August 3, 2023 - Investor optimism from better-than-expected economic growth and slower inflation sent financial markets higher in July. Loans returned 1.29%, per the Morningstar/LSTA Leveraged Loan Index (LLI), with HY bonds at 1.38% and IG bonds 0.34%, according to Bloomberg Indices. Renewed investor bullishness sent the S&P500 3.11% higher in the month. Back to loans, total return stands at 7.85% so far this year and is on track for the best performance since 2009. While loan bids are up 200 bps for the year, returns primarily have been driven by interest income from higher reference rates. In fact, looking back to March 2022, just prior to the Fed’s campaign to increase interest rates, loans have returned 7.18% over that time frame, despite a decline in prices. In contrast, equities have returned only 4.92%, and corporate bond returns were negative over that time period.

After an up-and-down first half of the year, loans have rallied over the last two months. Advancers led decliners in July by a ratio of 4:1, sending average bid levels 59 basis points higher (up 194 basis points since June) to 94.83, the highest level in a year. Loan bids advanced in 11 of the 20 trading sessions in the month. Correspondingly, bid-ask spreads continued to tighten to an average of 107 basis points in July. The richer secondary also sent the share of loans marked above par higher to 6%, with 57% of loans marked at a price of 98 or higher. Conversely, the share of loans priced below 80 dipped to 8% in July. Unlike last year, riskier loans have excelled in 2023. CCC-rated loans, representing 8% of the index, returned 2.32% in July (11% YTD), the fifth time this year they outperformed. B-rated loans, which comprise 60% of the market, returned 1.43% in the month for a YTD return of 8.72% Stronger market conditions in July led to a pick-up in lending, including the return of repricings for the first time in five months, according to PitchBook LCD. Nevertheless, of the $32.8B of institutional volume recorded in July, the share of new loans was limited to 29%.

Turning to the demand side, the lack of new loan supply, alongside a richer secondary and a decline in demand from bank investors were key factors behind low CLO issuance. July recorded $6.9B of new CLOs across 16 deals, higher from the previous month but below the monthly average for the year. YTD volume stands at $63.8B or 26% below last year’s tally. More important than issuance figures, though, is that the CLO market may be beginning to address its “reinvestment problem”. July saw $1.3B of resets, as managers chip away on the wave of CLOs scheduled to exit their reinvestment period this year. As for retail demand, as of the time of publishing with monthly reports yet to weigh in, Lipper reports a small monthly inflow of $42M in July for loan mutual funds & ETFs, in what would be the first inflow since April of last year. Aside from any revision, the large outflows that were common over the last twelve months appear to be ebbing as retail demand shows signs of life.

Despite the headline positive sentiment around the economy, the picture is complicated for loans. While markets expect the Fed not to raise interest rates at their September meeting, they are also not expecting cuts anytime soon, which means the higher interest rates that propelled loan returns will continue to weigh on borrowers and the loan market. High interest costs along with tighter lending conditions have led Fitch Ratings to forecast a default rate of 4%-4.5% for YE2023 – its trailing-twelve-month (TTM) default rate currently sits at 3%.

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