NEWS

On November 14, 2023, Oaktree Specialty Income (OCSL) held its earnings conference call for the quarter and year ended September 30, 2023. Management spent a considerable amount of time – outside of recapping the latest results – on its credit outlook for leveraged lending in the months ahead. Here are the relevant extracts:

The economy grew in the calendar third quarter, supported by a strong U.S. job market. However, broader macro conditions remain vulnerable due to the presence of higher interest rates and slowing earnings growth. This is particularly evident in the leveraged credit markets where we believe investors are increasingly exposed to tail risks. These risks arise as borrowers struggle to service increasingly expensive debt, especially those that are burdened with high cost on floating rate loans, which have become more expensive following the Fed’s aggressive campaign to raise interest rates over the past 2 years.

When we examine this further, we see that many companies, particularly those with outstanding leveraged loans or private debt borrowed heavily at a time when interest rates were near zero. As a result, they now have capital structures that may be unsustainable in today’s higher-for-longer interest rate environment. Importantly, the amount of debt represented by these markets is substantial. Not only have the U.S. broadly syndicated loan and private credit market has grown roughly twofold and sevenfold, respectively, since the global financial crisis of 2008, but the proportion of lower quality debt in these markets has also increased. By the end of the third calendar quarter, loans of credit ratings of B or below represented almost 75% of U.S. leveraged loans compared to roughly 35% prior to the financial crisis.

When the weakest segment of the credit markets is both sizable and more vulnerable than usual, investors face a heightened risk of increased defaults and lower-than-anticipated recovery rates. If this were to happen, both performing and distressed credit investors are likely to encounter an expanded set of challenges and opportunities.

Ryan Lynch Keefe, Bruyette, & Woods, Inc., Research Division – Managing Director

Okay. And then one last question, maybe just a higher-level question for you, Armen. It sounds like some of the market commentary you gave sounds a little bit cautious given where people financed some of their liability structures over the last couple of years and kind of the big movement in rates. I’m just curious, fundamentals for private credit when you look at revenues and EBITDA growth has been pretty healthy over — throughout 2020, ’23 . I’m just curious as if we roll into 2024, you’ve already seen sort of the decline in longer-term rates. Certainly, the forward LIBOR curve and the Fed funds probabilities continue to trend lower, especially with a report like today. Does your more cautious stance start to change if we start to see sort of rate cuts or if inflation comes down more materially, which implies the greater likelihood of rate cuts earlier or kind of in 2024?

Armen Panossian Oaktree Specialty Lending Corporation – CEO & Chief Investment Officer

It’s a good question. So I don’t think we will see material rate cuts in the front end of the curve, which is kind of what matters for floating rate assets and liabilities, without a meaningful recession. I don’t think the Fed is just going to cut rates because it can. Or I don’t — I just don’t think they’re positioned to do that unless and until there’s a meaningful economic issue. So I think that the rates are — while they might not be this high for a long period of time, into 2025 or 2026, I do think that rates are going to be materially higher for the foreseeable future versus what they were in 2018 or 2019 or 2021.

So with or without a recession, I think that there will be stress and a reason to be very cautious. So without a recession, there will be highly levered businesses that fail because they can’t make their principal and interest as it comes due. With a recession, I think you see a broader issue in the economy. And just as — just a little bit of a data point for you using the broadly syndicated loan market as a benchmark, about 50% of the broadly syndicated loan market is B3 rated by Moody’s. I would say that’s pretty similar to a good chunk of private credit in terms of credit quality that was issued in 2018 or 2019. Of that, roughly 50% of the market, 60% will have a 1:1 fixed charge coverage ratio or lower at the end of this year. And so I think that that’s 30% of a $1.5 trillion broadly syndicated loan market, that’s a fair bit of sort of issues that need to be handled. And I think as those defaults pick up and they roll through, the banks are going to have a tough time stepping up to kind of support the market.

… I just think that there’s going to be stress and fits and starts. And I think that looking backward at performance of businesses over the last 12 months being surprisingly good relative to what we thought it would be, it doesn’t necessarily mean that it will remain surprisingly good in the next 12 months because we have had a pretty stimulative environment. We’ve had a few trillion dollars of stimulus through the CHIPS Act, the Inflation Reduction Act, the Infrastructure Act. And those are all — those all help us sort of band-aid our way through a pretty challenging economic picture, and I think it has buoyed the economy more than anybody thought. But I think that that’s going to start rolling off.

And then we’re going to get into an election year where what the Fed does with rates may be called into question because of that election overhang. So a lot — I think there’s a lot of uncertainty out there and the reason to be cautious. I don’t think that rates will decline just because inflation is heading in the right direction. I don’t think rates will decline until you actually see a meaningful economic issue.

OAktree Specialty Lending – Conference Call – November 14, 2023

ANALYSIS

Different

We read just over 40 BDC conference call transcripts every quarter (you’re welcome). Typically, the BDC managers speak in general terms about the way ahead, adopting a reassuring tone while acknowledging that some credit challenges might be forthcoming.

(Of course, every BDC without exception – including OCSL – is confident of its own ability to navigate whatever the future may hold).

These comments about the leveraged finance – and BDC – markets, though, are unusually candid and offer a much more “conservative” (i.e. gloomy) perspective than we’re accustomed to.

As a result, the BDC Reporter thought it would be interesting to highlight the BDC’s Cassandra-like commentary.

Key Arguments

OCSL appears to be arguing that many companies binged on debt in the easy money period before the Fed began raising rates. With the Fed Funds rate at 5.5% – versus 0.25% in 2021 – that level of borrowing is “unsustainable”.

That means a company’s EBITDA generation may not be able to match its debt service costs going forward.

One-Two Punch

Compounding the risk is that OCSL is concerned that borrowers’ earnings power may decrease in 2024 as stimulative factors in the economy fall away – even in the absence of a recession.

Should a recession occur, the situation would be even worse.

OCSL is careful to say that these are “tail risks” – which is credit speak for impacting only some of the leveraged companies. But it’s a big tail: 50%-60% of the market. However, OCSL does not name its source for this monumental statistic. It may come from Moody’s but there’s no direct attribution.

By implication – with the compare and contrast data offered about current leveraged companies today versus before the Great Recession, OCSL seems to be suggesting non-investment grade companies may be facing risks of default greater than in the GFC. However, that is never said explicitly.

VIEWS

Thanks

We appreciate OCSL’s candor, and the message is all the more powerful given the size and reach of the Oaktree platform.

There is plenty of food for thought here and a message that deserves to be considered, especially at a time when leveraged loan prices are rising again.

Upward Bound

Here is the stock price of the Invesco Senior Loan ETF – BKLN – which invests in the top 100 leveraged loans in the U.S.:

BDC prices, too, are also on the ascent with BDCZ – the UBS-sponsored exchange-traded note that owns most BDC stocks – only (2%) off its 2023 highest price.

Yes Or No

The markets are not yet embracing the darker aspects of OCSL’s cautionary message.

Should they, just at a time when interest rates seem to have peaked; the economy is expanding at an impressive pace, and inflation metrics are trending favorably?

We’re going to dodge our own question and leave it to our readers to decide.