MTM Monthly: Riding the Floating Rate Wave

June 14, 2018 - As equity markets rallied in May (the S&P 500 is now positive on the year at 2%), the loan market barely churned out its sixth consecutive month of positive returns.  The S&P/LSTA Leveraged Loan Index (LLI) returned a three-month-low 0.17% in May, a level that trailed high grade bonds’ 0.45% but bested high yield bonds’ -0.02% return.  At a 2.04% on the year, loan returns not only continued to lead the other major asset classes (from treasuries to equities), they remained the only investment that actually delivered a positive return through April.  That said, market value (MV) returns in the loan market were negative for the fourth month running, at -0.29%. (In fact, MV returns have been positive just once since November).  All told, the market’s average bid level fell 23 basis points in May – to 98.35, marking the worst monthly performance in almost a year.

Just 18% of loans reported MV gains during the month while a staggering 67% reported losses.  In other words, for every one loan price that advanced, 3.7 declined in May.  Hit hardest was the cohort of loans trading above par, which experienced a 12 percentage point reduction to their market share (66% to 54%).

So why all the red ink in May?  A shift in technicals seems to be a likely reason. According to S&P Global, the market experienced a $6 billion supply surplus, the biggest in nearly a year.  On the supply side, LLI outstandings shot up by $21 billion to a new record $1.03 trillion.  But it wasn’t like demand waned in May; it was quite the opposite.  On the visible demand side, CLO issuance came in at $11.1 billion (right around its 12-month average) while loan mutual fund inflows totaled a 15-month high $3.7 billion.   Furthermore, after adding $11 billion in AUM so far this year, loan fund AUM now sits at a 45-month high of $164 billion – just $10 billion shy of the all-time record established back in May, 2014. 

Looking forward, we expect that loan fund flows should continue to be robust given today’s rising rate environment.  Just this week the Federal Reserve hiked its benchmark short-term interest rate 25 basis points, pushing the funds rate target from 1.75% to 2%.  The Fed then indicated in its minutes that two more increases are likely later this year, which would bring the total to four in 2018 (previously the central bank had forecast three rate hikes).    Cleary this is a positive for floating rate loans.  Since the Fed began raising rates back in December 2015, LLI returns have totaled north of 14% compared to the sub- 4% return on the Bloomberg Aggregate Bond Index.  And this level of outperformance shouldn’t come as a surprise because higher rate environments have historically proven to be constructive for floating rate loans.  Case in point, loans outperformed bonds during the last three rising rate cycles (1994-1995, 1999-2000 and 2004-2006) and should continue to lead the fixed income markets in the months ahead.

LSTA Full and Associate Members can access the full Summary, including charts, here.  For more information, please contact Ted Basta.

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