January 8, 2024 - 2023 recap. Lending activity was a mixed bag last year. LSEG LPC tracked total institutional lending at $311B, up 9% over 2022; however, excluding refinancings, institutional volume was down 47% to $106B, largely due to the lack of LBO/M&A transactions. The Morningstar LSTA U.S. Leveraged Loan Index (LLI) posted a 13.32% return for the year – its best performance since 2009 – primarily on account of higher base rates, with bids up 3.79 points to 96.23. Largely due to a strong secondary market, Pitchbook LCD recorded a tightening of new-issue institutional loan yields to 9.43% in December from 10.15% a year earlier. Despite the strong returns, investors pulled more than $13B from loan mutual funds in 2023, according to LevFin Insights, a Fitch Solutions company. Increasing perceived credit risk took precedence over rising interest rates, with outflows heavily weighted to the first half of the year and the last six months of the year generating modest inflows. BSL CLOs, still the single largest demand driver, provided $86B of institutional demand, down 19% from 2022 amid a challenging arbitrage environment and scant primary loan supply.

2024 primary market outlook. For 2024, JP Morgan is forecasting $375B in gross lending ($120B net of refinancings and repricings), while Barclays expects total volume in the $320-$350B range. Morgan Stanley and Citi trail these projections at $290B and $280B, respectively, on a gross basis. At the low end of the spectrum, BofA estimates total volume will register $240B, according to Pitchbook LCD. The consensus view is that refinancings will continue to comprise the lion’s share of transactions, with anticipated rate cuts acting as a tailwind and potentially providing a catalyst for green shoots in M&A activity. These amounts are still low compared to historical levels.

What of risk? The majority of respondents to Pitchbook LCD’s December U.S. Leveraged Finance Survey expect default rates to end 2024 in the 2.5%-2.99% range, compared to the LLI’s default rate of 1.53% at the end of December. Fitch forecasts 2024 default rates of 3.5%-4% for leveraged loans, up from 3.04% in 2023 (itself up from 1.6% at year-end 2022), reflecting ongoing macroeconomic impacts, including still high interest rates and slowing growth compared to 2023. Bixby Research, a Fitch Solutions company, notes that interest coverage ratios were effectively unchanged in the third quarter of 2023 at 1.7x reported/2.1x adjusted, compared to 1.7x/2.2x in the second quarter. BofA analysts highlight that coverage ratios won’t noticeably improve until interest rates fall to 3%, a great divide from the three rate cuts the Fed has indicated it may make in 2024 implying a year-end federal funds rate of 4.5%. But given borrowers’ increased use of liability management exercises (LMEs) – and the prevalence of document flexibility permitting LMEs, recoveries may become a more important consideration than the degree of defaults.

What of return? With respect to volatility, 53% of Pitchbook LCD’s survey respondents believe the worst of the volatility is behind us, an improvement from Q3, when 55% said the worst is ahead of us. As volatility is a driver of borrower migration from the broadly syndicated market to private credit, a less volatile environment may help stem the BSL’s market loss of share. (In 2023, the LLI shrank by $16B due to takeouts by private credit, according to Pitchbook LCD.) Aligning with this perspective, 58% of respondents said they think the LLI has hit its cyclical lows (91.75 in July 2022). LFI observes that analysts’ total loan return forecasts are all over the map, ranging from 7.2% (BofA) to negative 2.9% (DB).

And what of investors? It remains to be seen whether deliverance from a recession offsets the potential for multiple rate cuts to reverse 2023’s mutual fund flow trend. CLO issuance in 2023 at $116B (including middle market/private credit deals) tracked below 2022’s volume of $129B, according to LSEG LPC, reflecting a choppy environment attributable to tight arbitrage and a drop-off in lending activity. This year may also not provide much in the way of growth for the asset class (although the share of middle market/private credit CLOs is expected to increase). Analysts’ forecasts for 2024 issuance range from $100B (Barclays) to $120B (JPMorgan).

The bottom line: A broadening scope of geopolitical tensions, uncertainty around the timing and depth of monetary policy easing, the lagging impact of high interest rates and the final innings of the election cycle will all color performance in 2024. As for outcomes, here’s to planning for the worst and hoping for the best.

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