June 4, 2020 - Loan prices in the secondary market continued to rally in May alongside other risk assets.  The broader markets were clearly pricing in a more favorable outlook on the reopening of the economy and continue to do so in early June, despite the civil unrest across the United States and a potential faceoff with China.  The risk-on trade was evident once again in May as investors benefited from trading down the capital structure. At 4.8%, equity returns outperformed, followed closely by high-yield bonds (4.6%) and leveraged loans (3.8%).  All three asset classes though, remain in the red on the year in a range of -5% to -5.6%.  While safer assets, including investment-grade bonds (1.2%) and 10-year treasuries (-0.6%) underperformed in May, they still lead the YTD returns at 2.2% and 12.1%, respectively.  The S&P/LSTA Leveraged Loan Index (LLI) has now returned almost 8.5% since producing its second lowest monthly reading on record in March (-12.4%).  And after improving 326 basis points in April, the market’s average bid level rallied an additional 292 basis points in May, to just north of 89.  And as bids ran higher in May, bid-ask spreads tightened another 68 basis points to an average of 247 basis points – the first sub-250 reading since the second week of March.  Furthermore, while aggregate price gains were stronger in April, the market’s advancer/decliner ratio strengthened substantially in May, increasing from 3.8:1 to 6.8:1. This improvement in market breadth was driven by a larger percentage of loans reporting price gains (82% vs. 75% in April) as well as a smaller percentage of loans tallying declines (12% vs. 20% in April).  In turn, the percentage of loans priced above 90 surged to a 62% market share in May, from 48% in April and just 26% in March.

On Wednesday, Moody’s Analytics economist Mark Zandi said there are signs that the worst of the jobs crisis is over, as is the steep recession brought on by the coronavirus pandemic.  That said, back in March, the secondary market quickly repriced to reflect a rapid increase in downgrades and an accelerated default cycle.  And while secondary loan prices have rebounded off their lows (more so in the double-B space), credit quality remains the dominant issue in determining the shape of the loan market’s recovery.  Even as the pace of downgrades slowed in May to “ just” 90 loans, from a record 228 in April and 114 in March, the three-month trailing ratio of downgrades to upgrades climbed to a fresh record high 43.2x in May, wrote S&P Global.  Most troublesome to CLOs in particular, has been the noteworthy increase in B- rated loans via downgrades since the start of the pandemic.  According to the LLI, $79.4 billion, or 30% of the $269B in loans rated B-, were downgraded to this level since March 1.  At the same time, default rates have, as expected, run higher.  According to Fitch, the trailing 12-month institutional loan default rate stands at 3.6%, the highest level since February 2015. Furthermore, the past two months accounted for $23.4 billion of default volume. Fitch now forecasts default volume to finish the year at roughly $80 billion, equating to a 5-6% default rate.  In the broader LLI universe, the default rate by issuer count (3.3%), is at its highest level since September 2010. From a sector standpoint, Retail was the biggest contributor of LLI defaults in May, at 27%.  On an LTM basis, Oil & Gas leads at 20%.  Unsurprisingly, both sectors have underperformed since May, with Oil and Gas loans returning a cumulative -17.6% and Retail at -13.6%.

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