Apple Earnings Are on Deck. Will Apple Intelligence Help Drive iPhone Sales?

Ivanna Hampton: Welcome to Investing Insights. I’m your host, Ivanna Hampton.

A floating-rate investment with a risky reputation is growing in popularity. The bank-loan market has doubled in the past decade. That’s made it a bigger asset class than high-yield bonds. Their adjustable yields boosted demand when the Federal Reserve was raising interest rates. But the Fed cut interest rates in September and is signaling more could follow. Could bank loans’ appeal drop as rates fall? Katie Binns is the director of product management for Morningstar Indexes. Here’s our conversation.

Welcome to the podcast, Katie.

Katie Binns: Thanks so much for having me on, Ivanna.

What Are Bank Loans?

Hampton: I want us to start with what are bank loans, and how do they work?

Binns: Great question. So, first, this asset class actually goes by many names, which can be a bit confusing. The Morningstar Category for ETFs and mutual funds is called bank loans. Our index that measures this asset class is called the Morningstar LSTA US Leveraged Loan Index. And you’ll also hear the terms senior-secured debt or broadly syndicated loans.

So, nuances aside, these terms, very simply defined, a leveraged loan is a commercial loan provided by a sizable group of lenders to a commercial borrower. Deals are typically below-investment-grade. And these loans are broadly investable by institutional investors. And while not directly investable by retail investors, they’re widely accessible through ETFs and mutual funds.

Bank Loans vs. Junk Bonds

Hampton: Bank loans share similarities with junk bonds, but they’re still different. Can you talk about that?

Binns: Indeed, they do share a lot of similarities and some key differences. So, first of all, loans are actually private-market transactions, whereas high-yield bonds are typically publicly issued. And unlike high-yield bonds, which typically have a fixed-rate coupon, leveraged loans are floating-rate, meaning when rates rise, it’s typically beneficial to the asset class because you see a greater contribution from interest return to the total return component.

So, maybe put into context, starting in 2022, we saw a dramatic rise in interest rates. And that enabled yield on the loan index to cross into double digits for many months, actually well exceeding the yield offered by high-yield bonds. So, that’s the key component of the differences.

Aside from coupons and yields, some other key things to take into account. Leveraged loans are senior secured, meaning they’re actually higher up in the capital structure, meaning less risky than high-yield bonds from where they’re positioned. That said, default risk is actually still a bit higher in leveraged loans, but recovery rates are also a bit higher. All of this is to say that neither asset class is without some risk.

The Role of Bank Loans in Your Portfolio

Hampton: It appears that bank loans provide some diversification. Where would they fit in a portfolio?

Binns: Great question. Leveraged loans do provide an excellent source of diversification, certainly for investors seeking income, or coupon clipping, as we like to say. They’re very effective at that. Most importantly, when we think about their role in a portfolio, I think they offer really great inflation protection because of their ability to move as rates move. And also, this floating-rate component is really important to consider relative to other asset classes. So, loans have less price sensitivity to movements in the yield curve. So, that makes them less volatile than, say, Treasuries and also high-yield bonds.

So, a helpful resource that you might want to look at or investors might want to look at is some research that the Morningstar manager research team did recently, where they brought to light that leveraged loans can be a beneficial tool across a well-diversified portfolio because of their low correlation to other asset classes.

Why the Market for Bank Loans Has Grown

Hampton: And the markets for these investments have jumped. What’s making them so appealing?

Binns: Great question. I think the appeal comes from several different factors. First on the supply side. Private equity is playing a really important role here because leveraged loans are really important instruments to M&A activity. Then, on the demand side, CLOs [collateralized loan obligations], which are basically a type of security that’s backed by leverage loans, of course, need these loans to generate their cash flows.

For the borrower, they provide a very efficient source of financing that can be used for a variety of needs. And then for the investor, beyond the benefits we already talked about with diversification, I think they make a really useful parking lot for dry powder for investors waiting to make a private-credit allocation. So, all of these factors combined, I think, are what has contributed to the steady growth and appeal of the asset class, which now sits at about $1.4 trillion outstanding.

Companies With Bank Loans Today

Hampton: And Katie, can you name a few companies that are participating in this market right now?

Binns: Sure. When we look at the loan index, there are about 1,400 loan facilities from 1,100 issuers. And it may surprise you that actually many of these are household names. You have American Airlines AAL with leveraged loans for the aviation sector. You have Bayer BAYRY and Bausch + Lomb BLCO from healthcare. You also have fitness companies like Life Time Fitness LTH in the index. So, beyond the familiar names, which often make investors feel more comfortable, you do have a wide variety of other private companies that aren’t publicly traded and aren’t issuing high-yield bonds offering that diversification effect.

Why Bank Loans Are Less Volatile Than Junk Bonds

Hampton: And bank loans come with that higher credit risk, but less volatility than junk bonds. Why is that?

Binns: Great question. It’s important to understand the risks of this asset class and how they move with volatility. So, from a credit-ratings perspective, they do, in aggregate, have lower ratings than the high-yield bond index. The majority of loans sit at about single B in rating. But despite this, when we look at the history of the index, they have lower volatility as measured by standard deviation of returns than high yield. And that just goes back to that floating-rate component. Ultimately, these instruments are just less price-sensitive to big movements in the yield curve. And so, I think that makes it an important factor when decision-making.

How Interest-Rate Cuts Could Affect Floating-Rate Investments

Hampton: The Fed cut interest rates in September, and they have hinted that more could be coming. How could those moves affect the floating-rate investments?

Binns: As rates fall, yields will inevitably fall for this asset class. But loans still have their benefits. Remember that loans only have produced a negative calendar return three times in their history; 2008, 2015, and 2022 compared with five times for high-yield bonds in the same period. So, in the current environment, there’s still a very, very nice base upon which to create income. SOFR [secured overnight financing rate] is at about 4.5%. Effective yield is about 9% for the asset class. And even while that comes down, it’ll probably typically be higher than that of high-yield bonds.

Could Riskier Credit Investments Default With an Economic Slowdown?

Hampton: And what if an economic slowdown emerges? Should investors own riskier credits that could possibly default?

Binns: These instruments are certainly sensitive to the economy and the companies that are borrowing. But we’ve talked about that; we understand their credit profile is riskier than investment-grade, but it also offers the benefits, the lower duration, the stable income, the coupons, and the position in the capital structure. So, I think that these features can help an investor weather any type of recessionary storm.

Ultimately, it is quite a dynamic market that we’re in. And the pace of rate cuts hasn’t been what investors thought earlier this year. So, I think there’s still a lot of unknowns out there. But with that backdrop, I’d like to think that loans still fit very well in the context of a diversified portfolio.

Hampton: Well, Katie, thank you for coming to the table and sharing your insights on bank loans.

Binns: Thanks, Ivanna. It was a pleasure.

What’s Coming Up in the Markets?

Hampton: Here’s the markets in brief for the week ahead: Big Tech will talk earnings, and Wall Street will listen. Google parent Alphabet GOOGL is scheduled to report its third-quarter performance on Tuesday, Oct. 29. Microsoft MSFT plans to update investors on its fiscal 2025 first quarter on Wednesday. Apple AAPL is expected to post its fiscal fourth-quarter financial results on Thursday.

Here’s a question: Will Apple’s artificial intelligence suite revolutionize how people do things or just fade into memory? The tech company is powering up its release of Apple Intelligence. Meanwhile, it has also pulled the plug on other promising innovations this year. What’s next for Apple’s future, and should investors buy into its vision? William Kerwin is an equity analyst for Morningstar Research Services and covers the company. We discussed his outlook for the tech titan ahead of earnings.

Welcome to the podcast, William.

Will Kerwin: Thank you for having me.

Is Apple Intelligence Worth Upgrading Your iPhone?

Hampton: Apple seems like it’s making a big bet with Apple Intelligence. Many folks will need to ditch the old iPhone and buy a new one to use it. Is it worth the upgrade?

Kerwin: We think it will be, but it’s going to take a while. So, Apple Intelligence hasn’t actually rolled out yet. It’s set for the last week of October. And even then, it’s going to roll out in multiple stages. So, they’re going to roll out some features initially. There actually is a beta going on right now, but when the full release happens, it won’t really be a full release. It’s going to come out over the course of several months.

So, we think those features will be really appealing for consumers. And ultimately, what matters is if consumers think it’ll be worth it. And we think they will, but we think it’ll take a while. It’s not going to be instantaneously over this holiday season or the course of the next year. We kind of think it’ll be a two-year cycle, over the iPhone 16 this year and the iPhone 17 that we expect to come out next year. So, it is an appealing feature set, but it’s going to take some time.

How Important Are iPhone 16s Holiday Sales to Apple?

Hampton: And you brought up iPhone 16s. How important is it for those phones to sell well this holiday season?

Kerwin: It’s a little bit important. At Morningstar, we focus more on the long-term view. So, we’re really more focused on what do iPhone sales look like over the next five years. But the December quarter is Apple’s seasonally strongest. It’s always their best quarter over the holiday season. They usually time up new product releases during that time. So, it’ll be a good first data point, the first indicator about how much consumers are really excited about the iPhone 16, about Apple Intelligence. But we don’t think it’s the whole story. We think we’ll need to see more quarters in the books to really see what the full impact is.

Why Apple Stopped Developing Self-Driving Vehicles and Electric Cars

Hampton: And Apple has pulled the plug on a couple of innovative projects this year, self-driving vehicles and building electric cars. Why steer away from these products as their competitors move forward with their versions?

Kerwin: For Apple, it’s really about focus, I think. And we think the highest value to Apple’s products and to the stock is this ecosystem of consumer devices, hardware, and software, they even make their own chips now. And a car doesn’t fit well in that ecosystem quite as much. It could maybe in the future, but we think they kind of narrowed down their focus on a new product like the Vision Pro that came out last year, or earlier this year, excuse me. And that fits more with that software ecosystem, their apps, it can link to your Mac, it can link to your iPad. So, you know, they’re always exploring new projects. They talk about kind of this basement lab that they have in Cupertino with all these top-secret things. We think a lot of these ideas are getting thrown out all the time. The car has gotten some focus, but ultimately, we think they’re right to focus on these consumer devices.

Hampton: Have you seen that lab before?

Kerwin: No. I wish. I would love to. I don’t think anyone has.

Could Nvidia Taking the Title as the World’s Most Valuable Company Affect Apple?

Hampton: Market watchers have been keeping track when Nvidia NVDA briefly takes the title as the world’s most valuable company, which Apple holds. Does this matter, or is it noise? What do you think, William?

Kerwin: I think it’s totally noise. I mean, if you’re an investor in Apple, you want the shares to appreciate, you want its market cap to go up, but it doesn’t really have anything to do with what Nvidia’s shares are doing. So, ultimately, it’s more about what can Apple do to improve its own performance, rather than competing on stock price with Nvidia.

What to Look for in Apple Earnings

Hampton: And Apple’s going to report earnings on Thursday, Oct. 31. What do you want to hear from the CEO Tim Cook and his team?

Kerwin: Yeah, Halloween, spooky earnings. Really the two biggest things, well, the iPhone is the company’s biggest driver. So, that’s always the number-one thing that we look to when we look at Apple’s earnings. So, really this quarter we’re looking at, how are the early reports of shipments from the iPhone 16? It launched on Sept. 20, so there’s only going to be about 10 days of data in the quarter but still an early indicator. And then really the most important thing is their guidance and outlook for the December quarter. We talked about how that’s seasonally the strongest, it’s the holiday season.

So, that’ll show what management is expecting for that holiday season. And again, kind of a first initial data point, not the whole story, but a first hint into what will the sales of the iPhone 16 look like, how much is the impact from Apple Intelligence going to be?

Apple Stock Outlook

Hampton: And what is your outlook on Apple stock?

Kerwin: Well, we love the company, but we don’t love the stock price right now. We have a wide economic moat rating on Apple. We think it is in a tremendous competitive position—again, this tight ecosystem of hardware, software, and devices that just works, this premium, we call it a walled garden. It’s very difficult to switch out of it. So, we love the company fundamentally. We think our expectations for the financials are actually pretty strong going forward over the next five to 10 years. But we think that stock is pricing in some exuberance right now from investors. We think that the excitement over AI has really generated a ton of appreciation in the stock this year. And while we think that’ll drive some fundamental improvement, we think that what’s implied in market prices right now is just overexuberant, as I said.

Hampton: William, thank you for coming to the table and sharing your insights into Apple ahead of earnings.

Kerwin: Thank you so much for having me. Loved it.

Hampton: That wraps up this week’s episode. Thanks for watching and making this show part of your day. Subscribe to Morningstar’s YouTube channel to see new videos about investment ideas, market trends, and analyst insights. Thanks to senior video producer Jake VanKersen and associate multimedia editor Jessica Bebel. I’m Ivanna Hampton, lead multimedia editor at Morningstar. Take care.