Morgan Stanley warns this corner of the credit market could be the first to explode as interest rates rise

Now that Federal Reserve Chairman Jerome Powell has made it clear that the Fed has no plans to slow the pace of rate hikes, some bond market experts are warning that the most lucrative sectors of the credit market may be in for a rough ride. awakening.

A team at Morgan Stanley MS,
-1.08%
warned that leveraged loans could be the “canary in the credit mine” because of their fluctuating interest rates and the increasingly poor creditworthiness of issuers. As the U.S. economy slows, these borrowers can expect to be hit with a double whammy as cash flow deteriorates while debt servicing costs rise.

For those unfamiliar with this corner of the credit market, the term “leveraged loans” typically refers to subprime secured bank loans made to borrowers with below-investment-grade credit ratings, according to the Wells Fargo Investment Institute.

I see: Is the junk-bond market too bullish on a soft landing for the economy?

Typically, these loans are purchased by institutions such as investment banks, which then pool the loans and repackage them into collateralized loan obligations, which are then sold to investors.

The era of low interest rates that followed the Great Financial Crisis of 2008 caused the leveraged loan market to take off. It has nearly doubled in size since 2015 to $1.4 trillion in outstanding loans at the end of June, according to data cited by Morgan Stanley’s Srikanth Sankaran. Much of this issuance was leveraged by private equity firms to finance acquisitions of companies or simply to refinance.

As loan balances increased, borrower quality deteriorated, which was not particularly significant when benchmark rates were close to 0%. But as interest rates rise, investors should watch this space as the quality of borrowers is much lower than it is for the old bond market. While about half of junk-bond borrowers have credit ratings near the top of the non-investment-grade pile, only a quarter of leveraged borrowers have a ‘BB’ rating. The rest are lower.

Source: Morgan Stanley

To be sure, Morgan Stanley isn’t the only bank urging clients to approach with caution. A team of analysts from Wells Fargo WFC,
+0.50%
The Investment Institute said in a research note on Tuesday that investors should approach leveraged loans with caution.

However, they added that an explosion is not predetermined and Wells maintains a “neutral” outlook on space.

One reason is that only 9% of outstanding LL loans will expire between now and the end of next year.

Source: Wells Fargo

With interest rates rising, demand for new leveraged loans has fallen. Year-to-date, the value of loans issued by leveraged borrowers in the U.S. was below $200 billion, down about 57% from the same period last year, according to a Bank of America BAC credit analyst group.
+0.56%.

This makes sense given the sharp decline in mergers and acquisitions.

Retail investors can invest in leveraged loans through the Invesco Senior Loan ETF BKLN,
-0.14%
and the SPDR Blackstone Senior Loan ETF SRLN,
-0.16%.
The former is down just 5% so far this year, while the latter is down 6%.

Leveraged loans have outperformed other sectors of the bond market so far this year, with both of the aforementioned ETFs outperforming the iShares 20+ Year Treasury Bond ETF TLT,
+0.25%,
which is down almost 24% since January 1st.

However, credit strategists expect this could soon change with interest rates now expected to remain higher for longer. For that reason, investors should be on the lookout for warning signs like a wave of downgrades, according to Morgan Stanley’s Sankaran.

However, it remains to be seen if the rates will shock into something bigger.

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