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Loans continue to offer senior secured positioning, floating-rate income, liquidity and attractive starting yields. Though the market remains broadly constructive, a return to interest rate hikes and stubborn inflation highlight the importance of issuer-level credit selection.
Our view turned modestly more bullish during the third quarter. Fundamentals remain strong, technical demand has firmed with steady loan fund inflows and active CLO issuance, and current spread levels look fair to attractive relative to the risk profile. At the same time, credit spreads remain wide in pockets, CLO formation has slowed from earlier-year highs, and uncertainty around the size and timing of further Federal Reserve (Fed) rate moves continues to suggest two-way risk.
Macro Backdrop: Rate Path Still Unsettled, Two-Way Risk Building
- The Fed’s 25-bps rate hike in September to 3.75%-4.00% — its first since 2023 — signals a policy stance driven by inflation, not by growth concerns. With most Federal Open Market Committee projections pointing to at least one more hike before year-end, near-term tightening looks likely, though the path beyond that remains less clear.
- Inflation remains the binding constraint. The core personal consumption expenditures (PCE) price index is running near 3.3%-3.4% and headline PCE near 3.7%, both well above target, while energy prices and Middle East supply risk keep the risks tilted higher. Growth, meanwhile, has proven firmer than expected, with third quarter gross domestic product tracking well ahead of the second quarter’s 1.5% given AI-related capital expenditure and steady consumer demand. That backdrop gives the Fed room to keep tightening without an immediate growth trade-off.
- Higher-for-longer dynamics remain a double-edged sword: Elevated coupons continue to support loan income, but a higher terminal rate raises the risk of higher defaults, particularly for the most levered, lowest-rated credits rather than the market broadly. For CLOs, rising interest rates could be a near-term positive, widening collateral spreads and creating attractive deal-execution windows, even as the longer-term impact on issuer credit quality cuts the other way.
Credit Fundamentals: Improving Beneath the Surface, LBO Wall Coming Into Focus
- Underlying fundamentals remain healthy, with revenue and EBITDA* growth data reinforcing the constructive case at the aggregate level.
- The 2021-2022 LBO vintage is approaching its refinancing window. Issuers that have not already refinanced or extended maturities are, in most cases, dealing with company-specific challenges rather than broad market access issues — reinforcing the case for credit selection over broad-market exposure.
- Liability management exercises (LMEs) continue, but the tenor has improved; transactions are showing more pro-rata treatment and less creditor-on-creditor conflict than a year ago — a modest positive for the asset class’s structural integrity.
- Spread widening persists in select sectors, notably software and insurance. This dispersion argues for continued issuer-level scrutiny.
Technical Factors: Firmer Demand, More Selective Positioning
- Technical conditions have strengthened, with steady loan fund inflows and active CLO issuance supporting the bid for loans, even against a backdrop of somewhat reduced CLO formation versus earlier in the year.
- As with credit fundamentals, technical support is real but uneven; sector- and issuer-level work remains essential to distinguish where demand is genuine versus where it is more indiscriminate.
Leveraged loans remain well positioned to deliver income and capital preservation in a market still working through interest rate uncertainty and credit dispersion. Fair valuations, resilient fundamentals and improving technical demand support a modestly more constructive stance, and reinforce our conviction that active management and credit selection remain essential to navigating the LBO refinancing wall ahead and the sector-specific pockets of spread widening still in play.
*EBITDA = Earnings before interest, taxes, depreciation and amortization.
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Floating-Rate Loans: An imbalance in supply and demand in the income market may result in valuation uncertainties and greater volatility, less liquidity, widening credit spreads and a lack of price transparency in the market. There can be no assurance that the liquidation of collateral securing an investment will satisfy the issuer’s obligation in the event of nonpayment or that collateral can be readily liquidated. The ability to realize the benefits of any collateral may be delayed or limited. Investments in income securities may be affected by changes in the creditworthiness of the issuer and are subject to the risk of non– payment of principal and interest. The value of income securities also may decline because of real or perceived concerns about the issuer’s ability to make principal and interest payments. Borrowing to increase investments (leverage) will exaggerate the effect of any increase or decrease in the value of investments. Investments rated below investment grade (typically referred to as “junk”) are generally subject to greater price volatility and illiquidity than higher rated investments. As interest rates rise, the value of certain income investments is likely to decline. Investments in foreign instruments or currencies can involve greater risk and volatility than U.S. investments because of adverse market, economic, political, regulatory, geopolitical or other conditions. Changes in the value of investments entered for hedging purposes may not match those of the position being hedged.
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