Fundamentals and technicals combine
After an exceptionally strong 2023—the second-best year ever for loans and eighth best for high yield—gains have continued at a moderated pace in Q1. Investors’ risk appetite has been broad-based, reflected in the strong performance of equities and lower-rated credit. Treasury rates rose and spreads tightened in the first quarter, elevating valuations based on spreads even higher relative to history. However, yields remain historically attractive in leveraged credit and fundamentals, especially in high yield, which mostly remain firm.
Last quarter, we discussed our return expectations for 2024 with our outlook for high yield and loans to provide returns at or near current yields, and income playing a dominant role. With credit yields now sitting around 7.75% for high yield and 9.82% for loans, we continue to expect income to drive total returns, but see additional upside in high yield. Conversely, in loans, total returns may fall short of current yields as declining quality and persistently higher rates have increased expected credit losses. Default rates have increased in loans and recovery rates—although modestly improved—remain deeply depressed relative to the long-term average. We continue to note the risk of higher defaults and distressed exchanges in smaller private loan-only issuers, a small part of the market with generally riskier profiles.
Credit fundamentals and technicals remain largely supportive, as companies remained conservative in managing their balance sheets through the end of 2023. Gross issuance in loans has been particularly strong to start the year; however, 88% of volume has gone toward repricing and refinancing as credit conditions have supported borrowers seeking to address near-term maturities and reduce interest costs. We expect the volume of loan repricing to remain high in the coming quarter, which has historically been associated with lower returns in subsequent periods.
Key takeaways
- Income-driven return outlook remains favorable.
- Maintain up-in-quality bias.
- Prefer bonds versus loans due to quality and price convexity
