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An Analysis of the US Leveraged Loan Market in the First Half of 2023

The first half of 2023 has been marked by challenging conditions in the US leveraged loan market, with tightening credit conditions, a sluggish M&A pipeline, rising debt costs amid unprecedented rate hikes, and a more selective lender base. Despite these headwinds, leveraged loans have shown resilience, and we explore their performance so far and the potential opportunities and concerns that lie ahead for the remainder of the year.

Strong Performance Amid Rising Rates: Surprisingly, the floating-rate loan asset class has been on track for its best year, return-wise, since the Global Financial Crisis. With a remarkable 6.48% gain in the year to date, nearly three-quarters of the growth came from coupon-clipping. The increase in rates has contributed to this upswing, making interest returns account for 70% of total returns in the first half of 2023.

Volatility Remains Elevated: Though the secondary loan market has been calmer compared to 2022 and 2020, this year has witnessed more significant fluctuations since the Global Financial Crisis. In the first half of 2023, daily returns of over 10 basis points occurred 36% of the time, higher than any year since 2009. This volatility demands careful market monitoring and risk management.

Tightening Credit Conditions and Refinancing Dominance: Tightening credit conditions have resulted in minimal net supply, with primary market activity primarily driven by refinancing, amend-and-extend deals, and add-on transactions. As borrowers seek to address near-term maturities, the 2024 maturity wall has already reduced by more than half, while 2025 maturities have declined by 26%. However, some risky segments of the market still need attention.

Credit Quality Deterioration: The credit quality of outstanding loans continues to deteriorate, with a record 36% of index loans belonging to borrowers rated B-minus or lower. While default rates are on the rise, they remain below historical averages for now.

Stress Indicators Raise Concerns: Various stress indicators in the market are signaling potential trouble spots. Falling interest-coverage ratios, high distress ratios in sectors like Healthcare and Software, and increased downgrade-to-upgrade ratios should be closely monitored by market participants.

Persistent Net Supply Drought: The year has been characterized by a persistent supply shortage, as the par amount outstanding tracked by the Morningstar LSTA US Leveraged Loan Index declined by $12 billion in the first half of 2023. Refinancing-related issuance nearly doubled year-over-year, and loans extended through amendments also surged. While these efforts reduced maturities in the near term, borrowers with B-minus ratings may face challenges refinancing in the current risk-off environment.

Conclusion: The first half of 2023 has presented both opportunities and risks in the US leveraged loan market. While rising rates have provided a boost to returns, persistent volatility and deteriorating credit quality demand caution. Market participants should closely monitor the evolving landscape and potential risks in the remainder of the year to make informed investment decisions.

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