LCD Leveraged Loan Survey: Investors concerned about inflation, shifting Fed

The first half of 2021 extended the recovery in leveraged finance markets, as issuance records were challenged and default rates tumbled. Global monetary policies that fueled an abundance of liquidity after the initial pandemic-induced crash in March 2020 also aided a rally to record tight pricing levels in the riskiest corners of corporate credit. Inflation, rates and cryptocurrencies all drove sentiment in the second quarter of 2021, and ESG firmly entered the conversation as a nascent part of the market.

To take stock for the year ahead, each quarter LCD surveys leveraged finance professionals to gauge sentiment on the $1.2 trillion leveraged loan asset class. Results from our wide-ranging survey — conducted between June 14 and June 28 — are detailed below. Some of the headlines:

* Respondents are divided on whether U.S. credit is in bubble territory.

* ESG policies are seen as neutral to credit portfolio performance.

* Inflation risks top the list of concerns, followed closely by withdrawal of Fed support.

* The leveraged loan default rate is forecast at 1.77% 12 months from now.

Respondents were divided on the question of asset bubbles, with 43% of market pros deeming U.S. credit as not being in bubble territory, and 41% believing that it is.

Some 15%, meanwhile, said the market is "approaching" this level. One respondent opined that "It could be a long frontage [to overvaluation], but we will hit the ramp at some point."

Others commented that U.S. credit markets are 6-12 months away from bubble risk and that with the risk "getting close," a "catalyst could send the market downwards."

Encouragingly, respondent feedback also suggests that while the market is "frothy," there is "still time to correct bad trends on credit quality."

ESG considerations

Given the heightened focus around the environmental, social and governance considerations in the finance markets, LCD this quarter posed questions to the buyside to glean the prevalence of ESG policies within portfolio mandates, the expectations on performance trends with the inclusion of ESG, and more broadly, to get a sense of the biggest challenges a company or portfolio manager might face in implementing ESG goals.

Although the market for ESG-related issuance is in the nascent stage, feedback from LCD's survey suggests demand is extremely high, with 68% responding that a formal ESG policy was part of their portfolio mandate. Meanwhile, 19% said a formal ESG policy was in the planning stage, and 13% said there was no formal ESG policy to their portfolio guidelines.

MORE ESG ANALYSIS: ESG goes mainstream across global leveraged finance markets in 2021

The European market has taken the lead in embracing ESG. The volume of European term loans completed with margin ratchets linked to ESG-related key performance indicators, or KPIs, skyrocketed to €16 billion in 2021, from near-negligible volumes in 2019 and 2020. This compares to just $4.6 billion of U.S. loans issued in 2021 with ESG margin ratchets. Note that U.S. and European research subscribers can access LCD's recently launched ESG tracker for new-issue loans and high-yield bonds in the U.S. and Europe that have an ESG component.

An overwhelming majority (83%) expect ESG policies to be neutral to performance, LCD's survey finds. This is followed by 12% expecting ESG policies to improve performance, and just 5% expecting it would worsen performance.

The two biggest challenges to implementing and achieving portfolio or company ESG goals are "Lack of historical data" and "Standardization of ESG frameworks," according to LCD's polling, with 31% and 28% of responses, respectively. A lack of regulatory clarity, and ESG issuance in which to invest, came in third and fourth, at 18% and 11%, respectively.

Other challenges listed within a write-in option of "Other" include political policy as it relates to ESG, disclosure requirements surrounding privately held companies and a lack of definition around what qualifies as ESG.

From fundamentals

As the last of the 2020 peak defaults roll off the trailing-12-month calculation, LCD once again asked market pros for their view on the restructuring landscape, one year from now.

On average, respondents expect the leveraged loan default rate to budge slightly from where it sat at the time of polling, with a prediction of 1.77% for June 2022.

Per LCD's data, nearly $5.7 billion rolled off the trailing calculation in June, bringing the rate to 1.25% (assuming no new defaults) by month-end. In July, the amount rolling off — the last of the mega 2020 default months — will ramp up to $7.7 billion, potentially lowering the rate to just 0.58% (again, assuming no new defaults).

Against that backdrop, the default rate will almost certainly dip before potentially rising to the predicted 1.77% in June 2022. Timing is the trickier aspect to forward predictions, but the expectations are clear that liquid debt markets have resulted in fewer restructurings than initially feared, and that while default rates are plunging, when they do rise in the coming year, they should still remain well below the 2.9% historical average.

Pivoting to outside influences, recent statements from the Federal Open Market Committee have brought inflation and tapering discussions back to the fore. With that in mind, LCD asked respondents for their views on inflation, rates, and when the Fed will start to dial back its low interest rate policy.

Among LCD's survey base of buy-side, sell-side and advisory professionals, 47% expect U.S. headline inflation to range from 2.0%-2.9% one year from now, while 45% see inflation above 3.0%. Put another way, 92% believe inflation will be at or above the Fed's policy target of a 2% average, which could force the U.S. central bank to accelerate its timeline for raising rates. Perhaps more ominously, the 45% of respondents who see inflation above 3% one year out speak to perhaps more significant Fed action — and sooner — than markets currently expect.

With respect to the timing of potential Fed action, the majority (37%) of respondents see the Federal Reserve raising rates in the second half of 2022. As noted, 45% of respondents also believe that inflation will be higher than 3% in 2022, implying that the Fed will allow higher inflation in an economy that is perceived as in recovery as opposed to overheating.

Note that on June 16, during the polling period, the Fed accelerated its timeline for rate hikes, saying it may act sooner than previously planned to start dialing back the low interest rates, taking a more hawkish tone on inflation. While the majority of Fed officials now see at least one rate hike in 2023, seven of the 18 members called for possibly increasing rates as early as next year.

One risk to the lofty valuations in the fixed-rate high yield bond market especially — where the yield-to-worst on the S&P U.S. High Yield Corporate Bond Index is once again sitting at a record low of 3.81% as of June 28 — is the specter of rising rates. During the June 14 to June 28 polling window, 10-year U.S. Treasury yields fell from 1.51% to three-month lows of 1.45% on June 10 and June 18. Against that backdrop, two-thirds of respondents think the 10-year U.S. Treasury yield will be between 1.50% and 2.49% one year from now.

Given the 4.2% spike in headline CPI in April, potential inflation risks unsurprisingly topped the list of variables that would likely impact credit portfolios in the second half of 2021, with a 25% share of the responses. The withdrawal of Fed liquidity followed, at 18%, and the rate environment came in third, at 16%.

In contrast, in the first-quarter survey conducted in March, the rate environment topped the list at 24%, followed by pandemic-related impacts at 20%, and credit quality at 16%.

Finally, among the different industries, healthcare retained its top spot as the most likely to outperform in the next six months, netting 14% of the responses (versus 17% in the first quarter).

With the economy continuing its recovery, and with pandemic fears subsiding, consumer discretionary — which includes retail and leisure — was second most likely to outperform, with 13% of responses. In the first-quarter survey, consumer discretionary was tied for third, also at 13%.

When given the option to "add any comments on influences driving the leveraged credit markets" that LCD might want to note on background for readers, one institutional investor wrote in that "overwhelming demand will lead to unjustifiably tighter and tighter clearing prices for weak B and middle market issuers."

This sentiment was echoed by a restructuring advisor, who said, "fundamentals are out the window," and added that there is no rationale behind the valuation increases and strong yield compression.

Other responses included concerns around weak documentation standards, the influence of private equity powder, and higher purchase multiples that could potentially inflate valuations.