November 6, 2023 - Loans’ four-month-long rally came to an end in October, as markets grappled with a complicated geopolitical picture while digesting the latest round of quarterly earnings and readings from the economy. The secondary traded lower sending returns to -0.02%, according to the Morningstar/LSTA Leveraged Loan Index (LLI). Despite the setback, loan investors were better off compared to U.S. high-yield bond (-1.16%), or investment-grade bond investors (-1.87%), per Bloomberg Indices. The S&P500 declined for a third straight month (-2.2%), with October joining February as the other month this year where all the asset classes were in the red. Year-to-date, loan returns stand at 10.14% ̶̶ the best performance post-Great Financial Crisis.
While loan prices slid 80 basis points in the month, high-yield bond bids were 158 basis points lower, but unlike fixed-coupon bonds, returns for floating-rate loans were cushioned by 0.79% of interest income. For the year so far, the 10.14% in total return can be broken down into 2.14% from market-value gains and 8% from interest income – or 79% of total return can be attributed to higher base rates.
Nevertheless, the bearish sentiment in October bucked the trend toward downplaying credit risk present for most of the year, sending CCC-rated loans 1.03% lower in October, with B-rated loans at -0.07% and BB-rated credits advancing 0.37%. Year-to-date, CCC loans remain well ahead of higher-rated loans at 13.8%, with last month only the third time this year that CCCs fared worse than the benchmark LLI.
Looking more closely at performance metrics during the month, loan prices declined in 17 out of 22 trading sessions, with 73% of loans ending October lower – a reversal from the last four months. A majority (52%) of the price declines were less than 1%, with the average bid-ask spread widening to 106 basis points. In turn, the share of the secondary marked above par declined to 4%, while the less-than-80 share increased marginally to 7% of loans.
After the busiest month for lending this year witnessed in September, the sell-off and volatility dampened October supply. Lending was more expensive and clearing yields widened 36 basis points to 9.8%, per Refinitiv LPC. In turn, institutional lending declined 59% month-over-month to $30B, per Pitchbook LCD, with refinancings and repricings especially hard hit and down 61% from the previous month.
Unsurprisingly, the tide also changed for retail demand and October saw a resumption of outflows from loan mutual funds and ETFs (-$667M), after recording small inflows across August and September, according to Lipper. However, new issuance for CLOs, the largest buyers of loans, ticked higher to $11.4B. Although the average AAA spread remained at 182 basis points, spreads widened throughout October, as investors reacted to the volatility in markets. As has been the case this year, middle-market/private credit CLOs made up 20% of the monthly volume with Barclays and JP Morgan forecasting these vehicles will continue to grab market share into next year, mirroring the expansion in private credit and direct-lending originations. Overall, the banks expect new-issue CLO volume of $90-$100B for 2024.
Turning to fundamentals, the trailing-twelve-month (TTM) rate on the Fitch U.S. Leveraged Loan Default Index increased to 2.92% in October, from 2.8% in the prior month, whereas the ratio of downgrades to upgrades for loans on the LLI improved to 1.6:1, the lowest ratio since mid-2022.
