Yields maintain record highs and offer positive relative value

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

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 second 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 continue in 2024, 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 ~9.25%, 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. Floating rate feature: 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 9.25%, outpacing the average high yield coupon of 6.15%¹. After averaging around 245 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 two years ago when loans were yielding ~4.80%; loans recently have been yielding over 400 basis points more than that¹.

Direct lending: Attractive Yield and Deployment Opportunities to Continue

Ron Kantowitz, Head of Direct Lending

So far in 2024, inflation has appeared to break its downward trend, causing market participants to rethink their outlook for interest rates. Investors now expect a slower and shallower rate cutting cycle as potentially stickier inflation complicates the Federal Reserve’s path to exiting a higher rates regime.

For example, SOFR (the base interest rate for our loan coupons) is now projected to average ~5.20 for 2024 – in-line with 2023 and higher than the ~4.90% projected earlier in the year. While we may see spreads and OID compress to some extent, we still believe all-in, direct lending yields will remain in the 11-12% context on an unlevered basis. We believe these represent incredibly attractive levels from a risk/return perspective and are meaningfully higher than those leading up to the Fed’s tightening cycle.

Further, we believe the current backdrop is supportive of a favourable transaction environment given better visibility into the macro landscape, a more stable inflationary picture relative to prior years, and heightened pressure from LPs for private equity firms to generate realizations and invest in new platform companies. Combined with continued discipline in terms of credit quality as well as relatively stable and attractive yields, we continue to believe this is a compelling environment to deploy capital in the direct lending asset class.

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.