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Leveraged loan investors should brace for higher defaults, as rising interest rates and a weaker economic backdrop begin to constrain free cash flow, said panelists at the ABS East conference in Miami today.

Borrowers that are able to maintain strong liquidity buffers are likely to come out on top, said Lauren Law, a portfolio manager at Octagon Credit Investors.

“I think third quarter earnings expectations are pretty low,” she said during a panel discussing the outlook for leveraged loans. “What would be most telling is what management teams say about the outlook. We are certainly prepared for some negative prints in the third quarter.”

While higher base rates are boosting returns for loan investors, they are constraining free cash flow just as the economic backdrop starts to hit earnings. This is now a “credit picker’s market”, said Roberta Goss, a senior managing director at Pretium Partners.

“Rates are definitely impacting free cash flow,” she said. ”The real question is are we being paid for that risk right now. As Libor and SOFR move over 4% on a three-month basis, the all-in yield right now is over 10%. That’s generally a very attractive point for leveraged credit.”

“There are definitely some things we will have to navigate over the next couple of years, and inflation and rates are two of those factors. But we feel like we’re getting to a point where we’re being paid for some of that risk.”

While pricing is beginning to look more attractive, for now investors are mostly having to turn to the secondary market to put cash to work.

Primary loan issuance has slowed significantly this year. The LBO machine in particular has slowed dramatically, and banks have had to offload underwritten debt at steep discounts (as in the case of Citrix) or abandon syndication entirely (as with the Brightspeed buyout).

As we discussed in a recent episode of our Cloud 9fin podcast, this is reducing banks’ appetite for new underwriting. Higher interest rates are also making refinancing harder, and may force issuers to consider alternatives to regular-way refinancings.

Primary leveraged loan issuance is unlikely to recover until there is more clarity on the direction of interest rates and the severity of the expected recession, said Goss.

“[Until then] we’re going to see a few months where we’re working through a backlog of deals from this year, and then we’re going to see a bit of a lull,” she said. “That will be interesting in terms of secondary loan performance.”

While most investors are focusing their efforts on first lien debt, the yields on offer in the second lien space are often better than equivalent fixed-rate high yield paper, noted Lauren Basmadjian of Carlyle in our recent 9Questions interview.

However, finding liquidity is a challenge in today’s market, said Goss during the conference discussion. “Dealer desks are running flat books at best,” she said.

When underwriting and primary issuance eventually recovers, investors are likely to be a lot more conservative than they were earlier this year, said Daniel Miller, chief credit officer at Capra Ibex Advisors, who was also part of the Miami panel.

“Free cash flow to total debt coverage numbers start to get very challenged,” he said. “I think the market is still coming to grips with this. It will challenge originations going forward, but as long as everybody keeps their eyes open, it should be an environment for intelligent underwriting.”

However, he said there was a risk that origination ends up skewing towards sectors that are considered to be more resilient to recession.

“It seems like origination volumes have shifted pretty significantly to the technology sector,” he said. “This is the biggest sector in the leveraged loan space right now. When you see that much volume that quickly, it’s a little bit of a warning.”

He noted that lower-rated issuers now represented a greater proportion of the overall market, and that many of those issuers were backed by private equity firms. He said loans rated B- represented roughly 24% of his current portfolio, compared to around 14% in 2019.

“In terms of fundamentals, we had a huge growth in lower-rated credit, and private equity funds constitute a high portion of these origination volumes,” he said. He later noted that these loans may have much looser documentation, potentially posing greater risks for lenders.

The CLO market, which provides the majority of demand for leveraged loans, has also slowed down this year.

Amid falling demand from lynchpin investors like Japan’s Norinchukin Bank (which is reportedly pulling back from the market) and new regulation like the NAIC’s proposed capital charge hikes, the outlook for issuance is cooling.

CLO issuance has fallen this year, albeit from record highs in 2021. But the CLO market is still the main buyer of leveraged loans by a long stretch, said Goss.

She pointed out that other buyers of loans, such as retail-driven mutual funds, have seen outflows this year despite the tailwind of higher base rates.

“The CLO issuance pipeline is the biggest driver of the technical picture for loans,” she said. “Year-to-date retail fund flows for bank loans have just turned negative for the full year in the last week.”

More broadly, the turmoil in debt and equity markets is likely to test the established model for private equity buyouts, said Miller. “The whole dynamic for PE is going to be different,” he said.

He noted the difficulty of getting debt financing at the aggressive leverage metrics that until recently have been the norm. Nevertheless, he said sponsors should be able to continue driving loan issuance if they adjust equity checks and leverage expectations.

Loan investors warn of earnings shocks, rising defaults (9fin)

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