September 7, 2022 - August turned into a tale of two halves in the secondary loan market. While bid levels continued to rise off their early July lows during the first 10 trading sessions of August, the market reversed course and gave back roughly half those gains over the two weeks that followed. But all was not lost in August as the Morningstar/LSTA Leveraged Loan Index (LLI) still produced a 1.54% return, which lifted the YTD return to -1%. While nothing to write home about in isolation, the loan market’s relative outperformance this year should not be discounted. With the exception of loans, returns generated up and down the capital structure fell back in the red in August. In turn, the loan market’s YTD performance lead moved into the double digits against the outsized losses suffered in the HG bond (-13.75%), HY bond (-11.04%), and equity (-16.14%) markets.
But let’s head back to August’s secondary loan market where, despite the late-month sell-off, market breadth actually strengthened over the previous month. (For context, July enjoyed a 2.1% return – a 20-month high – on 3.2 advancers for every decliner.) In August, the market’s advancer/decliner ratio improved to 5.3:1, with 80% of loan prices advancing and just 23% declining. Better still, each side of the ratio demonstrated improvement over July. In turn, average bid levels increased a notable 91 basis points, to 94.56, across August. But as mentioned earlier, average bid levels reached an intra-month high of 95.5 on August 12th, before trading off 94 basis points through month-end.
While prices remained volatile to the upside across most of July and August, the market’s average bid-ask spread sat in a fairly tight band. Spreads have tightened just 7 basis points, to 135 basis points, over the past two months after widening 65 basis points through the second quarter. One reason for wider spreads in today’s market could be the threat of a downward shift in credit quality, which some would argue has already begun. Back in June, the trailing 3-month rating downgrade/upgrade ratio began favoring downgrades for the first time since January 2021. And over the past three months, the ratio has worsened from 1.32 to 1.89. Furthermore, according to the LLI, default activity (by dollar amount) surged in August. Bankruptcy filings from four issuers totaled $4.46B and raised the default rate of the index to 0.69% by issuer count, and 0.60% by amount, from a respective 0.43% and 0.28% in July. Interestingly, LCD noted that there was more defaulted loan volume in August then in the past 17 months combined. That said, today’s default rate (by dollar amount) sits roughly 200 basis points shy of its historical average and second, the CCC bucket remains below 5%, with just 0.25% rated CCC-. Ultimately, there may be a rather long runway before defaults become problematic.