drivers in the first part of 2022) have been more than offset by volume declines. Accordingly, we are keeping a close eye on trends in consumer spending (particularly among low- to mid-tier income cohorts), as well as destocking and inventory buildup across retailers. Other areas that warrant increased caution include lower advertising budgets (media), weakening video/broadband subscriptions, elevated capital spending (cable); also, industries such as chemicals that potentially are subject to softening demand, volume deceleration and inventory destocking.
Sectors that we believe remain favorable include those such as packaging, where volumes and price pass-throughs are stable; and those such as restaurants that have not felt meaningful impacts from inflationary pressures, as top lines have expanded driven by continued consumer spending on experiences. We believe that gaming and leisure companies likely will continue to fare relatively well, but the macro backdrop and consumer demand will be key performance drivers in 2023. Sectors that we expect to remain stable include insurance brokers, a growing sector of the loan market; and financials, primarily asset managers and certain mortgage real estate investment trusts (REITs).
Over the near term, we believe higher-quality loans will continue to outperform lower quality (Exhibit 7) should macro conditions remain challenged. Given high coupon carry and large price convexity, we believe B-rated loans are positioned for relative value opportunities, but careful selection is warranted. As downgrade risks mount, weaker B-/B3 loans may come under additional pressure. CCCs are likely to stay under stress until more clarity emerges on Fed policy and the path of economic activity.
We expect similar, cohort-related trends to pertain among yield bonds (Exhibit 8). Valuations appear reasonable and spreads are currently pricing in only a mild recession. An up-in-quality tilt could benefit the asset class in 2023 given higher duration and less credit risk than the riskier parts of the market, while single Bs remain a cohort where credit selection is key. CCC-rated bonds will remain highly sensitive to major macro drivers in either direction, and to company-specific developments. Similarly, we expect secured bonds to outperform unsecured ones given the 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.
As we progress toward what many see as the end of the hiking cycle, we expect central bank policies to diverge globally, driven by regional differences in growth and inflation. In the US, a material reduction in the pace of inflation should allow the Fed to pause its rate hikes, if the Fed is convinced that nominal rates are in line with expected inflation. Unless the US dips into a deep recession, we don’t expect the Fed to cut rates until labor markets rebalance and inflation shows signs of settling below 3%. 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.
Our 2023 return expectations are underpinned by high 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, leveraged credit should deliver positive returns. For floating-rate loans, we forecast a potential return in the range of 5–7%. The average coupon for loans is now over 7% and likely will reach well over 8% due to rising base rates. Therefore, we expect the strong carry to cushion modest declines in loan prices and increased credit losses. We think the high yield market will perform in comparable fashion. In the absence of material spread widening, the market should benefit from falling government bond yields 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.