At the end of 2020, the path ahead for U.S. leveraged finance market players seemed relatively clear: position for the COVID-19 reopening trade and an abundance of Fed liquidity pumping into the system. Fast forward 12 months, and a dizzying set of potential headwinds — from stretched valuations, inflation, evolving COVID-19 variants, supply chain problems and the dismantling of the Fed's liquidity framework — suggest a bumpier 2022 than some might have expected.
So, with another unprecedented year in the leveraged finance markets consigned to the history books, LCD once again surveyed buy-side, sell-side and advisory professionals to gauge sentiment for the year ahead. The results are detailed below. Some of the headlines:
* A majority do not expect a correction in 2022, but instead expect periods of "mini volatility."
* The loan default rate will linger near post-crisis lows.
* Inflation remaining above 3% tops the list of concerns.
* Leverage levels on new deals are unlikely to fall.
An interactive graphic of the complete survey results can be found here.
With valuations top of mind given the record amount of high-yield bonds and leveraged loans added to a growing debt pile in 2021, and with secondary market yields still stubbornly close to historic lows, LCD asked respondents when they expect a market correction. A large majority (61%) said a correction would not occur within the next 12 months, though 30% called for a correction within 12 to 18 months.
Just over a quarter (28%) of respondents expect a market correction could happen in six to 12 months.
Although a market correction in 2022 is seen as unlikely, "we will have periods of mini volatility of one to two weeks, as happened in 2021 due to COVID-19, geopolitical events, etc.," responded a senior syndicate banker.
Per LCD's polling, inflation is most likely to impact the performance of credit portfolios in 2022, taking 21% of all responses. Inflation also dominated responses at the second-quarter survey.
Debuting on the list, "Supply chain/Labor shortages" tied for the second-most-likely factor to impact portfolio performance, alongside the withdrawal of Fed liquidity, at 16% each. Despite polling after the emergence of the omicron variant of the coronavirus, COVID-19 pandemic-related impacts rose only slightly from the midyear reading to 13% of responses.
Several respondents wrote in to cite the transition to secured overnight financing rate as influencing the loan market in 2022. Others pointed to the impact of private credit, elevated valuations and the dominance of CLOs.
As LCD's survey in the previous two quarters also showed, the consensus market expectation is for inflation to be persistent rather than transitory. Moreover, a much higher share, 23%, see U.S. headline inflation equal to or exceeding 4% one year from now. Expectations for 4% or higher inflation one year on were at 12% in the third-quarter reading and 6% at the midyear poll.
Only 7% of respondents expect inflation to be 1.9% or lower. Put another way, 93% believe inflation will be at, or above, the Fed's policy target of a 2% average. Over 90% of responses also reflected this view in the previous two surveys.
Polling for LCD's survey took place Dec. 1-13 — before the Federal Reserve Bank signaled three rate hikes by the end of 2022. Nevertheless, 85% of respondents called for rate hikes in 2022.
The largest share (39%) of LCD's survey base of buy-side, sell-side and advisory professionals expect 10-year U.S. Treasury yields between 1.5% and 1.99% a year from now (yields fell to a 2.5-month low of 1.35% during polling). Thirty-two percent said yields will be between 2.0% and 2.49% by the end of next year, up from 29% in the third-quarter survey.
In the face of rising inflation costs and underlying borrowing rates, LCD asked the polling base which sectors would outperform in the next six months. For a second quarter, Technology topped the list, with 22% of votes. Healthcare was again second, at 18%.
As an aside, Technology and Healthcare are the two largest sectors in the S&P/LSTA Leveraged Loan Index, accounting for 15.34% and 10.21% of the index, respectively, meaning any movements from these sectors will have an outsized impact on the broader loan market performance.
To gauge sentiment on the current period of ultra-benign default rates, LCD once again asked participants whether they expect leveraged loan default rates to remain below the current 1% for longer than the 13-month stretch seen following the global financial crisis.
Sentiment this time was more mixed, with 34% of respondents expecting the sub-1% default environment to last longer in this new, current cycle, versus 47% in the third-quarter reading.
Ultralow default rates following a restructuring wave is a typical cycle phenomenon, given that the weakest balance sheets are flushed from the markets and subsequent economic recovery. For reference, the loan default rate dipped below 1% in July. With more than half of respondents expecting this sub-1% default rate to last for at least 13 months from that July date, the expectation is the rate will stay below 1% until August 2022 or beyond.
With that said, respondents, on average, expect the leveraged loan default rate to increase from 0.29%, where it ended in November, to 0.91% by the end of 2022. This sentiment is nearly unchanged from the third-quarter read that called for a default rate of 0.98%.
Defaults and debt, of course, go hand in hand. While the benign default rate may be supportive of market valuations, leverage multiples of speculative-rated loan issuers have crept higher in 2021. A debt/EBITDA of 5.45x in the fourth quarter for loan issuers in the new-issue market is the third highest on record. Nevertheless, only 19% see the leverage of companies raising debt in the new issue market decreasing next year.