June 6, 2023 - Loans traded off in May for the third time in the last four months, sending returns to -0.18%. May’s return represented an eight-month low and just the second time this year the asset class was in the red, according to the Morningstar LSTA Leveraged Loan Index (LLI). Despite the setback, year-to-date loan returns stand at 4.12%, compared to -2.45% over the same time last year. Corporate credit was negative across the board in May, as loans outperformed HY and IG bonds (-0.92% and -1.45%, respectively) but trailed the tech-driven S&P500 (+0.25%). At the same time, US Treasuries lost 1.16% in May, according to Bloomberg Indices, as expectations around interest rates remain fluid.

All told, loans traded off 78 basis points in May, translating to a market value loss of 0.95%, the largest this year. At 0.77%, interest income was the highest since May 2000, but insufficient to turn total return positive. Decliners outpaced advancers by a ratio of 3.6:1, with loan prices losing ground during 19 of 21 trading days in May. But the declines were not severe: 42% of loans dropped less than 1%, while 32% of loans declined between 1% and 5%. This sent the share of loans priced at or above 98 9% lower to a 37% share in May, while the below 80 share was flat at 10%. Looking across credit quality, returns for B-rated loans, which make up 61% of the LLI, declined 0.43%, underperforming BB-rated issues for the first time this year (-0.01%). CCC rated loans continued to outperform, gaining 0.78% in May, with YTD returns reaching 6.27%, per the LLI. Driven by rating downgrades from the challenging economic outlook, the CCC share of the index stands 13% higher YTD, comprising $104.8B, or 8% of the LLI. While the CCC universe has expanded, LLI total outstandings declined to $1.34T in May, and are now 1.3% lower YTD, as higher interest rates and a weakening economy continue to pressure the new issue market. According to Pitchbook LCD, institutional loan volume is 43% lower YoY with the bulk of what activity has emerged driven by refinancings (65%).

Away from primary market struggles, CLOs saw their volume in May increasing to $10.6B, including $2.4B in MM CLOs.  MM CLOs represent a noteworthy 20% of total CLO volume this year, compared to 9% last year, a trend that has mirrored the expansion of private lending and the struggles of the BSL market. In contrast to CLOs, retail demand remained absent, with loan mutual funds and ETFs adding $3.9B of outflows in May to take the YTD sum past $17.4B, according to Lipper. Loan funds have recorded $54.6B of outflows since May 2022, when the Fed started raising interest rates. Investors remain concerned with the impact higher rates will have on the macroeconomic picture in general – and leveraged borrowers, in particular. To that point, default activity jumped in May to $8.6B across six issuers, the highest since May 2020, pushing the trailing-twelve-month default rate higher to 2.6%, according to Fitch Ratings. And despite indications that the Fed will not raise interest rates at their June meeting, the robust labor market suggests further tightening may be required to bring inflation closer to target.