March 3, 2022 - Last month we discussed why loans, in contrast to equities and bonds, delivered a positive return in January despite a late month pull-back in secondary market prices. (Hint: we generally outperform in rising rate environments.) February proved to be a far different animal as global equity and credit markets traded off in anticipation of Russia’s invasion of Ukraine, which finally occurred during the last week of February. This event clearly rattled global markets, even the US loan market, which prior to that point had remained mostly insulated from the contagion. To wit, the secondary went on to suffer its worst monthly loss since the COVID-19 induced sell-off of March 2020. All told, the S&P/LSTA Leveraged Loan Index (LLI) returned negative 0.5% in February, which sank the YTD return into negative territory at -0.15%. In comparison though, equities were down close to 8% on the year, through month-end February, while the high-yield bond market was off nearly 4%.
Back to the February loan market, where the sell-off proved to be indiscriminate in the secondary: 92% of loan prices declined while just 4% advanced. In turn, the market’s average bid level fell 80 basis points to 97.88 while bid-ask spreads widened 12 basis points to an average of 83 basis points. Needless to say, par-plus market share fell sharply in February, by 11 percentage points, and ended the month at a nearly non-existent 2% share. Furthermore, returns were negative across 36 of the 37 industries covered by the LLI (nonferrous metals/minerals being the lone exception). And while returns were negative across all rating categories, credit quality didn’t seem to drive the level of decline. For instance, BB rated loans outperformed CCC’s by just four basis points. That last point makes sense given that credit quality isn’t a major concern when assessing near-term risk in the loan market. First off, the loan default rate (by amount) fell 10 basis points to 0.19% in February – just two basis points shy of its 2007 all-time low. Additionally, upgrades continued to outpace downgrades for the 13th month running. Another reason for optimism? Visible demand remained robust in February. To that point, after investors poured a record $9.7B into loan mutual funds and ETFs in January, flows were estimated to approach another $9B in February. As this money generally needs to be put to work quickly by fund managers, this record pace of inflows appears to have generated a floor on price declines in the secondary. And while CLO creation doesn’t give such an immediate impact on secondary price levels, CLO issuance came back to life in February at the tune of $13.7B. Finally, even though risk levels remain heightened in March, the loan market may well outperform in the near-term.