U.S. leveraged loans are delivering some of the best returns in the fixed-income market this year, indicating that investors think any impending downturn could be slow to come and end up being relatively mild.
Total year-to-date returns on a key US leveraged loan index touched 7.2% this week, the highest for the period since at least 1997. Loans have outperformed other areas of credit, such as US high-yield debt, which posted total returns of 5.28%.
Leveraged loans are floating rate, which means they pay more to investors as the Federal Reserve tightens rates. Performance of leveraged loans is on track to hit 10% this year if prices stay at current levels, according to Frank Ossino, senior portfolio manager at Newfleet Asset Management. Returns for the asset class last topped that figure in 2016, according to data compiled by Bloomberg.
Much of this year's performance will be driven by higher coupons, Ossino said.
Lack of new issue supply will also be a positive technical throughout the summer, as slowing sales will push investors to the secondary market, driving prices higher, he said. Ultimately, a slowing economy and deteriorating corporate health will weigh on the asset class, but it's taking longer than expected for that play out, according to Ossino.
"Fundamentals are deteriorating however you measure it," Ossino said. "But it's happening slower than maybe some folks thought."
While interest expenses for leveraged loan issuers have climbed 14% over the last year as of the end of the first quarter, companies have generally been able to withstand the higher costs of borrowing, according to a June report by JPMorgan Chase. About 9% of loans in the market are set to mature within the next one to two years, according to UBS Group. Companies typically refinance their debt at least one year before maturity.
Companies have been seeing a key measure of income fall relative to their interest expense, signaling they have slightly less capacity to pay their obligations. But that ratio, known as debt service coverage, is only slightly below the four-year high of 4.58 times seen in the third quarter of 2022, according to JPMorgan.
"Balance sheets for most US leveraged loan issuers are in a good position heading into a more challenging fundamental landscape for corporates," analysts including Nelson Jantzen wrote in the JPMorgan report.
Still, not everyone is bullish about the prospect for leveraged loans.
For Christian Hoffmann, portfolio manager at Thornburg Investment Management, the outlook for leveraged loans is grim heading into a potential recession.
"We remain extremely cautious on the loan market, owing to deteriorating fundamentals like rising defaults and poor recovery rates, as well as persistent pressure from outflows," Hoffmann said.
The cumulative impact of the Fed's quantitative tightening won't just impact companies' ability to service their debt, it will also lead to downgrades and defaults in the asset class, according to Bill Zox, portfolio manager at Brandywine Global Investment Management.
"Leveraged loan outperformance is on borrowed time," Zox said. "It's just a matter of time until leveraged loans are faced with meaningful deterioration in credit metrics followed by rate cuts. That is the worst environment for leveraged loans."
--With assistance from Carmen Arroyo
