June 7, 2022 - Even though the secondary loan market has rallied off its most recent lows in June, May’s performance was included in the worst monthly loan returns top-ten list – at number nine. The S&P/LSTA Leveraged Loan index plunged 2.6% in May, marking the lowest monthly return since March 2020. While there is a cornucopia of macro explanations as to why the loan market’s impressive streak of outperformance ended in May, a less hawkish view on future rate hikes led the list. As the market seemingly reduced its rate hike expectations, the possibility of a new rate paradigm lifted returns across the fixed income (and equity) markets at the expense of the previously unflappable floating rate loan market. Even after May’s dismal performance, the leveraged loan market continued to grossly outperform other major asset classes in the year-to date period, including the high-yield (-7.8%) and high-grade (-11.9%) bond markets as well as 10-year Treasuries (-10.6%) and the S&P 500 (12.8%). This makes sense given that monetary policy still supports the use case for loans given the need to lower inflation via higher interest rates. But of course, there is a downside to higher rates. To that point, a recent report by S&P Global Ratings suggested that Sofr could rise 100 basis points in the next two months and another 175 bps by year-end 2022. The agency went on to explain that average issuer interest expense could rise 40% in the next year, leading to deteriorating credit quality.
Back to May performance in the loan market, but first a view on technicals. While CLO issuance remained robust in May at $13.5B, CLO creation doesn’t generally produce an immediate impact on secondary price levels. Unfortunately, the same cannot be said for fund flows. The loan market’s 17-month streak of positive inflows (from loan mutual funds and ETFs) came to a screeching halt in May as outflows totaled $4.3B. Before that, inflows had totaled north of $28B across the first four months of the year, a level that created somewhat of a price floor in the secondary market. In turn, loans were generally shielded against the viscous sell-off which were occurring across other asset classes. But that trend ended in May as a massive 97% of loans reported MTM price declines, with almost 10% of loans reporting losses of 5% or worse. And as bids softened, MTM bid-ask spreads gapped out 44 basis points to 128 basis points, illustrating a rather large 52% increase in the difference between bid and ask levels. The market’s average bid level went on to fall 284 basis points in May, to 94.64 (marking the market’s first sub-95 month-end reading since November 2020). That said, average bid levels actually fell into a sub-94 context during the third week of March, prior to rallying 81 basis points across the last four trading sessions of the month. Even still, the three-week sell-off reshaped the distribution of secondary loan prices, where the median bid level fell 273 basis points to 96 (illustrating that 50% of the market was bid below 96). Furthermore, the percentage of loans priced in a sub-90 context swelled five percentage points to an 8% market share.