March 17, 2023 Recent Insights on the Loan Market

With the fallout of the two regional banks, how have your credit market views changed? What risks are you focused on, in particular?

Our base case on the loan side has been that higher rates would slow growth and reduce debt service ability, so we have positioned as such.  The events of the last week have introduced capital markets risk into the equation, which may be the catalyst to accelerate the cycle and push the U.S. into recession.  In fact, a number of opportunistic loan refinancing transactions have been pulled from syndication this week.   While the loan maturity wall in the next two years is negligible, the inability to raise capital/funding for refinancing debt maturities, growth CapEx, M&A, or other corporate finance activity, could slow growth further and negatively impact risk assets.  We are also monitoring Collateralized Loan Obligation (CLO) creation going forward.  A slowdown in this major loan market demand driver could impact the technical, albeit the offset potentially being less new issue loan supply.

Do you expect the financial condition to further tighten? What are your current default expectations for the loan market?

The last 12-month default rate is currently just over 1%.  The long-term historic average is 2.5%.  Our modeling is generally unchanged - we expect defaults to reach or slightly exceed historic averages in the next 12-15 months.  Note that just as important, is the recovery rate on defaults.  While historic averages are in the 70-80 cent range, we are modeling a worse than historic recovery rate on defaults (and out of court restructurings as well) that could be 50-60 cents given the loosening of documentation terms in the recent vintage of transactions.

Has the recent volatility provided potential opportunities? What is your approach to credit risk in your portfolios?

The opportunity set has not widened materially.  As of March 15, 2023, loans are down only 1.2% in the last week (BBs down 1% and CCCs down 1.7%) and index spread has widened by roughly 45 bps to +633.  We have already de-risked portfolios since November 2021, cutting loan exposure in half in the multi-sector portfolios and positioning with an up-in-quality bias in the dedicated loan strategies (underweight CCC and B-, while overweight investment grade loans, and underweight technology and healthcare industries). While the triggers we watch to add risk have worsened—growing cohort of loans priced below 80 cents, downgrades exceeding upgrades, increasing defaults, declining debt service ratios—they are still below levels experienced in other stressed periods (Global Financial Crisis and Covid notwithstanding) and they are not at levels that create a meaningful enough opportunity set at this point to add more risk; certainly not at current valuations.  But there will be a time when repositioning with a risk-on bias will be warranted in the medium term.

What is your perspective on Credit Suisse?

The Credit Suisse (CS) events are very fluid as demonstrated by the March 15^th announcement of $53B+ in backstop support by the Swiss National Bank.  The action is an important step to allow CS to fund its operations in the near term, but the bank will have to raise capital or break up or sell itself to fully arrest their challenges. CS is very different than the recent two bank collapses in the U.S. given its size, and global position, making it a systemically important institution within the global banking system.  As it relates to counterparty risk, we currently have only one open trade with CS on the loan side that we expect to settle in the very near term. At the moment, we have not experienced any material reduction in broad loan market liquidity.