In a preemptive move, companies with low credit ratings are swiftly reducing their borrowing costs even before the Federal Reserve considers an interest-rate cut. Notably, entities like SeaWorld Entertainment and Dave & Buster’s have collectively sought to cut the interest rates on approximately $62 billion of sub-investment grade loans in January, marking the largest monthly total in the past three years, as reported by PitchBook LCD.
This trend is a consequence of a broad rally in both stocks and bonds that commenced late last year, instilling optimism among investors that the prolonged era of high inflation might be drawing to a close, with no imminent signs of a recession. Leveraged loans, frequently utilized for private-equity buyouts, have seen a substantial surge in prices, primarily due to a slowdown in such deals, resulting in a scarcity of new loans entering the market.
The enthusiasm among investors has reached a point where they are willing to accept lower rates on existing loans, creating favorable conditions for businesses to refinance loans easily mere months after issuance. This practice, known as "repricing," reflects the strength of the market, indicating resilience against the Federal Reserve's efforts to combat inflation.
The year-end 2023 witnessed the loan default rate comfortably remaining below historical averages, dispelling initial concerns that companies heavily indebted before 2022 would face challenges as interest rates surged. Companies have strategically extended debt maturities by replacing older debt with new bonds or loans, and now many are taking the additional step of reducing their interest costs.
The interest rates on leveraged loans are variable, fluctuating with the rates set by the Federal Reserve. Despite initial apprehensions, companies have navigated this by adjusting the "spread" – extra compensation demanded by investors for the risk of default. Rate reductions have varied in size, with companies like Clarios, SeaWorld, and Dave & Buster’s successfully implementing adjustments, prompting approval for reductions in loans totaling around $35 billion this month.
Repricing waves typically occur when loans trade above their face value in the secondary market, signaling to companies that investors are willing to accept lower returns on their debt. Recent market dynamics show a significant share of loans trading at or above par, rising from 5% at the end of October to more than 40% early this year.
Despite the challenges posed by a compressed yield environment, low-rated corporate loans and bonds present a compelling alternative for investors, less volatile than stocks yet riskier than investment-grade bonds. Some investors anticipate debt's appeal over stocks in the coming years if interest rates remain higher, with sub-investment-grade bonds offering an average yield of around 8%, slightly elevated from the pre-pandemic era.
David Albrycht, chief investment officer at Newfleet Asset Management, emphasizes the cautious approach of portfolio managers, prioritizing safety amid yield compression. However, a potential selloff might see an inclination towards risk, with a strategic focus on floating-rate loans relative to fixed-rate bonds, offering an 8% yield that, with adept credit selection, proves to be an attractive return.
