Despite data over recent months creating a credible case for interest rates to remain higher for longer, major central banks have continued to fuel optimism of rate cuts this year and investors have increasingly been drawn into locking in the attractive yields across fixed income markets.
Demand for yield has driven credit spreads lower
This demand to lock in yields has seen a significant inflow into both investment grade and high yield U.S. corporate bonds. Investment grade bonds are offering yields north of 5.3% and U.S. high yield bonds around 7.70% to start the year. These attractive entry points are helping to push credit spreads lower even as new bond issuance has flooded the market this year. Credit spreads on U.S. investment grade and high yield bonds are at their lowest levels since 2021. This as corporate default rates are inching higher, with S&P expecting default rates to continue to rise.
As interest rates have risen, the proportion of the total return from credit spreads has also diminished significantly relative to recent history across most parts of the fixed income market which means that the risk premium received to compensate investors for risk of default losses has diminished even as financial conditions have become more restrictive.
So where are the opportunities for investors to get better compensated for their risk in the current environment?
U.S. Senior Loans offer an attractive risk premium relative to high yield bonds
Based on both credit spreads and yields, U.S. senior loans present an attractive part of the market for investors who are looking for the potential for higher returns with reduced volatility relative to fixed rate bonds.
The compression in credit spreads has been somewhat less pronounced in U.S. senior loans when compared to high yield bonds and they continue to offer an attractive implied yield of around 9.4% which is in the 90th percentile over the past 10 years. Credit spreads are comparatively much more palatable than their fixed rate counterparts in the high yield market. The spreads between single-B rated loans and single-B rated bonds is around two times higher than the 10-year average witnessed between these asset classes.
Loans have surpassed the expectation of most investors in recent times, providing attractive returns with significantly reduced volatility. Over the past 12 months, U.S. senior loans have produced returns in line with the ASX 200 but with nearly 1/5th of the volatility, and we believe that loans are well positioned to continue to provide these strong return characteristics.
Also read: 10-year Expected Returns – Reordering Asset Class Profiles
Of course, the returns are representative of the risks associated with the investment. So, avoiding losers is important and we are seeing names that are missing their earnings estimates get punished. This represents a risk but also a good opportunity for active managers who can pick up beaten-up names that will ultimately still return your capital, providing good total return opportunities on top of the attractive interest that is on offer in the loans market.
The question is whether or not you are being adequately compensated for this risk. Our base case is for active senior loans managers to return between 7-8% over the next 12 months which allows for falling interest rates, moderately wider credit spreads and the impact of defaults that a good active manager might expect to incur – leaving room for better returns than that, while acknowledging that a spike in defaults or credit spreads will challenge this outlook.
Higher for longer is good for floating rate loans
While we should expect rate cuts over the coming months, it is clear that the Fed is in no rush as Chairman Jerome Powell clearly outlined last week. While adding fixed rate exposure has historically provided positive returns at the peak of a rate hiking cycle, we believe that the bar to a series of sharp rate cuts is high and what is already priced in may be challenged. Interest rates remaining higher for longer is positive for loans investors as it keeps the coupon that investors receive higher. Given this we do not expect falling interest rates to have a material impact on the performance of loans over the next 12 months.
While recent bullish sentiment has markets seemingly celebrating a soft landing, the dual risks of a resurgence in inflation or a recession shouldn’t be ignored. Which is taking a balanced approach to interest rate risk, credit risk, as well as diversification, is as important as ever.
