July 11, 2023 - Morningstar/LSTA Leveraged Loan Index (LLI) returns jumped to 2.26% in June, the highest in five months. Prior to June, monthly returns were mixed for most of the year, punctuated by bank failures in March and a higher interest rate environment that pressured credit fundamentals, not to mention fears of recession. In June, the Fed opted to not raise interest rates, and subsequently loan bids advanced in 18 out of 21 trading sessions. Across the first half of the year, loans returned 6.48%, according to the LLI, representing the best first half of the year since 2009. Loans have now outperformed the bond markets by a sizeable margin so far in 2023, with high-yield and investment-grade bonds returning just 5.4% and 3.2%, respectively, per Bloomberg Indices.
Higher interest rates have driven loan market performance this year, with monthly index coupons averaging 0.74%, which has contributed 71% of index total return. Meanwhile, the secondary market recorded gains in three of the six months, including in June when 84% of loans advanced. In turn, the market’s average bid level jumped 135 basis points in June to a 94.24 level. June’s price action drove index market value returns to 1.49%, the highest since January. And while not a big move, a better bid secondary market sent the share of loans priced below 80 lower for the first time this year at 9%, down from 10% a month earlier. Notably, the share of loans priced at 98 or higher jumped 15 percentage points to include 51% of loans. At the same time, bid-ask spreads continued to trend tighter for a third successive month, ending June at an average of 113 basis points. While gains were widespread across industries and rating categories, the riskiest credits did not outperform as they had done for most of the year. B-rated loans, which comprise 60% of LLI outstandings, returned 2.52% in June, ahead of the 2.08% return posted by CCC-rated loans. For all of the first half, however, CCC returns led the way at 8.47%, compared to 7.19% for B-rated loans.
While the loan market’s strong performance this year highlights the advantages of floating rates over a period of rapid interest rates increases, pressures abound. Secondary market price volatility remains high by historical standards while primary market lending activity remains under pressure. To that point, LLI outstandings have declined eight out of the last nine months and stand 2.6% lower from their peak in October 2022. Furthermore, the makeup of the market is also riskier with the share of CCC rated loans rising 18% this year to $109.93B, or 8% of total LLI outstandings. The challenging credit environment has also driven the LLI trailing-twelve-month default rate to 1.7% in June, from under 1% at the beginning of the year. Meanwhile, on the demand side, CLO issuance sputtered to $5B in June, the lowest level since January 2022, with 1H volume at $56.4B, or 22% behind last year’s. Challenging arbitrage levels and a dearth of new loan supply continue to weigh on the CLO market prompting several banks to revise their full year 2023 issuance forecasts lower. At the same time, retail flows remained a (smaller) drag on demand with loan mutual funds and ETFs registering $518M of outflows in June, compared to an average monthly outflow of $3B over the first half of the year (according to Refinitiv Lipper, $18.6B have exited loan funds year-to-date).