August 4, 2022 - Prices in the secondary loan market surged in July, alongside other risk assets; of course, this relief rally followed a brutal two-month stretch where loans traded sharply lower. The Morningstar LSTA produced a 2.1% July return (a 20-month high), trimming the 4.66% loss produced during the May-June period – the second-worst two-month tally in a decade. In turn, YTD returns improved from -4.6% in June to -2.5% in July. And yes, the loan market is still markedly outperforming the other major asset classes as rising rates, inflation and the threat of economic recession has shattered safe havens. Take the ultra-rate sensitive investment grade bond and 10-year treasury markets as examples, where YTD returns still total -11.4% and -8.6%, respectively. Worse yet, equities have plummeted almost 12.4% on the year, while high-yield bonds continued to run in the middle of the pack at -8.9%.
But let’s head back to July’s secondary loan market where the change in market breadth was decisive. During the May-June 2022 period, advancer and decliner percentages averaged 3% and 95%, respectively. But in July, 73% of loan prices advanced, while just 23% declined. In turn, average bid levels surged 150 basis points last month, to 93.65, but remain 500 basis points lower on the year. And as prices rallied, the market’s average bid-ask spread tightened marginally (by 5 basis points) in July to 135 basis points, after widening 65 basis points through June.
While the primary loan market hadn’t closed entirely during the past three months, getting the few new deals to clear market has proven challenging. As a result, LLI outstandings have contracted by $4B since April, and that’s after tacking on $4.5B in new loans in July. However, this lower lending activity has met head on with a reduction in visible inflows into the asset class. While CLO issuance has remained surprising this year at $81B, monthly issuance totaled $11.8B in July – a three-month low. We see the same trend (diminishing demand) on the loan mutual fund/ETF side of the market, where loan funds experienced $5.7B of outflows in July – and $15.8B since April. While fund flows do remain positive on the year at $12.4B, that number has clearly been diminishing. At the same time, we’ve began to witness a downward shift in credit quality. This trend could eventually lead the loan default rate, which sits at a near all-time low of 0.28%, to rise more quickly than we’d thought just a few months back. To that point, in the three months through February, there were just 34 downgrades; in the last three months, there have been 80. Furthermore, July’s rolling three-month downgrade-to-upgrade ratio increased to 1.7 from 1.3:1 in June (which marked the first-time downgrades surpassed upgrades since January 2021). Finishing off on the glass-is-half-full side, as we always like to do, “CCC” market share still sits at a very respectable 4.6% of LLI outstandings, with a miniscule 0.06% rated CCC-.