Over the last two years, leveraged U.S. bank loans (“loans”) have outperformed their high yield bond counterparts; however, we believe this trend may be coming to an end. The relative outperformance of loans during this period was primarily a function of duration, or more notably in 2022, the lack of duration. Loans are floating rate, while high yield bonds are generally fixed rate; as a result, high yield bonds tend to lag as interest rates sell off. With global central banks raising policy rates in an effort to stamp out high inflation over much of 2022, at a pace and to levels not seen in decades, duration assets felt the full brunt of the impact. As laid out in our quarterly fixed income outlook, it’s our view that the potential for a U.S. recession in 2023 remains elevated and the Federal Reserve (Fed) is likely approaching the end of their aggressive hiking cycle. Against that backdrop, we believe now is the time for investors to reassess return expectations and take a closer look at the relative value of U.S. high yield bonds vs. leveraged loans.
The demand story
Bank loans experienced steady inflows in 2021 that continued through early 2022, but that trend reversed in May, and the asset class finished the year with eight consecutive months of outflows. We view the quick and sustained reversal of flows as a negative technical for the asset class, and one that could continue for months to come.
Cumulative monthly flows
Source: Lipper U.S. Fund Flows. As of December 2022.
By contrast, high yield bonds had relatively muted outflows in 2021 but started 2022 with six straight months of heavy outflows. The second half of 2022 witnessed choppy flows—three months of inflows and three months of outflows—but the consistent monthly outflows ceased.
Flows can lend a quick insight into the demand for an asset class and, based on the last two years of activity, demand may have bottomed out for bonds while loans are currently in a weakening demand environment. If demand continues to erode for loans, it will likely prolong the negative technical indicator for the asset class and could result in weaker prices and weaker returns.
The fundamental story
While the demand story of the asset class plays a role in our portfolio positioning, the real disparities between loans and high yield bonds becomes more evident in the fundamental profile of the two sectors.
The credit quality profile of the high yield bond market has been consistently improving since 2010, with the BB/CCC ratio moving from less than 2x to more than 4.5x. The improving credit quality of high yield bonds is further bolstered by the increasing levels of secured bonds in the asset class, recent recoveries well above historical averages, and historically low levels of maturities over the next two years. In short, from a fundamental standpoint, high yield bonds are more attractive now than they have been in more than a decade.
The credit quality of the leveraged loan market is trending in the opposite direction.
In 2010, B-rated loans represented about 20% of the Credit Suisse All Loans Index, but today that figure is north of 50%. During the same time, the index’s share of BB-rated bonds was cut in half. From a credit quality perspective, high yield bonds have the preferred trajectory and profile over loans.
Rating agencies have taken notice as well. In 2022, leveraged loans experienced more downgrades than upgrades (0.67 upgrades for every downgrade), with December experiencing 39 downgrades to only eight upgrades, the lowest level in nearly three years. In contrast, high yield bonds ended 2022 with upgrades outpacing downgrades by a ratio of 1.35:1.
Senior loan rating by percent market value
Source: Credit Suisse, reflective of rankings in the Credit Suisse All Loans Index. As of December 2022.
The macro story
2021 was a strong year for U.S. GDP growth—and inflation. The expectation for rate hikes going into 2022 was high, and it was logical to increase allocations to floating-rate securities to insulate portfolios from interest-rate risk. In March 2022, the Fed commenced its rate hiking cycle to counter inflationary pressures, but at that time, the word “transitory” often preceded “inflation”. We now know that the belief that inflation would be transitory was unfounded, as it remained persistent, and the Fed has had to continue to raise rates with urgency.
The story from transitory inflation quickly pivoted to one of a Fed-induced recession. The swift and steep rate hikes helped loans outperform high yield bonds, but now the narrative needs to shift from a rising rate focus to one of recessionary headwinds. The increased coupons that leveraged loan investors benefitted from in 2022 should now be seen as an increased cost of debt to loan issuers, and the increased cost of debt coincides with expected negative EBITDA growth and the likelihood of a recession. It’s arguably not great for any risk asset, but it’s not an ideal scenario for floating rate loan issuers compared to fixed rate bond issuers.
As we head into what is expected to be a volatile macro environment, the high yield bond market has an attractive fundamental backdrop when compared to loans. The sub-par price of bonds creates an environment for attractive convexity, the low maturity wall limits default risk, and the asset class’s credit quality is near its most attractive in a decade. The same cannot be said for loans, as credit quality is deteriorating, and increased coupons coupled with lower growth present a very challenging setting for outperformance. Over longer periods, high yield bonds have shown to outperform their leveraged loan counterparts, so after a very challenging 2022 where loans vastly outperformed, we believe it’s prudent to revisit allocations and consider rotating risk exposures away from leveraged loans and into high yield bonds.
Principal Fixed Income: A leading global fixed income platform
Principal Fixed Income is the fixed income investment management platform of Principal Asset Management and manages US $133.9 billion in assets under management as of December 31, 2022. Importantly, we have capabilities that span all major fixed income sectors. Our globally integrated platform, with eight investment centers worldwide and over 110 investment professionals, helps to directly access global fixed income markets and deliver a diversity of investment perspectives. Our structure and proprietary investment tools foster cross-sector collaboration across sector-specialty teams, whether the sector is explicitly integrated into a portfolio or not. In our view, this diversity of insight helps each sector-specialty team formulate richer investment theses and make better-informed investment decisions on behalf of our clients.
Investing involves risk, including possible loss of principal. Past Performance does not guarantee future return. All financial investments involve an element of risk. Therefore, the value of the investment and the income from it will vary and the initial investment amount cannot be guaranteed. Fixed‐-income investment options are subject to interest rate risk, and their value will decline as interest rates rise. Potential investors should be aware that Investment grade corporate bonds carry credit risks, default risk, liquidity risks, currency risks, operational risks, legal risks, counterparty risk and valuation risks. Lower-rated securities are subject to additional credit and default risks. Fixed-income investment options that invest in mortgage securities, such as commercial mortgage-backed securities, are subject to increased risk due to real estate exposure. Emerging market debt may be subject to heightened default and liquidity risk. International investing involves greater risks such as currency fluctuations, political/social instability, and differing accounting standards. Private credit involves an investment in non- publicaly traded securities which are subject to illiquidity risk. Portfolios that invest in private credit may be leveraged and may engage in speculative investment practices that increase the risk of investment loss. Investments in Private Credit may also be subject to real estate- related risks, which include new regulatory or legislative developments, the attractiveness and location of properties, the financial condition of tenants, potential liability under environmental and other laws, as well as natural disasters and other factors beyond a manager’s control.
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