Yields remain attractive and may maintain positive relative value

Significant focus on the uncertainty of the US macroeconomic backdrop and its potential implications on the market remain top of mind for investment opportunities. Against this cautious outlook, we asked the experts from Invesco’s bank loan, direct lending and distressed credit teams to share their views as the third quarter of 2024 wraps up.

Bank loans: potential for high income and relative value

Kevin Egan, Senior Portfolio Manager, Senior Secured Bank Loan Group

As we approach the end of the third quarter, there has been a significant focus on the uncertainty of the US macroeconomic backdrop and its potential implications for the senior secured bank loan market. We continue to believe there are still several compelling reasons to consider investing in senior secured loans: 

1. Potential high level of current income: Current income is comprised of two key components—base interest rates (which are expected to stay higher for longer) and credit spreads (which continue to remain wide). Coupon income for bank loans today is ~9.19%, which is near its highest since 2009¹. Market expectations are for rates to remain higher for longer, well above pre-2022 levels. Loans have proven to provide consistent, stable income through varying market cycles, including recessionary periods and periods of falling rates.
2. Are rates higher for longer?: Loans have virtually no duration risk (average ~45 days). The forward SOFR curve currently implies an average 3-month SOFR rate of approximately 5% over the course of 2024. This reflects the broadly adopted market view that the US Federal Reserve (Fed) will pivot to easing interest rates late in 2024 and will lower interest rates cautiously. Recent economic data has been more supportive of a higher for longer interest rate environment, benefiting higher loan coupons.
3. Compelling relative value: Loans have offered one of the best yields in fixed income, while providing downside risk mitigation by being senior in the capital structure and being secured by the assets of the company. Loans have offered these high yields with no duration risk. In a recessionary environment, loans offer downside risk mitigation by being senior which means they are the highest priority to be repaid in the event of default. Senior secured assets may offer added risk mitigation throughout recessionary periods.

We feel current loan yields and spreads look very attractive both on a historical and a relative basis. The average coupon for loans has been around 9.19%, outpacing the average high yield coupon of 6.24%¹. After averaging around ~170 bps less than high yield bonds over the past fifteen years, this is the first time in history the average loan coupon has surpassed that of high yield bonds. It was only around three years ago when loans were yielding ~4.80%; loans recently have been yielding over 400 basis points more than that¹.

Direct lending: Direct lending yields to remain attractive amid potentially shifting Fed policy

Ron Kantowitz, Head of Direct Lending

During the first half of 2024, the economy demonstrated resilience despite the persistence of higher-than-desired inflation, and the Federal Reserve maintained its "higher for longer" stance on interest rates. As a result, private equity-related M&A volume, typically a significant driver of direct lending opportunities, saw a further decline of 34% when compared to the already-low levels exhibited during the first half of 2023. It’s worth noting however that the direct lending deals that were completed over the period continued to be fundamentally strong, especially when supported by a disciplined approach to structuring and documentation. Importantly, all-in yields on an unlevered basis remained attractive and well above historical levels.

For the remainder of the year, inflation is expected to abate and the Federal Reserve may shift to a more accommodative policy. It is also anticipated that M&A volumes will improve as pressures mount for private equity firms to return capital to investors. Should new direct lending opportunities increase in number, ample dry powder remains available – although a continued emphasis on maintaining discipline in leverage capacity and credit terms will be key.

Importantly, the quality of direct lending deals we are seeing remains very compelling. We remained focused on underwriting conservative capital structures with moderate leverage and tight documentation. We believe the current environment should allow for a continuance of historically attractive yields. Given the potential for a more accommodative Fed, SOFR is now projected to average around 5% for 2024. While we may see some compression in spreads and original issue discounts (OID), we still believe that all-in direct lending yields will remain in the 11-12% range, unlevered. These levels represent incredibly attractive opportunities from a risk/return perspective.

For most major central banks, the primary objective for 2023 was fighting inflation while simultaneously maintaining financial stability. They appear to have done this with some degree of success so far, despite challenges earlier in the year when Silicon Valley Bank and Credit Suisse triggered temporary concerns.

Indeed, price rises have slowed sufficiently to allow the Fed, the European Central Bank and the Bank of England to pause rate hikes in recent months. Furthermore, growth in all three regions proved more resilient than expected over the course of the year.

That said, it remains clear that underlying pressures persist. With this in mind, markets are adjusting to the realisation that interest rates are likely to remain higher for a longer period than initially anticipated. Furthermore, we are likely to see slowing economic growth across regions in 2024, as the impact of higher interest rates starts to bite.

Against this backdrop, we sat down with experts from Invesco’s bank loans, direct lending and distressed credit teams. They shared their views on what we can expect from 2024.

Bank loans: coupon levels are near all-time highs

Kevin Egan, Senior Portfolio Manager, Senior Secured Bank Loan Group

It is important to start by acknowledging today’s unstable geopolitical landscape. The troubling conflict in the Middle East has added an additional degree of uncertainty to the investment backdrop.

Our outlook is based on the assumption that the conflict will remain relatively contained, rather than spilling over and significantly altering the operating environment for loan issuers. However, we continue to watch this closely.

Overall, we believe 2024 will be another strong year for loan returns. Coupon levels are near all-time highs and will remain at these levels until central banks pivot aggressively towards lowering rates.

While an aggressive easing cycle is possible based on historical experience, it is not our base case. Furthermore, even if this environment were to materialise, it would not materially diminish loan coupons until late 2024.