April 5, 2018 - While the headlines read Trump, Tariffs and Trade Wars, loans quietly proved their mettle once again during the first quarter of 2018. Loans boasted a 1.45% total return (a six-quarter best) while all other major asset classes (from treasuries to equities) bled red ink during the first three months of the year. And over the same period, return volatility in loan land fell to its lowest level since the summer of 2014. Case in point, the average 12-month lagging standard deviation of return (SDR) on the S&P/LSTA Leveraged Loan Index (LLI) came in at just 0.29% in March. In comparison, High Yield and High Grade bonds reported six month high SDRs of 0.68% and 0.81%, respectively. But it’s not as if loans have been hitting the ball out of the park. Truth be told, LLI market value returns were negative during four of the previous five months, with January being the lone exception.
At an average bid of 98.4, the secondary market is currently off 30 basis points from the 2018 high water mark registered two months earlier. That said, bid levels are still up year-to-date by an average of 38 basis points (thanks to January) despite dipping 12 basis points in March. In total, just 38% of loans reported MTM gains during the month while 42% reported losses. Across the quarter though, results were much more upbeat as 55% of loan prices advanced and just 35% declined. From a price distribution standpoint, par-plus market share remained flat in March at 66% after increasing by six percentage points since year-end.
In taking a closer look at the first quarter, technical conditions remained robust amid a flurry of new issue but fundamentals looked a bit weaker. On the demand side, loan mutual funds raked in an estimated $3 billion-plus which propelled AUM to $160 billion – a 3.5 year high. CLOs too, came out of the gate swinging this year and recorded their busiest first quarter ever at $32 billion in new issuance. On the supply side, new deal flow strengthened as the quarter wore on. In total, LLI outstandings swelled 3.6%, or by $34.3 billion, to a fresh record $989.5 billion. To the downside, the new issue market remained extremely borrower friendly as spreads tested their post-crisis lows and terms continued to test lenders’ patience. Not all was lost from an all-in rate perspective though, as 3-month LIBOR increased at a faster rate than new issue spreads contracted.
On the credit side, the current cycle may be waning as it enters its 10th year. But most managers still believe there’s plenty of runway ahead – 64% of managers surveyed by S&P said the default rate will not hit its historical average (3.1%) until sometime in 2020. Interestingly though, almost 10% predicted that could happen as soon as this year. So, why the near-term concern?
First off, the ratio of downgrades to upgrades, on a rolling three-month basis, was worse than 2:1 during the past three months. Second, following the iHeart bankruptcy, the default rate, by amount, spiked to a 3-year high of 2.42%. But to be fair, S&P noted that the subsequent pick-up in the default rate is the “culmination of a now 10 year-old failed LBO, and not indicative of a material pickup in systemic risk”. Fitch also weighed in and agreed that the spike was “not indicative of current credit conditions”. We hope they are correct.