Cold November Returns: The Secondary Loan Market Giveth and Then Taketh Away

December 7, 2017 - After a rousing start to the fourth quarter (returns hit 0.6% in October), the S&P/LSTA Leveraged Loan Index (LLI) returned just 0.12% in November.  Loans though, actually outperformed the other fixed income markets where returns were in the red across the board (HY returns were negative 0.27%).  Aiding and abetting the declines were retail investors who seemed to sour on credit products in November; they pulled almost $5 billion from high yield bond mutual funds and roughly $3 billion from loan funds.  On the other hand, equities continued their storied march higher; the S&P 500 tacked on another 3% in November which raised its year-to-date return to a staggering 20% (including dividends).  In the fixed income space, HY bonds have been the top performer at 7.17%, while loan returns have totaled a “coupon-only” 3.71%.  Many expected loan returns to be in the low 4% range by this point in the year but a combination of falling coupons (-52 basis points) and unforeseen market value losses (-68 basis points) have chipped away at total return levels.   

November, of course, didn’t help those year-to-date return stats. Last month, market value losses on the LLI came in at -0.28% - the worst showing in three months.  All told, prices in the secondary retreated 20 basis points to a sub-98 average bid.  Price declines were widespread across the secondary with 55% of loans reporting LSTA/LPC Mark-to-Market (MTM) losses and just 35% reporting gains.  In total, decliners led advancers at a 1.6:1 ratio; the worst showing since August.  Furthermore, 26 of the 33 sectors (79%) in the LLI reported market value losses in November while 9 of 33 (24%) tallied negative total returns.     

So why all the red “MTM” ink in November?  First off, four defaults occurred, with Cumulus Media being the largest. This marked the busiest month of the year for troubled borrowers.  In turn, the default rate by amount hit a 13-month high of 1.95% (up from 1.51%) while the default rate by number increased to a 10-month high of 1.72% (up from 1.41%).  And those numbers did not include IHeart Communications, which is widely expected to default in first quarter 2018.  (According to LCD, IHeart’s default would cover more than $6 billion in loans and would push the default rate by amount to a 32-month high 2.68%.)   Second, technical conditions changed in a big way as October’s $13 billion demand surplus morphed into November’s $5.5 billion supply surplus.  On the supply side, the size of the LLI grew by more than $14 billion – to a fresh record of $961 billion.  But on the demand side, the $3 billion of loan mutual fund outflows ate away at net demand levels despite the $12 billion-plus in new CLO formation.  Moving forward, CLO issuance should begin to taper off as we get closer to year-end.  But that decrease in demand could potentially be somewhat offset by retail investors who might jump back into loan funds (and other vehicles) as the Fed is widely expected to announce another rate hike during their upcoming policy meeting in mid-December.               

LSTA Full and Associate Members can access the full Summary, including charts, here (located under Secondary Market Monthly).  For more information, please contact Ted Basta.

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