December 7, 2022 - Loan prices in the secondary market maintained their momentum in November as risk assets continued to rally off their September lows.  The Morningstar/LSTA Leveraged Loan Index (LLI) returned 1.2% in November following a 1% return in October; this erased a sizeable portion of September’s 2.8% loss.  But despite the recent recovery in price levels, year-to-date loan returns remain in the red at -1%, leaving 2022 on pace for the market’s worst year since 2008. That said, even though loans underperformed other risk asset classes over the past two months, they still hold an extraordinary (relative) return lead over high-yield bonds and equites on the year, which came in at -10.5% and -13.1%, respectively.

But let’s head back to November’s secondary loan market where market breadth ran decisively bullish. In November, the market’s advancer/decliner ratio improved to better than 2:1 (from 1.7:1 in September), with 64% of loan prices advancing and 31% declining.  Even better, November’s ratio improved on both sides of the equation with advancers increasing by three percentage points and decliners falling by four percentage points.  In turn, the market’s average bid level increased a notable 58 basis points, to 92.8.  November’s final reading was 103 basis points above the intra-year low of 91.75 on July 6, but 272 bps below the recent high of 95.50 in mid-August. For reference, the market’s average bid level is down 586 basis points, or 5.9% on the year. 

While price levels have improved so far during the fourth quarter – though December is proving to be challenging — the market’s average bid-ask spread remained stubbornly wide in a 130-basis point range.   Since the end of the third quarter, the spread decreased just 10 basis points, to 133 basis points.  Year-to-date, bid-ask spreads are wider by 58 basis points, or 77%, which highlights the many risks ahead as the calendar approaches 2023.  The foremost reason for pessimism in today’s market is the ongoing threat of a downward shift in credit quality, which we’ve already begun to witness to some extent. Back In June, the trailing 3-month rating downgrade/upgrade ratio began favoring downgrades for the first time since January 2021.  And over the past five months, the ratio has worsened from 1.3 to 2.2.  Not surprisingly, we’ve also witnessed an increase in the percentage of loans that are categorized as “distressed”, that is, bid below 80.  While the broader secondary moved higher over the last two months, the distressed ratio increased to 7.3%, up from September’s reading of 5.8%.  Moreover, the ratio is more than six times the level it was during the same time last year.  But it all comes back to defaults, and according to the LLI, the default rate (by amount) fell for a second consecutive month in November, to just 0.73%.  While the runway – and defaults – ahead might be uncertain, today’s default rate remains well below its 10-year average of 1.9% and its historical average of 2.7%.