Loans outperformed credit in 2022, while high yield outperformed loans in the fourth quarter. HYBL returned 3.74%, outperforming the Blended: 50 Morningstar LSTA US Leveraged Loan Index + 50 ICE BofA US HY Constrained Index by 38 bps.¹

Performance Commentary

HYBL outperformed its benchmark in the fourth quarter primarily due to credit selection within its high yield bond allocation as well as its collateralized loan obligations (CLO) allocation. Loan selection had a modestly negative impact relative to the benchmark. HYBL de-risked and diversified its loan allocation during the quarter, reducing lower-rated exposure while rotating into higher-quality credits.

The top contributors to total return in the fourth quarter were Point au Roche Park CLO, Ltd., Royal Caribbean Cruises, and Iron Mountain. The top detractors were Mitchell International, Crown Finance, and Ivanti Software.

Outflows from loan retail funds persisted, losing over $12.6 billion during the fourth quarter and taking the full-year outflow at $12.7 billion. By contrast, high yield funds reversed course in the fourth quarter with a positive inflow of $5.6 billion, although this wasn’t enough to offset the full-year outflow of almost $50 billion.²

Quarter in Review Commentary

Markets rallied alongside improved broader macro sentiment through much of the final quarter, bolstering performance across credit markets.

The Federal Reserve (Fed) eased the pace of hikes in December in response to encouraging data suggesting inflation may have peaked, opting for a 50 bps raise after four consecutive 75 bps hikes. However, markets sold off in late December following hawkish comments from Fed officials that interest rates were unlikely to fall in 2023, despite November US CPI data posting its smallest monthly advance in more than a year.³

The loan market notched up three consecutive months of gains over the fourth quarter of 2022 and the high yield market retreated from its summer lows. The 2.74% gain for loans in the quarter helped bring full year 2022 returns to -0.60%, materially outperforming other asset classes for the year.⁴

High yield bonds posted a 4.17% gain for the fourth quarter, but a -11.19% loss in 2022, marking its worst annual performance since 2008.⁵

CLO debt tranches outperformed US Loans and HY for the year, returning +0.21% due to the +1.05% return for CLO AAAs. Returns for all other rated CLO debt tranches were negative for the 2022 period.⁶

Primary market activity was another victim of the increasing choppiness as banks and issuers stepped back. The fourth quarter saw just $35.7 billion of issuance, and the $225 billion in institutional loan issuance for 2022 was a 63% drop from the historic peak of $615 billion set in 2021. High yield bonds saw just $15.4 billion of issuance in the fourth quarter and $102.3 billion in 2022, which was the lowest annual volume since 2008.⁷

CLO issuance was limited to just $22.6 billion over the fourth quarter⁸ while CLO AAA spreads expanded to an average of 223bp during the fourth quarter from 212bp in the third quarter.⁹

The up-in-quality bias among investors, especially CLO buyers, persisted amid rising credit risk and lower growth expectations. That pushed credit spreads wider generally and left returns for CCC loans lower, with a 2022 total return of -12.00%, compared with 2.99% for BB loans.¹⁰ Similarly, CCC bonds lagged the broader index with 2022 total returns of -16.29% ,¹¹ providing more evidence of the theme of higher-quality credits outperforming lower-rated assets amid the ongoing flight to quality across credit markets.¹²

Positioning and Outlook Commentary

After a tumultuous 2022, we believe global credit markets have entered 2023 in a more constructive mood. Uncertainty remains, reflected in the wide-ranging outlooks from bank research desks, but for now expectations are for a more positive performance across sub-investment grade credit markets.

Based on historical precedence, floating rate loans tend to outperform both fixed rate and equities during Fed hiking periods,¹³ and we expect these assets should continue to benefit from ongoing rate hikes in the months ahead. Meanwhile, high yield should benefit from tailwinds including a potentially clearer backdrop for growth and inflation, an anticipated slower pace of Fed tightening,¹⁴ and less rate/yield volatility.

The higher-quality composition of the high yield market relative to historical levels and to the loan market is another advantage,¹⁵ while balance sheets are also in good shape. We expect interest coverage metrics to come under pressure as an economic slowdown weighs on cash flow, but current robust levels provide a good cushion.¹⁶ Following the deeply negative performance of 2022, high yield returns are forecast in the positive 5-8% range,¹⁷ and we believe current yields continue to offer an attractive entry point to the market.

There are multiple headwinds to negotiate, including disinflation, which we believe will prove both longer and more costly than generally assumed, largely due to tight labor markets and persistently strong wage pressure.¹⁸ The need for higher-rates-for-longer means volatility is expected to persist as a key feature of the investment landscape in 2023.¹⁹

Markets have largely priced in higher real rates, but in our view have only just started to price in the impact of a global recession. That creates the potential for credit spreads to widen again in the coming months.²⁰

The new year is also expected to bring fundamental deterioration as companies become more vulnerable to higher interest expenses and cost pressures due to slower growth and tight financial conditions.²¹ Unlike COVID, when downgrades spiked and then returned to normal relatively quickly, the weaker economic outlook means rising downgrades and defaults are expected to increase.²²

Pressure on CLO WARF and CCC buckets in CLOs will likely increase, although strong fundamentals mean CLOs should be able to withstand a potential downgrade and default wave, depending on vintage and active risk management.²³

Technicals will remain a key driver of performance in our view, although the picture here remains unclear. Primary loan and high yield supply is expected to remain subdued over the near term, with the focus on amend-to-extends, although the new year rally could bring repricings of higher quality 2022 transactions. As well, a slower pace of CLO issuance due to tight arbitrage and limited loan supply could help liability spreads tighten.

Retail demand is expected to return as macro stability returns.²⁴ Demand from CLOs, which represent 61% of the loan buyer base, ²⁵ is forecast to stay subdued, at least during the first half of 2023.²⁶

We believe robust credit selection underpinned by our fundamental bottom-up approach to investing will help us preserve capital as we reposition portfolios, rotate into higher quality issuers and prune risk.