July 8, 2020 - Loan prices in the secondary market continued to recover in June alongside other risk assets. The broader markets have now rallied for three consecutive months after falling precipitously in March. In loan land, returns have softened since peaking in April, when the S&P/LSTA Leveraged Loan Index returned 4.5%. Even still, loans returned 9.7% across the second quarter after tallying a 1.1% June return. YTD, loans remain in the red at -4.4%, a level that trails equities (-3.1%), but leads high-yield bonds (-4.8%). At the same time, safer assets, such as 10-year treasuries (12.7%) and high-grade bonds (4.8%), have – to no surprise – outperformed through the first six months of 2020.
After improving more than 600 basis points across April and May, the loan market’s average bid level rallied more slowly, adding “only” 80 basis points in June. (While we were happy to hit 89.9, bids remain seven-plus points lower than their mid-January 2020 high-water mark.) A sharp decline in market breadth drove the difference in performance between June and the April-May period. Across the first two months of the rally, the secondary market’s advancer/decliner ratio came in better than 5:1 as loans improved from oversold territory. In June, that trade became much more difficult; the advancer/decliner ratio fell below 2:1 as 61% of loan prices advanced while 32% declined. In other words, both sides of the ratio weakened. But as bids continued to generally run higher in June, bid-ask spreads tightened another 30 basis points to an average of 217 basis points. This is the first sub-220 reading since the second week of March; spreads had previously gapped out to 400 basis points at the end of the first quarter.
The percentage of loans bid above 90 increased to 68% in June, from 62% in May, and just 26% in March. At the same time, the portion of the market bid sub-70 fell to just 9%, from 12% in May and 14% at the end of the first quarter. But despite the lower end of the market showing resilience over the last three months, credit trends remained bearish as the market continued to experience a heightened level of rating downgrades and an accelerated default cycle. First off, the default rate swelled to 3.2% by amount and 3.7% by count in June. Just six months ago, those rates sat at just 1.4% and 1.6%, respectively. Second, downgrades continue to pressure funds and CLOs alike, albeit at a far less worrisome rate than just one month ago. In June, the three month-trailing downgrade-to-upgrade ratio was reported at 18.4:1 – a far cry from May’s 43:1 reading, but quintuple the pre-pandemic 12-month trailing ratio of 3.4:1. And as a result of the downgrade onslaught, the percentage of loans outstanding rated B- has rapidly expanded almost 3 percentage points to more than 18%. Even more daunting for CLO managers, CCC rated loans outstanding has increased by almost 3% since March to 9% of total outstandings. As we look forward, the potential for a V-shaped recovery in loan land is now in the hands of the second quarter earnings cycle, which is set to kick off next week. Stay tuned.