October 11, 2023 - Loans were resilient across September, outperforming other asset classes and advancing for a fourth consecutive month. Bid levels increased 20 basis points in the month to an average of 95.6, the highest level since 2Q22, driving the month’s return to 0.96%, according to the Morningstar/LSTA Leveraged Loan Index (LLI). For the year through September, loans returned 10.16%, the best showing for the market post-GFC. Returns were higher through September 20th, before following the broader markets lower in the last week of the month. In comparison, US high-yield bonds declined 1.18% in September and investment-grade bonds returned -2.67%, per Bloomberg Indices. Worse still, the S&P 500 declined for a second consecutive month (-4.77%).
Looking more closely at the composition of loan returns in September, market value gains were positive (but lower) for a fourth consecutive month, at 0.19%. Broader market volatility sent prices 35 basis points lower over the last week and a half of the month. In contrast, across September, loan bids advanced in 14 out of 21 trading sessions and more broadly they advanced in 61 out of 85 days since June. Over the four-month period, average bids rallied 267 basis points for a market value return of 3.15%. Although loans rallied in the secondary, total return was driven by higher base rates. Return from interest rates added 0.77% of the 0.96% total return in September and 7% of the 10.16% return so far this year. Back in the September secondary, 53% of loan prices advanced in September, while 39% declined; the average bid-ask spread tightening to 100 basis points on September 20 before widening to 104 basis points at month end. The share of the secondary market priced at par or above ticked lower to 7% in September, after reaching a 12-month high of 8% the previous month. Nevertheless, 61% of loans were priced at 98 or higher at the end of September, compared to 58% a month earlier.
While the secondary chugged along in September, primary institutional lending activity spiked to $38.4B, the highest all year, according to Pitchbook LCD. And even though refinancings made up the bulk of activity, as borrowers take advantage of favorable market conditions, several billion-plus M&A deals, including a $5.2B term loan for the leveraged buyout of Worldpay, hit the market. In turn, the non-refinancing share of lending increased to 32% in September, compared to 26% year-to-date.
The uptick in new lending drove the size of the institutional market $10B higher to $1.4T – the largest increase this year and only the third time in 2023 that the market has expanded, adding much needed supply to meet CLO demand. More than $10 billion of CLOs were issued in September, while the average spread on new-issue AAA bonds declined 20 basis points to 174 basis points – the tightest since 2Q22. The cheaper cost of capital for CLOs improved arbitrage, which had been a challenge for most of this year. As has been the trend this year, direct lending/middle market CLOs made up over 20% of the volume last month ($2.1B), roughly double last year’s share as direct lenders continue to gain market share.
In addition to strong institutional demand, retail funds recorded $623M of inflows in September. While modest, these mark positive inflows for the second consecutive month after 15 months of outflows. Combining CLO new issuance with loan fund flows, visible demand for loans reached $10.6B, in line with the increase in LLI loan outstandings.
Despite the strong metrics across the market, the last week of September highlighted the uncertainty that is now rattling the markets. Although the Fed elected to not raise interest rates at its September meeting, there is a new consensus that rates will have to remain higher for longer to contain inflationary pressures. To wit, yields on the benchmark 10-year Treasury jumped 31 basis points between mid-September and month-end. And while investor calculus so far has favored floating rate loans, the stress on borrowers from a higher for longer interest rate scenario could shift the focus towards credit fundamentals. That said, the trailing-twelve-month (TTM) default rate on the Fitch US Leveraged Loan Default Index declined to 2.8% in September. Looking ahead, Fitch forecasts the default rate to reach 3%-3.5% range by year-end and climb to 3.5%-4.5% in 2024.