CMP Overview
Credit markets logged another strong quarter as resilient earnings, strong technical supply dynamics, and improving capital markets activity continued to support record-tight spreads in many markets. Throughout the first quarter, market expectations around Fed interest rate cuts changed significantly. The year began with predictions of a soft landing and a handful of interest rate cuts, with persistently strong economic readings, employment momentum, and inflation prints through March. By the end of the first quarter, however, the market was only pricing in a 67% probability of a single rate cut by the Fed’s June meeting, and several forecasters were predicting no cuts at all in 2024.
In corporate credit, the U.S. and European high yield and leveraged loan markets posted positive quarterly returns, with spreads tightening and lower-quality credits outperforming their higher-rated counterparts. However, the market seems to be trading on yield rather than spread, as the rise in Treasury yields was partially offset by spread compression, resulting in modestly higher absolute yields for the quarter. On the demand side of the market, fund flows were positive for both high yield and leveraged loans, with strong CLO formation driving loan prices higher and continuing the refinancing wave that started at the end of the fourth quarter. On the fundamental side, there was a continued increase in the contribution of distressed exchanges in both the high yield and leveraged loan markets in the U.S., but overall corporate fundamentals remained sound.
Within structured credit, spreads tightened across most RMBS and consumer ABS sectors to start the year, with the more subordinated tranches outperforming. After a lighter year of issuance in 2023, primary issuance was remarkably strong in both RMBS and ABS in the first quarter. Consumer performance was supported by the onset of the tax refund season, benefitting sectors such as unsecured consumer loans and auto. While strong new issue demand drove CMBS spreads tighter throughout the quarter, credit trends continued to weaken, driven primarily by an uptick in office loans being transferred to special servicing. CMBS remains cheap relative to alternative structured products, and the large money managers that have been absent in recent quarters seem to be reemerging in the market.
Total U.S. sponsored middle market loan volume was higher in the first quarter. All-in yields for first-lien term loans remained attractive, but we observed dispersion by sector and borrower size. The lower middle market default rate ended 2023 below 1%, while the rates in the core and upper middle markets increased.
Turning to commercial real estate, persistently elevated interest rates coupled with uncertainty about future rate decisions from global central banks continued to cloud the marketplace. Despite stubbornly high inflation, the global economy has demonstrated resilience, adding further complexity to the task facing central banks. This interest rate environment has driven a substantial slowdown in commercial real estate investment activity, as both buyers and sellers grapple with price discovery amid limited comparable transactions and financing availability. While higher rates have led to notable valuation declines, uncertainty remains regarding how much further values will deteriorate before stabilizing. Overall, fundamentals across many real estate sectors remained on relatively sure footing as future supply has been constrained by higher financing costs, which should continue to support sector fundamentals. Despite lingering uncertainty, we believe that the current market dynamics will create openings to identify high-quality assets at reset valuations, presenting a significant investment opportunity.
In the U.S., with the consensus view of a soft landing now somewhat clouded, market participants have remained on the sidelines. Investment volume was down close to 50% year-over-year as of the end of February, reflecting uncertainty about pricing, elevated debt costs, and limited availability of financing. The challenges posed by the upcoming wall of maturities are becoming apparent, as delinquencies in commercial real estate debt have increased materially. Meanwhile, fundamentals across most real estate sectors – with the exception of office – have remained strong, though there have been indications of oversupply in certain markets, particularly in the multifamily and industrial sectors.
In Europe, the ECB surprised the market by maintaining its record-high base rate in April, highlighting the ongoing challenge of managing sustained inflationary pressures. Unlike in the U.S., the European economy has been sluggish, with no growth in eurozone GDP reported in 2023. Against this backdrop, the commercial real estate market has been under considerable pressure, with investment volume down materially from recent peaks and valuations declining. We continue to expect that the material amount of debt maturing starting in late 2024 will result in a significant amount of stressed and distressed sellers entering the market.
Across Asia, the commercial real estate market has been less impacted by global macroeconomic pressures. Inflation has generally been well managed throughout the region, and GDP growth has remained relatively stable. While certain markets – such as Korea and Hong Kong – have grappled with increased interest rates, overall, real estate fundamentals have remained favorable across the region.