Safeguarding Leveraged Credit Portfolios Amid Heightened Interest-Rate Volatility
While rapidly deteriorating credit quality and excessive market leverage were the chief culprits behind the end of the previous credit rally in 2007, neither factor is currently a significant concern in the leveraged credit market. Interest-rate risk, specifically the market’s uncertainty regarding future monetary policy, precipitated the recent market sell-off and will likely continue to shape the performance of high yield bonds and bank loans in the near term.
Despite the parallels being drawn between current credit conditions and those of 2007, the chances of experiencing a sudden spike in near-term defaults, similar to what ensued following the end of the previous credit cycle, remain remote given the robust capital markets activity. While rapidly deteriorating credit quality and excessive market leverage were the chief culprits behind the abrupt end to the previous credit rally, neither factor is currently a significant concern in the leveraged credit market.
Interest-rate risk, specifically the market’s uncertainty regarding future monetary policy, precipitated the recent market sell-off and will likely continue to shape the performance of high yield bonds and bank loans in the near term. Amid increased interest-rate volatility and a gradual softening in underwriting standards, investors should seek to safeguard portfolios by shortening interest-rate duration and improving credit quality. While we continue to view bank loans as the preferred investment vehicle to achieve these dual objectives, the backup in bond yields has created an attractive re-entry point to selectively increase allocations to high yield bonds.
- The Federal Reserve’s (Fed) announcement of possible tapering as early as the end of 2013 has caused investors to re-price risk. With yields on the 10-year Treasury note 82 basis points higher since May, current market conditions necessitate a greater focus on optimal positioning on the yield curve.
- Investors’ preference for bank loans over high yield bonds is likely to persist until interest-rate volatility subsides. During the second quarter, high yield bonds lost 1.4 percent while bank loans returned 0.3 percent.
- Credit conditions remain relatively benign compared to the experiences of 2006 and 2007. Analyzing market leverage and the financing terms of leveraged buyouts (LBOs) from the respective periods helps illustrate this contrast.
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