Loan market effective yields continue to inch higher as the three-month London interbank offered rate (Libor) rises due to Fed tightening and as refinancing activity slows. Although the Fed decided to forego a rate hike in September and November, three-month Libor rose that month from 1.31 percent to 1.34 percent as the market priced in a potential rate hike in December. Effective loan yields—the all-in coupon rate divided by the loan price—are now 4.8 percent, 0.2 percent higher than they were in July 2014 before the oil market selloff that set off an 18-month stress period for risk assets. Looking ahead, our Macroeconomic and Investment Research team’s expectations for rate hikes suggest that loan investors will gain from higher coupons going forward. We expect the Fed will raise rates four times in 2018, which is more than the market is currently pricing in.
The Credit Suisse Leveraged Loan index recorded a gain of 1.1 percent in the third quarter. Leveraged loan average contractual spreads and discount margins tightened by 12 basis points quarter over quarter, bringing them to 363 basis points and 432 basis points, respectively.
For floating-rate borrowers, rising short-term rates directly flow through interest expense. The question becomes whether or not the bank loan market can sustain more rate hikes from an interest coverage perspective. With interest coverage at 3.8 times, according to S&P LCD, our view is that the sector continues to look healthy. Our sensitivity matrix, which models interest coverage under a range of three-month Libor rates, suggests that if earnings stay flat, which is a conservative assumption, Libor would need to rise to 3.0 percent for coverage to fall to below 3.0x interest expense—a level that we believe is associated with weaker credits.
Interest Coverage Under Various Libor Scenarios
Our sensitivity matrix, which models interest coverage under a range of three-month Libor rates, suggests that if earnings stay flat, which is a conservative assumption, Libor would need to rise to 3.0 percent for coverage to fall to below 3.0x interest expense—a level that we believe is associated with weaker credits.
Source: S&P LCD, Guggenheim Investments. Data as of 9.30.2017. Assumes no change in earnings or contractual spreads.
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