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On September 21, the US Federal Reserve (Fed) announced another 75 basis-points (bps) rate hike and is now targeting a 3.00% – 3.25% federal funds rate. At a high level, the Fed is attempting to engineer an economic slowdown to combat stubbornly high inflation. Going forward, we anticipate a series of additional rate hikes over the next nine months before the Fed takes a pause. As of this writing, the futures market is pricing in a terminal fed funds rate of around 4.7% sometime in 2023.
Overall, our base case is for a mild US recession in the second half of next year. We believe the weaker global macroeconomic environment will likely drive further bouts of market volatility across many asset classes. However, we believe bank loans may continue to outperform in a higher-interest-rate setting. Bank loan coupons mechanically adjust upward as rates rise, boosting their income and total-return potential for investors. Today, the bank loan index yields approximately 10%, which is poised to increase with additional Fed rate hikes. At the same time, we acknowledge there has been some negative press lately about the impact rising rates could have on floating-rate issuers from a fundamental perspective.
Since bank loans have floating-rate coupons, many issuers of such loans are naturally at risk of incurring higher financing costs (interest expenses) amid rising short-term interest rates. Yet, we believe many issuers can withstand this not-insignificant headwind because most are starting from very strong positions in terms of their liquidity levels, debt servicing abilities, and extended maturity schedules, potentially enabling them to bear the pressure of rising interest expense costs.
We recently performed a sensitivity analysis of the leveraged loan market (Figure 1) and concluded that many loan issuers’ interest-coverage ratios can likely withstand further increases in three-month LIBOR. (Currently, the futures market is pricing in an additional 150 – 175 bps of Fed rate hikes.) Under this scenario, even if the EBITDA (earnings before interest, taxes, depreciation, and amortization) of bank loan issuers declines by 20%, their interest-coverage ratios should still remain above 2.0x. In general, we believe such coverage ratios are sufficient to service the debt on most issuers’ balance sheets.
Bottom line: Broadly speaking, we believe the bank loan market, particularly higher-quality issuers, will be able to overcome the challenge associated with higher interest rates.
As of September 27, the Morningstar LSTA Leveraged Loan Index had outperformed both US investment-grade debt and US high-yield bonds by more than 12% year to date. With the macro backdrop likely to deteriorate in the months ahead, we expect to see an uptick in bank loan defaults from today’s very low levels back toward long-term historical averages (~3%). However, we also continue to believe default recovery rates should remain close to their historical averages (~70%), given bank loans’ senior secured position in most issuers’ capital structures.
All things considered, we believe bank loans are capable of outperforming most fixed-rate bond sectors over the next 12 months. At today’s bank loan prices, we see price appreciation potential, coupled with the benefit of higher coupons, and believe now is an attractive entry point for longer-term investors.
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