January 3, 2019 - If one (hyphenated) word described December 2018, it likely would be “risk-off”. As the first chart in LCD’s Quarterly Review demonstrates, the riskier the asset class, the more it traded down. To wit, in fourth quarter, equities were down 13.5%, HY bond returns were -4.6%, leveraged loans were down 3.5% and HG bonds edged into negative territory (-0.04%).
But did this fourth quarter rout ruin the whole year? Perhaps not. As JPM mused, “While the leveraged loan asset class endured a heavy bout of selling since 10/22 which has returns down 3.40% peak-to-trough, leveraged loans were still among the top performing asset classes in the world during 2018.” By our count, the S&P/LSTA Loan Index returned a positive 0.44% in 2018. And in a year that ended this bloodily, we’ll call that a win.
While loans were hammered by headlines in fourth quarter, the reality is that default rates are low and the sell-off appears to have had technical components. Investor demand, which had been strong for much of the year, weakened significantly in fourth quarter and turned negative in December. On the positive side, CLOs eked out a record $128 billion of issuance in 2018. However, the CLO machine slowed sharply in December; issuance fell to $5.7 billion, approximately half 2018’s $11 billion monthly average.
The real pain, of course, was in funds. After pulling in nearly $15 billion through September, loan mutual fund flows reversed dramatically. There were $17.3 billion of outflows in fourth quarter, with $12.7 billion in December alone, says Lipper and LPC. As loan funds sold to meet redemptions, loan prices – like prices everywhere – slid. The average bid in the S&P/LSTA Leveraged Loan Index ended the year at 93.84, off 477 bps in fourth quarter and nearly 300 bps in December alone.
As secondary prices tumbled, the (few) deals that cleared posted far wider spreads. The all-in spread (including amortized OID) on B+/B loans jumped nearly 200 bps – to L+580 – in December. To be fair, there were only 10 such deals, but LCD’s dot plot illustrates a decided shift upward in the final month of the year. Flex trends further highlight the swinging market: LFI writes than 29 deals flexed up in December and exactly none reverse flexed.
But higher spreads weren’t the only changes lenders sought. According to Covenant Review, loan covenants tightened materially in fourth quarter (and this is true even though the deals are weighted to pre-Thanksgiving days before the market slowed to a crawl). LFI notes that all accordion and MFN trends moved in lenders’ favor in fourth quarter, In fact, since November 20th, LFI didn’t see a single MFN sunset cross the tape.
While 2018 ended with a thud – or a welcome rebalancing of power – that didn’t necessarily shift the volume trends for the year. Overall syndicated loan volume edged up 6% to a record $2.5 trillion, according to LPC. However, this is due entirely to investment grade lending, which jumped past $1 trillion. In the leveraged space, things were rather different. All the data firms use different collection methodologies and hence post different numbers – but the trends are the same: Nominal leveraged lending was down (because refinancing declines in a softer market), but real money lending (M&A, LBOs) was up. LPC and LCD both see leveraged lending declining (by 12% and 5%, respectively). Institutional lending dropped more materially, falling 21% to $730 billion for LPC, slipping 13% to $436 billion for LCD. But, frankly, these numbers may be misleading. In a market where spreads were flat to wider, it was the optional refinancings that evaporated, leaving only the “real” lending. As merger activity rebounded, so did the financing that backed it. LPC saw $381 billion of leveraged M&A, while LCD tracked $349 billion. Both these figures surpassed the previous record, set back in 2007. At $142 billion (LPC) and $136 billion (LCD), LBO lending remained well short of record levels – but still was the second strongest year the firms have tracked. This strong “real” lending led to a growing “real” market. Outstandings in the S&P/LSTA Leveraged Loan Index climbed 20% to $1.15 trillion.
Net-net, 2018 was a reasonably solid year with a very shaky ending. But does this ending portend a buying opportunity or a long-term back-up? While lenders sound cautious, few observers see a material downturn in the near term: The maturity wall is benign, the leveraged loan default rate sits at 1.63%, LCD’s managers forecast a default rate of 2.16% by year-end 2019, and few people see defaults hitting the historical average (3%) before 2021. Fingers cautiously crossed for a 2016-style rebound.