23 | 2023 Investment Outlook | December 12, 2022 FLOATING-RATE LOANS The Paradox of Opportunity KEY POINTS Loans have outperformed every major equity and bond index, and offer a yield 1 to maturity of about 9.4%, as of mid-November 2022. Andrew Sveen, CFA Head of Floating- Thorough credit research, as practiced by MSIM’s floating-rate loan team, is Rate Loans, Portfolio especially important in this environment. Manager 2 In 2023, loans offer the opportunity for high income, capital appreciation and 3 participation in the rising rates that may lie ahead. What We Are Seeing ƒ Floating-rate loans present a bit of a paradox at the end of 2022. Through mid-November, the asset class outperformed every major equity and bond index by a wide margin. Yet there are good reasons to consider the asset class a cheap buying opportunity in 2023. ƒ The core floating-rate feature of loans was highly attractive in a year when the U.S. Federal Reserve raised rates by 300 basis points. Loans escaped the downside peril of duration, while loan fund distributions nearly doubled from the beginning of 2022. ƒ Investors flocked to loans trading at $98 and yielding 4.5%, based on the Morningstar LSTA Leveraged Loan Index. But now, with loans trading at about $93 and a yield to maturity around 9.4%, buyers are harder to find. Call it the paradox of opportunity. What We Are Doing ƒ We have always maintained that loans are an asset class exposure that benefits from the thorough due diligence of credit research and active management, especially in this environment. ƒ Our investment team of 40-strong has re-underwritten our portfolio companies, gauging how they may be affected by today’s set of risks, like higher input and debt service costs. ƒ As part of this effort, we have resized or in some cases exited positions, where appropriate. Despite the spike in inflation and rising rates over the year, our “watch list” of credits—where we are truly concerned in the near term—remains limited. What We Are Watching ƒ For investors, the important question is whether the prices and yields on loans are compensating for the heightened recession risks in today’s market. ƒ We believe the answer is a solid “yes.” In mid-November, loans had an approximate seven-point discount from par. Conservatively assuming that 70% of defaults will be recovered (historically, that number has been 75%), the discount in the market today implies a cumulative 23% default rate ahead.