Overb-loan Bearishness
Arguments about the health of the leveraged-loan market persist. Coming into 2023, the consensus was bearish against the backdrop of a steep hiking cycle and a potential economic downturn. A banking crisis and problems in commercial real estate added to the negative outlook.
The price performance of European leveraged loans in aggregate has nevertheless been solid this year (Figure 1), likely explained by the delayed or averted European recession. Another sign of resilience is that issuance, having collapsed in 2022, has recovered without being driven solely by refinancings (Figure 2).
That said, risks do still remain. One is the other side of the issuance coin: the possibility that higher supply will depress prices. Beyond that, we are aware that leveraged-loan issuers have been in a net downgrade trend for the past 17 months.1 In part, these deteriorating fundamentals just reflect their rate exposure. However, we think it is also notable that 15% of B3 issuers (the lowest rating above CCC) have a net negative outlook.2 This matters because some credit portfolios, including CLOs, are limited in the amount of CCC debt they can own; if downgrades materialise, we could see pricing dislocations from these forced sellers.
More positively, CLOs do seem fairly well-insulated against such shocks, in our view. They don’t mark to market, their closed-end structure means they don’t face redemption demands, and they have relatively little low-rated collateral that will mature before 2025. In addition, bid/ask spreads have tightened considerably since the bank-crisis spike in March, indicative of calmer market conditions (Figure 3).
Figure 1. Morningstar European Leveraged Loan Index (Last Price)
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Source: Bloomberg; as of 12 May 2023.
Figure 2. European Leveraged Loan Issuance
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Source: Man GLG and Moody’s; as of 31 March 2023.
Figure 3. Bid/Ask Spread of All Euro Loans
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Source: Man GLG; as of 5 May 2023.
There’s More to Banks Than Their Share Price
Last week, PacWest Bancorp released its 10-Q report, which included a note that the bank’s deposits had declined by approximately 9.5% during the week ending 5 May, following headlines suggesting it could be next on the crisis conveyor belt. PacWest’s share price immediately plummeted.
However, the bank making it through the weekend without intervention by the Federal Deposit Insurance Corporation (‘FDIC’) suggests some stability has been achieved through recent moves to establish greater liquidity buffers (Figure 4), albeit the bank’s position remains fragile in our view.
More broadly for the banking sector, whilst equity prices can have a reflexive force, the FDIC’s focus appears to be on the broader funding base and how that affects an institution’s viability. Mid-sized and smaller banks may still face earnings challenges, but we don’t believe this is the existential threat implied by their equity weakness.
Figure 4. PacWest Deposits
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Source: PacWest Bancorp; as of 10 May 2023. PacWest's 10-Q form did not disclose its insured deposits as at 10 May 2023.
A Different Look at How the Market is Pricing Rates and Growth
By now, we have all seen countless iterations of Bloomberg’s World Interest Rate Probabilities chart, which derives rate expectations from futures and options prices. The model’s latest inference, following last week’s US inflation print, suggests the Federal Reserve’s most recent hike could have been the last of this cycle and cuts may come by the end of the year. Is this reflected in other assets too?
For a broader view of how the market is pricing the macro outlook we can see that, despite equities registering another strong week at the headline level, there are continued murmurs of growth concerns, recessionary signals, and ultimately rate cuts. Specifically, the Growth factor and Communication Services sector both performed well (Figure 5), the narrative being that long duration equities tend to benefit from falling rates. We also see that copper, a bellwether for global activity, struggled.
The slight rub with this story is that gold fared poorly over the same period; the metal has traditionally had a negative correlation with real rates, so would have been expected to do better in such a scenario. However, this recent dip could just be gold giving back some of its past gains: in the current disinflation episode, which began at the end of June 2022, gold has wildly outperformed what we would expect based on historic precedent (Figure 6).
Figure 5. Recent Asset Performance.
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Source: Man DNA; 4-11 May 2023. Growth equities represented through US long/short quintiles.
Figure 6. Gold – Performance in Current Disinflation Episode Versus Historic Average for This Episode
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Source: Man DNA; 30 June 2022 to 11 May 2023.
With contribution from: Peter Doane (Analyst, Man GLG); Martin Kinsler (Portfolio Manager, Man GLG); and Henry Neville (Portfolio Manager, Man Solutions).
1. Source: Moody’s; as of 30 April 2023.
2.Source: Moody’s; as of 30 April 2023.
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