April 5, 2022 - First quarter 2022 ended with a flurry of activity in the secondary loan market as traders bought the dip during the second half of March. All told, the S&P/LSTA Leveraged Loan Index churned out a positive 0.05% return in March but found itself in the red, at negative 0.1%, for the quarter. The few basis points of return here in either direction belie a basic secondary market fact: Volatility levels have spiked since loans were trading in late January at an average bid level north of 99. February proved to be a challenge to say the least, as global equity and credit markets traded off in anticipation of Russia’s invasion of Ukraine. Pre-invasion, secondary loan prices had already fallen from their post-pandemic highs, as average bid levels hovered around 98. (The fact that they still were thathigh reflects that floating rate loans were benefiting from a rising rate environment relative to equites and fixed income). But once the invasion occurred, the loan market was no longer immune to the severe selloffs that other asset classes had been experiencing for most of the first quarter. From February 23rd through March 15th, the secondary traded down more than 215 basis points as the market’s average bid level sank below 96 for the first time since late 2020. But at that level, loan traders could no longer ignore the oversold conditions and the buying opportunity which ensued. To wit, bid levels experienced a strong V-shaped recovery during 11 of the last 12 trading sessions of March. Over those final two weeks, loan prices rebounded 172 basis points in the secondary. And by month-end, loans were once again changing hands at an average bid level of 97.6.
Although the loan market was unable to produce a positive return across the first quarter, it emphatically outperformed other asset classes, including the S&P 500 and high-yield bond markets that, even after late March rallies of their own, have both returned -4.6% on the year. Losses have been even more severe within the ultra-rate sensitive portion of the fixed income markets; high-grade bonds and 10-year treasuries have returned -7.7% and -6.8%, respectively. Floating rate loans on the other hand, have benefited from today’s rising rate environment as strong visible demand levels have created somewhat of a price floor in the secondary market. Consider this, LLI outstandings have risen by a robust $49.3 billion this year to $1.4T. At the same time, though, inflows into Loan Mutual funds (and ETFs) totaled $21.8B while CLO issuance came in at almost $30B, leaving behind a demand surplus of $2.5B. But while the new issue CLO market remained strong in March (issuance topped $11B), loan fund inflows dropped off considerably to an estimated $3.2B –after averaging more than $9B per month during January and February. Despite the late-month rally in risk assets, one cannot ignore the many headwinds facing the broader economy and the loan market for that matter. Those views were evident in the flight to quality trade that took place in the secondary loan market in March, where higher rated loans outperformed their lower rated brethren for the first time in two years. And while the LLI default rate still sits at a decade long low of just 0.19% and the rolling-three-month upgrade to downgrade ratio remains supportive at a ratio of 1.2:1, the times, they are a-changin’. First off, that ratio has been in slow decline since December when upgrades were outnumbering downgrades at a rate of 1.9:1. Second, most if not all market participants expect default rates to rise this year, including Fitch Ratings, which estimates their current default rate (0.6%) will more than double to 1.5% by year-end. That all said, the loan market’s rally of late March has bled into April (as of press time), and loan market returns have once again returned to the black at 0.19%. But again, we’re just talking basis points here.