Floating rate features and “senior” status: further opportunity ahead for private credit assets

Private credit outlook: opportunity set continues to look attractive

In 2022, public fixed income markets experienced one of the worst years in memory. Aggressive rate hiking from central banks led to a dramatic selloff, hitting long duration assets particularly hard.

Private credit assets, on the other hand, fared far better. This was partly due to their floating rate feature, which means that coupon payments adjust to reflect changes in the interest rate environment. This helped offset price declines.

Going forward, we believe the opportunity set continues to look attractive. In this piece, experts from our bank loans, direct lending and distressed credit teams share their views. In particular, they focus on:

• The market environment today
• What to look out for in the coming months

As ever, our Sales teams are on hand to discuss these topics in further detail, answering any questions you may have. Please do not hesitate to get in touch.

As introduced by Kate, the floating rate nature of bank loans was a real strength in 2022. But a common question from investors is, what happens when the economy starts to cool and rates stabilise?

We would start by saying that, right now, the forward curve suggests we are still in for one or two more rate hikes from the US Federal Reserve (Fed). Europe, meanwhile, is expecting even more rate hikes.

Once the Fed does pause rates, they are expected to stay at that level for quite some time and, when they ultimately fall, they are not expected to fall precipitously. In other words, we believe investors will continue to enjoy a high level of income.

Case study: what does history suggest?

To help illustrate the opportunity, let’s look at a historical case study.

There have been four periods since the Global Financial Crisis when loan yields exceeded 8% (they are currently around 10%).

If you look at the ensuing 6-12 months, you will see that the loan market has delivered very strong outperformance over these periods, with a 10.69% average 12-month forward return.¹

We believe this may present a compelling opportunity for long-term investors in bank loans and Collateralised Loan Obligations (CLOs) alike.

“Senior secured” status: attractive in times of turmoil

In addition to their floating rate feature, the “senior secured” status of loans can help mitigate downside risk.

Historically, this has translated into relatively high recovery rates (60-70%) compared to other subordinated asset classes, for example high yield bonds (30-40%).²

This may prove particularly attractive for investors if we enter a recessionary environment. 

Challenges in the banking sector in March now feel a long time ago, and many are viewing them as idiosyncratic in nature rather than systemic. What is important to note is that these events had minimal impact on direct lending as an asset class, as direct lenders are not reliant on banks to implement their investment strategies.

In fact, should banks continue to tighten their lending standards ahead of an expected economic slowdown or recession, direct lenders could stand to benefit as more businesses look to them as a source of capital. This could create a larger opportunity set with attractive yields, lower leverage and more lender-friendly documentation.

Outlook: markets are now offering better visibility

Having reflected on the events in the first half of the year, let’s now look forward to what we can expect in the months to come.

Our belief is that macro conditions will likely get worse in the short to medium term. However, markets like this excite us, and we believe the current opportunity set may result in one of the best vintages on record.

Markets now have good visibility on the headwinds that are likely to dominate the next 12-18 months and, as such, we believe our screening, diligence, structuring and asset allocation processes are now that much more informed.

Furthermore, from a yield/return perspective, direct lending remains quite attractive. As a floating rate asset class, Secured Overnight Financing Rate (SOFR)³ is now over 400 basis points higher than it was at the start of 2022.

Along with moderately wider credit spreads and original issue discounts, we are finding opportunities that are currently yielding in the 12% context. 

Small companies often run into problems, regardless of economic conditions. This is one of the main reasons that we focus on them in our distressed credit and special situations portfolios. It creates an evergreen opportunity set and allows us exposure to companies across a diverse range of industry sectors.

Additionally, today’s tough economic backdrop is creating an even larger investment universe. Companies are now having to pay a higher level of interest on their debt, and many have begun experiencing a fall in demand for goods and services.

Where this cycle differs to previous ones, though, is that it doesn’t have an industry tinge. The slowdown in the economy that we are going to see will likely impact businesses in all sectors. In other words, it will be more of a “traditional” recession. This should create the opportunity for us to skew our portfolios towards high-quality companies in good industries – companies that are simply overleveraged.

Sizing the opportunity: how big is our investment universe?

We are already seeing the effects of today’s challenging market environment in our investment pipeline, and we expect a far larger opportunity set than we saw in 2008 and 2009.

Indeed, over the last 15 years or so, non-investment grade credit markets have increased meaningfully in size to approximately $5 trillion. That’s two to three times larger than they were going into the Global Financial Crisis.

If you segment the overall market by deal size, you will see that the small cap distressed space is really quite large as it stands today, regardless of how you define it (Figures 1 and 2). 

As a result, even if we assume modest default rates of 5% over the next 12-18 months (approximately half of what occurred during the Global Financial Crisis), we expect a materially larger opportunity set than we saw in 2008 and 2009.

This is an exciting prospect for distressed credit investors.