Private credit quarterly roundup: Yields still hover at record highs and offer attractive relative value

Signals of slowing economic growth across regions at the beginning of 2024 have created a continued focus on sustained higher interest rates as the year progresses so far. Macroeconomic uncertainty and geopolitical events have driven capital across various segments characterising positive and negative implications we continue to monitor.

Against this cautious outlook, we asked the experts from Invesco’s bank loans, direct lending and distressed credit teams to share their views as the first quarter of 2024 wraps up.

Bank loans: potential for high income and relative value

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

2023 was an exceptional year for loan returns (second highest on record) on both a relative and absolute basis, driven primarily by robust coupon that is near all-time highs. Looking forward in 2024, we continue to expect loans to provide high income in a higher for longer interest rate environment. Despite two consecutive years of exceptionally strong relative performance, we believe there are still several compelling reasons to consider investing in senior secured loans:

1. Potential high level of current income: Coupon income for bank loans today is ~9.5%, which is its highest since 2009¹. Market expectations are for rates to remain high, 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. Floating rate feature: Loans have virtually no duration risk (average ~45 days). The forward Secured Overnight Financing Rate (SOFR) curve currently implies an average 3-month SOFR rate of approximately 4.5% over the course of 2024. This reflects the broadly adopted market view that the US Federal Reserve (Fed) will pivot to easing interest rates in the first half of 2024 but will lower interest rates cautiously.
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 that current loan yields and spreads are attractive with the average loan coupon surpassing high yield bonds. We believe bank loans currently offer higher relative value both from an absolute and risk-adjusted basis.

Direct lending: expecting potential compelling yield and deployment opportunities in 2024

Ron Kantowitz, Head of Direct Lending

We would characterise 2023 as a year in which uncertainty related to macroeconomic conditions, geopolitical events, and the US Federal Reserve’s (Fed) aggressive tightening stance created a challenging environment for merger and acquisition (M&A) activity. As a result, transaction volumes were down, driving fewer opportunities to deploy capital across the direct lending asset class.

While the transaction activity was slow, the quality of the deals that were executed was among the most compelling we’ve seen in direct lending. Only the strongest credits with conservative capital structures and tight documentation were able to cross the finish line. Further, given the floating rate nature of the asset class, direct lending offered yields of 12-13%, unlevered – a very attractive level when compared to historical yields of 7.5-8.0%.

In 2024, it appears the Fed is headed towards more accommodative monetary policy. While the timing and magnitude of their actions remain to be seen, we expect the impact on direct lending yields to be fairly muted. If we assume the Fed cuts three times in 2024, which is currently the consensus view, along with potentially modestly tighter spreads and original issue discounts, we believe direct lending yields should only decline 50-100 bps. Under this scenario, we believe direct lending yields should settle in the 11-12% area, unlevered – still incredibly attractive from a risk/return perspective and meaningfully higher than levels exhibited leading up to the Fed’s tightening cycle.

Further, we feel that the backdrop supporting a more favourable transaction environment is firmly in place, including better visibility into the macro environment, softening inflationary pressures, potential rate reductions and heightened pressure from LPs for private equity firms to generate realisations and invest in new platform companies. Combined with continued discipline in terms of credit quality and a relatively stable yield environment, we believe 2024 is shaping up to be a compelling opportunity to deploy capital in the direct lending asset class.

Distressed credit: A very attractive global opportunity set with potentially less risk

Paul Triggiani, Head of Distressed Credit and Special Situations

In short, we have never been busier. Our small capitalisation focus and investment pipeline is not only the largest it has ever been, but it also represents some of the highest quality opportunities we have seen in our careers. 2024 is likely going to be a difficult year for many small capitalisation companies, and in particular, over-levered corporate issuers. Within this space, approximately one-third of the companies with fixed charge coverage ratios below 1.0x – meaning a significant percentage of our investable universe cannot service its interest expense. 

Higher rates over the last year have also impacted liquidity in many leveraged capital structures, and even with the potential for central banks to modestly cut rates in 2024, liquidity and refinancings of overleveraged balance sheets are likely to be challenged. These factors lead us to believe the next two-to-three years will represent an unparalleled opportunity to generate compelling risk-adjusted returns for three specific reasons:

1. Prior cycles have been led by industry disfunction – sectors undergoing secular change and/or facing significant headwinds. Today’s target market for transactions is quite diversified – all businesses have to grapple with a higher cost structure in the face of declining revenues and to some extent a weakening level of consumer confidence.
2. We believe the special situations market, which encompasses everything from rescue financings through capital solutions and strategic capital investments, is very attractive. We believe such opportunities, especially where restructurings can be avoided altogether, allow for equity-like returns while remaining in a strong credit position within a capital structure – offering potential for strong risk-adjusted returns.
3. Finally, today’s pipeline is global. While growth may slow in the U.S., weak growth to a potentially recessionary environment in the UK and Europe is certainly not unrealistic, potentially offering higher quality opportunities. The large presence of regional banks as lead lenders bodes well for our approach given these holders are quite challenged when it comes to holding positions that may be perceived as needing a holistic, deleveraging restructuring.