January 6, 2021 - At the close of 2019, many loan portfolio managers were calling for a slow but certain deterioration in credit quality which would lead to a coupon-level return in 2020. Turns out, they were not off by that much – and let us not forget those calls were made pre-COVID-19. All told, the S&P/LSTA Leveraged Loan Index (LLI) returned 3.12% in 2020 as the market value component of return came in at -1.77%. And while downgrades were nothing short of brutal during the second quarter (the 12-month trailing downgrade/upgrade ratio peaked at 43:1 in May), rating actions normalized during the second half of 2020 with the ratio reported at just short of even in December. But defaults did increase in 2020 as the default rate (by amount) increased 245 bps to a five-year high of 3.83%. Needless to say, credit quality remains the greatest concern of loan managers as we begin the new year, according to a recent LCD manager survey that also indicated that the default rate is expected to rise to 4.76% by year-end 2021. Furthermore, Fitch expects the leisure & entertainment, retail, and energy sectors to lead loan defaults in 2021 with forecasted rates of 40%,18% and 9%, respectively.
So, what were the other noteworthy take-aways for the 2020 loan market? On the demand side, loan mutual fund outflows totaled more than $26B, $16B of which occurred during 1Q20. This was an actual improvement over the $38B in outflows reported a year earlier. As a result, loan fund AUM ended 2020 at less than $90B or just 8% of total loan outstandings. On the other hand, the CLO market, which continued to drive most of the loan demand in 2020, saw $90B in issuance, which elevated total CLO outstandings to a fresh record $731B or 61% of total loan outstandings. Looking forward, most major banks are calling for a rebound in CLO issuance in 2021 to about $100B, after falling 24% year-over-year in 2020. On the supply side, LLI outstandings barely budged, growing by less than 1%, its lowest growth rate in 10 years. Net-net, visible loan demand alone outpaced new loan supply by more than $63B – a stat that speaks volumes to the 2020 supply/demand imbalance that ultimately drove a continuation in borrower friendly deal terms and loose credit agreement provisions.
In terms of the 2020 secondary loan market, the epic COVID-19 induced March sell-off culminated in a negative 12.4% monthly return (only October 2008 was worse) as bids plummeted to 10-year lows. After falling 13 points in March, the secondary loan market began the second quarter by trading in a low 80-bid range and an average bid-ask spread north of 400 bps (after gapping out 270 bps in March). Clearly though, the market proved to be extremely over-sold and so, the storied rally began. It actually took the market eight months for returns to get back firmly into the black, despite flirting with positive territory in September and October. Risk assets went on to stage impressive rallies across November and December on hopes of a successful rollout of the COVID-19 vaccine. In the loan market, bids surged market wide while reporting an extremely bullish advancer/decliner ratio of 15:1 since month-end October. Over that two-month period, bid levels surged more than 300 bps (to 96.2) as average bid-ask spreads tightened 20 bps (to 122 bps). Even so, bids remained 115 bps shy of their pre-COVID-19 high registered in late January while spreads ended 2020 14 bps wider than their tights.