Current loan yields and spreads remain attractive with average loan coupons at close to record highs (~9.25%) and surpassing high yield bonds (~6.15%)1
Shifts in expectations to a slower Fed cutting cycle will likely strengthen the case for direct lending yields remaining in an historically attractive 11-12% context.
Healthy companies challenged by higher rates are seeking capital solutions which present attractive investment opportunities particularly in the small company space.
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.
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:
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.
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.
Within distressed credit and special situations, many themes from earlier this year continue to persist. Global economies remain strong overall, with some exceptions in Europe, particularly the U.K. and Germany. The U.S. Federal Reserve still has the opportunity to engineer a “soft landing” once monetary policy loosens, but this seems less likely for the U.K. and Germany.
Year-to-date, our pipeline of special situations opportunities, particularly capital solutions transactions, has grown exponentially. We are evaluating new investments in private equity-owned businesses almost daily. These businesses have healthy operations, but with leverage profiles that were set up between 2018 and 2022 which have now resulted in untenable cash interest expense levels. These private equity sponsors face a dilemma: they own performing businesses capitalized in a near-zero base rate environment, and now much of their free cash flow is spent on cash interest expenses. They have owned these companies for several years without the ability to reinvest in operations, expand into new products or geographies, or pursue accretive M&A strategies, resulting in minimal equity value creation.
That’s where we are able to step in and structure attractive capital solution transactions that significantly reduce interest expense, sometimes eliminating it, with appropriate downside risk mitigation through security and governance. These are healthy companies that do not need to restructure, which means they can offer significantly reduced risk and offer historically compelling risk/return asymmetry.
Private credit is an asset class that can generally be defined as non-bank lending. In other words, it includes privately negotiated loans and debt financing. The private credit market typically serves borrowers that are too small to access public debt markets, or that have unique circumstances requiring a private lender.
Broadly syndicated loans are privately arranged debt instruments comprised of below investment grade borrowers. They are made to large cap companies and syndicated by intermediary commercial and investment banks. These loans are then distributed to multiple institutional investors.
CLOs, or collaterialised loan obligations, are securitised versions of broadly syndicated loans. CLOs create portfolios of hundreds of loans and structure them into different tranches with different risk/return profiles. This allows investors to choose their preferred balance of risk and return, which benefit from a collateralised structure.
Typically, CLO notes offer a premium to other securitised vehicles because of the complexity of understanding the underlying private loans and the uniqueness of each CLO structure. CLO notes are registered securities and trade and settle like bonds.
Direct lending means providing capital to companies or businesses without the benefit of an intermediary. In other words, you’re directly lending to a company.
Distressed credit involves investing in the senior debt of companies at significant discounts to par, usually due to perceived fundamental weakness.
Returns are generated by investing in companies where, over the longer-term and through various actions, meaningful upside potential can be unlocked.
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As the 3rd quarter comes to a close, 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. Despite these challenges, we see three compelling reasons to consider investing in senior secured loans now.
Senior secured loans offer investors a unique source of income potential, but they’re often misunderstood. We highlight the myths and realities of this asset class.
Alternative Opportunities is a quarterly report from Invesco Solutions. In each new edition, we look at the outlook for private market assets.
Source: Credit Suisse as of 30 June 2024.
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