“Higher-for-longer” positive for loans but stay selective

Many investors in European loans have been wondering about the prospect of a debt write-down at media and telecommunications giant Altice France (SFR) following the company’s underwhelming fourth quarter 2023 (and FY 2023) earnings call, which triggered substantial falls in the trading prices and quotes of its bonds and loans. The earnings call, on 20 March 2024, raised concerns about the over-levered company’s use of asset sale proceeds, as well as the spectre of debtholders being impaired as part of the company’s suddenly announced aim to reduce net leverage to a new target of below 4x (net debt to EBITDA).¹

Further pressure on the company came in late March when S&P downgraded Altice France and its secured debt to CCC+ (CCC for Altice France Holding’s unsecured debt), citing, inter alia, weak credit metrics, weaker cash flow prospects, a growing interest burden and governance concerns.²

Greater dispersion of returns within loan market likely

While Altice France (encompassing Altice France S.A. and Altice France Holding S.A.) is the largest individual issuer of S&P-rated debt to European collateralized loan obligations, we see the wider market impact as rather limited.³ It is not a systemic problem for the European loans market.

That said, we do expect greater dispersion of returns within the European loan market due to a likely focus in the loan market on reducing exposure to over-levered credits in portfolios. We anticipate that we will see a repricing of risk, leading to possible price drawdowns of loans issued by companies that have large debt stacks coupled with weak operational performance.

Among the reasons why lower quality assets are unlikely to fare as well in 2024 as they did in 2023 are the following:

• Some of the highly levered names reliant on debt market financing may – whether due to M&A or capex programmes – need to issue new loans to meet liquidity needs. Amid increasing market focus on highly leveraged debt stacks, investors will likely demand that new issues reflect a more cautious risk pricing paradigm, in turn possibly leading to more stress on credit metrics. Investors are likely to remain cautious on large exposures rated B3, one step away from the riskiest C category (high risk of default).
• The increase in rates volatility since the beginning of the year – evident in the sharp rise in the MOVE Index in April and the significant back-up in 10-year government bond yields in 2024 after plunging to lows in late December 2023 – signals greater uncertainty for the financials of some highly leveraged corporates.⁴ The Swiss National Bank did cut its main interest rate by 25 basis points to 1.50% in March, but expectations around the US Federal Reserve (Fed) pivot in 2024 have been aggressively pared back (from expecting seven 25bps cuts to two or three). Similarly, the European Central Bank (ECB), on 11 April 2024, kept its key deposit unchanged at 4%. Although the ECB is expected to cut in June, there is generally now a relatively higher prospect of “higher-for-longer” policy rates, especially if oil prices rise further and global geopolitical tensions deteriorate. A higher-for-longer rate scenario is clearly negative for over levered companies, particularly those with a high percentage of floating-rate debt.

We believe that, along with lower correlation in returns across loans in 2024, investment strategies that can avoid price declines like Altice France will benefit in 2024.

What will drive returns in the loan market in 2024?

In 2023, we saw market participants reaching for risk, and lower-quality issuers rallying alongside high-quality names. In 2024, we see returns from the asset class continuing to be strong, largely driven by high coupons – in the region of 8%!⁵

Although defaults will likely pick up, they will still be contained, in our opinion. As of 29 February 2024, the trailing 12-month par default rate on the benchmark Credit Suisse Western Europe Leveraged Loan Index (CS WELLI) Index stood at 1.2%. Even if defaults rise to 3-4%, this still represents a manageable situation in an historical context.⁶

Investment outperformance in 2024 – relative to the CS WELLI Index – is likely to be driven by investment strategies that avoid distressed credits, excessive leverage and poor operating performance (i.e., credits that have not kept up with structural changes in the economy or have had poor business practices).

Positive return story intact

There are a number of reasons why we remain bullish on European loans. The first is relatively attractive spreads. In an asset class comparative context, valuations – if one compares the 4-year discount margin of loans to the z-spreads for fixed-rate corporates – continue to look reasonably attractive overall. Figure 1 shows spreads within a 10-year percentile ranking, as of 31 March 2024.

A second reason is risk-adjusted returns. If one looks at the 3-year discount margin for Western European loans, and then factor in a default and recovery scenario worse than the current situation – defaults of 3.5% of which 50% is recovered – we still end up with a loss-adjusted excess return (above cash) of more than 3%.⁷ Clearly these are statistics for the European loan market as a whole and we, in the Loans team, would expect to register a lower level of defaults than the market given our selective positioning.

High coupons underpin positive outlook

The third reason for our bullishness is coupons. Loan prices have, admittedly, moved much closer to par as a whole compared to this time last year.⁸ The rally in high quality names over this period effectively means that in order to reach beyond the average coupon yield, investors would have to reach further out for risk, which, in our view, appears imprudent at this juncture.

That means that returns will be largely driven by coupons. Fortunately, coupons are high and continue to make for a strong return story. Even with rate cuts, we foresee coupons remaining high. Figure 2 shows the evolution of loan coupons.

A fourth reason for our positive stance on loans is that they are a hedge against inflation – if it returns. Stubborn, or rising, inflation is clearly not a consensus view given moderating inflation data trends, but inflation remains a risk factor for fixed income credits. If, for example, oil prices rise further and central banks do raise rates, loan coupons will ratchet higher. Further, as we saw in 2022 and 2023, the real value of debt is eroded away as companies raise prices.

How we are positioning for success in 2024

Our current investment view takes a more defensive bent. Bearing in mind our afore-stated contention that the remainder of 2024 will see higher dispersion (decompression) in returns, with high-quality issues faring relatively better, our attention is on names with less highly levered cap stacks.

Important information

Past performance does not predict future returns. There is no guarantee that past trends will continue, or forecasts will be realised.

Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.

High-yield or “junk” bonds involve a greater risk of default and price volatility and can experience sudden and sharp price swings.

Beta measures the volatility of a security or portfolio relative to an index. Less than one means lower volatility than the index; more than one means greater volatility.