May 5, 2022 - April ended with a flurry of activity in the secondary loan market as traders finally sold into the relief rally that began in mid-March.  Despite a late month bearish tone, the S&P/LSTA Leveraged Loan Index (LLI) still churned out a positive 0.22% return in April – a three month best.  And while the market value (MV) component of return remained in the red, at -0.13%, advancers outpaced decliners for the first time since January.  Both sides of the ratio improved in April, as the monthly advancer percentage increased from 26% to 55%, while the decliner percentage decreased from 69% to 40%.  That said, the market’s average bid level still fell 12 basis points in April to 97.48. Meanwhile, the average bid-ask spread uncharacteristically tightened alongside lower prices, narrowing six basis points, to 84 basis points.  Since year-end, average bid levels have moved 115 bps lower while bid-ask spreads widened 10 bps. 

While YTD returns have since turned negative and the LLI’s total return through April sat at just 0.11%, loans’ relative outperformance to fixed income and equities should not be understated.  Take HY bonds as an example, where returns through April were firmly in the red at -8%.  Furthermore, a record 20% of the HY bond market is trading between 80 and 90 cents on the dollar, according to Citi Research.  In comparison, less than 2% of loans reside in that price range.  These are interesting price points, given that Fitch is still projecting a FY 2022 default rate of just 1% for HY bonds vs. 1.5% for loans.  But of course, this year’s cross-asset trade has been all about rates and duration.  Just this week, Federal Reserve officials announced a 50-basis point rate hike, part of an ongoing effort to control inflation.  But prior to this week’s announcement, net outflows from U.S. high-yield retail funds had already expanded to $28B, more than double 2021’s full year figure.  In comparison, floating rate loan mutual funds & ETFs have raked in $20B this year, after reporting inflows of $34B the year prior.

While the loan market has benefited from strong inflows this year, one cannot dismiss the many challenges ahead for the broader economy (and borrowers for that matter).  After all, floating rate borrowing costs are rising fast, and will eventually pressure the weakest borrowers. Those views have been evident in the secondary loan market’s flight to quality trade this year.  From a purely MV return standpoint, double-B rated loans have “outperformed” single-B loans by 40 basis points, while single-Bs have outperformed CCC’s by 232 basis points. But while the CCC rating cohort has dipped below 5% of total outstandings for the first time since 2015, the single-B segment has increased 19 percentage points to an all-time high of 63% share.  Why does this matter? Loans rated BB- (or higher) comprise just 30% of outstandings, making that flight to quality trade a bit more crowded these days.