October 9, 2019 - After returning more than 4% during the two-month rally that began the year, the S&P/LSTA Leveraged Loan Index (LLI) has failed to sustain any meaningful momentum. Since March, monthly returns have flipped from positive to negative while market value returns were positive just twice – the last time being July. In September, despite market value losses that were negative yet again (albeit at just -0.02%), the LLI sported a total return of 0.47%. Across the third quarter, the LLI returned 1%, implying a market value loss of roughly 50 basis points (inasmuch as the index creates roughly 50 basis points a month in interest). Market breadth remained mostly bullish over the latest three-month period as 1.5 loans advanced for every one that declined. All told, 57% of loans reported mark-to-market (MTM) price gains, while 37% reported losses across the quarter. September’s advancer/decliner reading was slightly better as a lower percentage of loans reported losses (31%). That said, September’s biggest movers were much more pronounced on the downside: 3.5% of price movements saw prices drop more than 5%, compared to just 0.5% that saw price appreciation of more than 5%. All told, secondary prices declined 45 basis points in the third quarter, to an average bid of 96.34. Across 2019, prices have increased 250 basis points, but are 120 basis points shy of May’s high-water mark. And despite all the trials and tribulations, the loan market has returned 6.8% on the year, the highest 1-3Q reading since 2016.
Several storylines developed across the third quarter, none more interesting than the flight to quality trade. We first saw this phenomenon in the equity markets where a massive rotation into value stocks emerged. And loans were quick to follow as lenders became more risk adverse and increasingly willing to forgo yield for quality. Performance in the loan market has clearly bifurcated by size and safety. For example, despite lower coupons, double-B rated loan returns (1.5%) have outperformed single-B loan returns (0.98%) by 52 basis points in the third quarter. At the same time the LLI 100 (1.33%) outgained the LLI (1%) by 34 basis points.
In September, the flight to quality trade was evident in the data, as the percentage of loans priced at a premium to par climbed 11 percentage points to an 11-month high of 24%. Not surprisingly, loans rated double-B-minus or higher accounted for the overwhelming majority of the increase. Such loans now represent nearly 60% of the par-plus cohort despite representing less than 40% of LLI outstanding In contrast, at the end of the second quarter, loans rated double-B-minus or higher comprised just 35% of the par-plus cohort. And as a natural result of heightened demand for better quality loans, average secondary yields have steadily declined for double-B rated loans over the past several months. This trend intensified in September as double-B yields ground lower in the secondary to 4.99% – the first sub-5% reading in 12 months. Furthermore, the yield gap (in the secondary) between double-B and single-B loans widened to a three year high of 181 basis points by the end of the quarter.