The Credit Suisse Leveraged Loan Index returned 2.1%,¹ with lower prices offset by income during the period; year to date, the index has returned 6.6%. Longer-duration assets saw greater success during the quarter, as the rate rally buoyed the performance of the Bloomberg US Corporate High Yield Index (up 5.3%) and the Bloomberg US Aggregate Bond Index (up 5.2%).²

Moderating Sentiment, Moderating Technicals

Though it remained largely positive, sentiment surrounding the US economy became more mixed during the quarter, as evinced in some of the extreme volatility across asset classes in late July and early August. While the S&P 500 Index was down more than 8% peak to trough during the quarter as risk appetites dissipated, loans were relatively resilient, losing less than 1%.³ Lower-quality loans continued to underperform through much of this period, though the trend reversed in September.

Though economic conditions potentially have weakened on the margin, on balance they appear largely benign for corporate credit investors. While the labor market remains a focus, the most recent data on job growth, wages and unemployment suggest a relatively strong dynamic. That, combined with an already accommodative Fed, created a constructive backdrop for credit despite the shifting sentiment.

Similarly, the technical environment for credit also remains strong, though perhaps more balanced than it had been earlier in the year. Demand for credit continues and increased net supply has been manageable. Institutional demand for loans from the collateralized loan obligation (CLO) market totaled $41 billion in the third quarter compared to $51 billion in the second and $48 billion in the first. Net supply, meanwhile, rose $44 billion in the third quarter, up from $31 billion in the second. Just over $20 billion of that net new issuance was driven by leveraged-buyout (LBO) volume, the highest level of LBO activity since first quarter 2022 and the March start of the Fed’s rate-hike cycle.⁴ While demand decreased slightly and supply increased quarter over quarter, net new issue volumes were more than offset by demand during the period, leading to a fairly firm market.

Fundamentals Remain Strong; Investors Should Expect Rates to Remain Elevated

From a corporate earnings perspective, operating results continue to trend in the right direction. Both revenue and earnings increased in the second quarter on a year-over-year and quarter-over quarter basis. Meanwhile margins remain at healthy levels, and leverage has been stable.⁵ Interest coverage, which has remained a bit tight given higher rates, should improve given the roughly 50 basis point decline in the Secured Overnight Financing Rate (SOFR) that loans reference.

Recent economic data and corporate earnings suggest higher rates are likely. While the recent reduction in borrowing costs will provide issuers with a reprieve on the margin, the cost of leverage is likely to remain at levels meaningfully higher than it has been since the global financial crisis. This should continue to keep pressure on issuers with more levered capital structures and is also likely to keep default and restructuring activity elevated.

Through the end of September, the combined default and restructuring rate for loans stood at 3.8% on a latest-12-month (LTM) basis as a percentage of par volume. Recovery rates on an LTM basis are averaging just over 50%, meaning a 3.8% default rate would result in a 1.9% annual loss rate for the market overall.⁶ Clearly, active managers with an ability to selectively avoid more stressed areas of the market may be able to deliver better results than the market overall.

Demand for Credit Likely to Remain Strong Given Risk and Return Characteristics

With base rates still elevated and spreads potentially creeping wider if the economy weakens materially, the income coming from credit-related assets is likely to be competitive with equities and other asset classes going forward. In particular, the total return potential for corporate credit, net of potential default losses, remains attractive. In such an environment, we expect the demand for credit to remain positive, which should support issuers’ access to capital and help mitigate future default losses. This is particularly true of institutional investors, many of whom utilize actuarial return assumptions of 6–8% for equities, a level we believe is achievable for credit-related assets, even assuming elevated default losses.

Environment Remains Supportive for Corporate Credit

Lower rates, benign fundamentals and steady operating results, coupled with a steady economic environment, continue to provide corporate credit with an adequate backdrop looking ahead. We remain vigilant, however, and continue to monitor current exposures closely, as rates do remain high and managing for downside risk is always paramount regardless of the environment.

We believe that corporate credit will remain a helpful component of an asset allocation framework for long-term strategic investors, particularly those looking for current income and/or those looking to manage ongoing volatility risk versus asset classes such as equities.