September 6, 2023 - Loans advanced in August for a third consecutive month, returning 1.17%, elevating the year-to-date return to a post-crisis best 9.11%, according to the Morningstar/LSTA Leveraged Loan Index (LLI). In contrast to earlier this year, loans have posted stable returns since June, anchored by progress on the inflation front combined with resilient economic growth. Looking across other markets during August, high-yield bonds returned 0.28% while investment-grade bonds were set back 0.78%, according to Bloomberg Indices, with the S&P 500 down 1.77% after gaining almost 10% over the preceding two months.
Turning back to loans, after a volatile first five months of the year, the asset class has returned 4.79% since June. Over the past three months, the market’s average bid level rallied 247 basis points, tightening the average bid-ask spread to 107 basis points. Average bid levels increased 35 basis points in August, with advancers outpacing decliners at a ratio of 2:1. In turn the share of loans priced above par increased to 8%, the highest level since January 2022 and up from 1% in May. The sub-80 share of the market remained at 8%. Higher base rates drove the interest component of the LLI’s return to a record 0.80% in August, while market value gains declined to 0.37%. Since June, market value gains contributed roughly half of total market return, compared to a 10% share between January and May, when interest income made up the lion’s share of total return. From a credit-quality perspective, the riskiest loans continued to outperform into August with CCC-rated loans up 2%, B-rated loans up 1.3% and BB-rated loans up 0.76%.
Fueling the rally in the secondary was demand from CLOs. New-issue volume jumped to $11.1B, the highest level in five months, taking YTD volume to $75.2B, or 20% lower year-over-year. Although average AAA spreads were unchanged in August at 196 basis points, they featured a mix of some of the tightest pricing this year, which was offset by several smaller managers accessing the market at wider spreads. Blackrock’s Magnetite 37 CLO printed its AAA notes at 165 basis points over SOFR, the tightest spread so far this year. Higher demand also led to over $4B in reset activity, the most since February 2022, as managers chipped away at the wall of CLOs scheduled to exit their reinvestment periods this year. As has been the case this year, MM/private credit CLOs made up roughly 20% of August volume and stand at $16.7B YTD, already eclipsing the $13.2B printed in 2022.
It was not just CLOs that were busy across the usually slow month of August. Loan retail funds recorded inflows of $326M, the first monthly inflow since April of last year when the Fed started to raise interest rates. The return of retail demand is not unexpected and comes after a sustained rally across risk assets and several months of declining outflows. YTD, retail funds remain deep in the red with $18.5B of outflows, according to Refinitiv Lipper.
Increased demand from investors combined with lackluster new lending activity exacerbated the long-running supply-demand imbalance in August, pushing prices higher. Visible August demand for loans (CLO new issue plus retail fund flows) totaled $11.8B, while the size of the institutional market declined by $2B and stands $15.3B lower so far this year, as measured by outstandings in the LLI. Although primary lending volume did improve, ($31B, per Pitchbook LCD) it was driven by opportunistic borrowers refinancing existing debt, with new-money deals once again lagging. Nevertheless, the fall pipeline has been building with several headline deals set to price, including the cross-syndication for GTCR’s acquisition of Worldpay and the LBO of Simon & Schuster by KKR.
Looking at fundamentals, metrics also improved. The LTM default rate on the LLI declined 20 basis points in August to 1.55% (by volume), driven partly by the base effect of four defaulters exiting the calculation versus two new additions. Related, while loan downgrades continued to outpace upgrades in August, they did so by the smallest margin all year (1.7:1).