Bank loan valuations already pricing in a draconian default environment
With the Morningstar/LSTA Leveraged Loan Index at an average price of US$94.2 as of June 30, we believe loan prices imply a significantly worse economic outcome than we expect over the next 12 – 18 months. While we acknowledge the weaker credit quality of the asset class relative to previous cycles, the current roughly six-point discount in bank loan prices already reflects the market’s expectations for heightened defaults and losses. In fact, a price of US$94.2 implies a default experience equal to the worst-ever trailing 12-month default experience for the loan market.1 We think this is an unlikely outcome and the loan market has more than priced in an economic slowdown already.
Additionally, with a 5.00% –5.25% federal funds rate, banks tightening lending conditions, and one of the most inverted Treasury curves in history, it’s a tough environment to bet on capital appreciation. As a result, we believe that focusing on income, which can act as a buffer in more volatile markets and significantly help drive total returns, could be prudent.
As of June 30, the Morningstar/LSTA Leveraged Loan market had a yield to maturity of 10.4%. This represents an attractive level of income, but one that also offers meaningful downside protection. For example, to offset that high level of income, the loan market would need to experience a default environment more than twice as great as the highest 12-month default rate in loan market history, or dollar prices would need to fall to global financial crisis or COVID pandemic-type levels. In our view, this type of event is unlikely, and we believe that investors could be well served by the high current income of loans and the downside protection they afford.