January 5, 2023 - After rallying across most of the fourth quarter 2022, loan prices in the secondary market were unable to maintain their positive momentum in December. While the Morningstar/LSTA Leveraged Loan Index (LLI) did in fact produce a positive 0.44% total return in December, it was solely interest rate driven as prices declined 0.3%. Made possible by an aggressive Fed that has become determined to fight inflation by raising rates, the LLI’s monthly interest return increased 40 basis points this year, to 0.73%, the highest level in more than two decades. This fact alone leads us to the main reason that floating-rate loan returns outpaced the major asset classes in 2022 – we outperform in rising rate environments. Outperformance is, of course, a relative measure. This was particularly true in 2022, as the LLI returned -0.6% on the year – the lowest annual return since 2015, and just the third negative print since the inception of the index in 1997. Moreover, Pitchbook LCD noted that when looking at just the market value component of return, loans lost 6.2% on year, their worst performance since 2008. But according to Citi Research, 2022 was the loan market’s best year relative to high yield bonds, which ended the year down more than 11%. Losses were severe across the rest of fixed income as well, where investment grade bonds and 10-year treasuries returned -12.5% and -15.8%, respectively. Equity returns were even worse, where the S&P 500 ended the year down more than 18%.
In looking back across what proved to be a rather volatile year in the loan market, secondary prices were stable in a high-98 range to begin the year, and even surpassed an average bid level north of 99 in late January. At the time, mark-to-market bid-ask spreads sat under 70 basis points. But once the invasion of Ukraine occurred, the loan market was no longer immune to the severe selloffs that other asset classes had been experiencing. The markets became far weaker during the second quarter, particularly during May and June, when rising rates, inflation, and the threat of economic recession combined to sink all ships. Across the second quarter, loan returns plunged 4.45%, which dropped YTD returns to – 4.55%, the second worst reading for any comparable period since the Great Financial Crisis. That said, the second quarter proved meaningful in several ways as several negative trends began to emerge in the loan market that would continue to grab headlines through year end – and into 2023. First, a noteworthy shift in technicals occurred in May, when loan mutual fund/ETF flows turned negative after 17 consecutive months of inflows. Through December, cumulative monthly flows remained negative to the tune of $38B. In total, funds lost $13B in AUM last year. Meanwhile, CLO issuance remained nominally robust in 2022 at $129B, but the outlook for 2023 remains uncertain after CLO issuance dipped to just $22.6B during the fourth quarter. The second trend of note occurred on the fundamental side of the market, where the threat of a downward shift in credit quality drove a flight to quality trade across the market. This change in market sentiment would go on to define trading levels and returns for the remainder of the year. In June, the trailing 3-month rating downgrade/upgrade ratio began favoring downgrades for the first time since January 2021. And, over the span of the next seven months, the ratio worsened from 1.3 downgrades for every upgrade to 2.2 in December. Lenders became increasingly risk adverse as the year wore on, as CCC and single B rated loans went on to return -12% and -1.1% respectively, while the stronger BB cohort produced a positive 3% return across 2022.
While the LLI still produced a 1.37% return, the third quarter ended on a sour note. After rallying in July and August, prices in the secondary market tumbled 2.8% in September, falling into a sub-92 context. September’s negative 2.27% return sank the loan market’s YTD return to -3.25%, which brings us to the fourth quarter. The market would go on to rally across October and November but gave back some of those gains in December. All told, returns totaled 2.7% – a two-year best – across the last three months of the year, as loans were once again trading in a mid-92 range. Bid-ask spreads, remained stubbornly wide across the fourth quarter, ending December in a 130-basis point range – or nearly double the level reported earlier in the year when the secondary was still trading in a 98-99 context.
Bottom line: Loans returned -0.6% in 2022. But given the succession of events that had decimated returns up and down the capital structure in 2022, a -0.6% annual loan return was a godsend to asset allocators and investors alike. As we look out into 2023, many of the same risks that defined last year likely will continue to challenge lenders. Chief among them being credit quality. Not surprisingly, we’ve already witnessed an increase in the percentage of loans that are categorized as “distressed”, that is, bid below 80. While the broader secondary traded off its previous lows during the fourth quarter, the distress ratio increased to 7.4%, up from September’s reading of 5.8%. Moreover, the ratio is more than six times the level it was during the same time last year. But it all comes back to defaults, and according to the LLI, the default rate (by amount) fell for a third consecutive month in December, to just 0.72% (after peaking at 0.9% back in September). While most market participants expect defaults to rise next year and a wider dispersion in recoveries to ensue, many believe that today’s higher rate of interest return will more than offset credit losses across the portfolio. All told, it was a good year for the loan market in 2022. Relatively speaking.