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- Episode 2: Summer of Volatility
Taking a look at current market dynamics in the leveraged lending space amidst volatility, inflation, and how loans are performing versus other asset classes.
Ioana Barza: Welcome to the Lending Lowdown. I'm Ioana Barza, Head of Market analysis and I'm joined by CJ Doherty, Director of Analysis. We're excited to host our second podcast together.
Second quarter wraps up on the heels of the Fed’s 75bp rate hike. We want to set the stage for what might lie ahead, with a stalled primary loan market and a deeply discounted secondary.
So, thank you everybody again for tuning in.
CJ, this was the biggest hike since 1994!
CJ Doherty: Thanks Ioana, and yes it was a big one and there are more hikes to come.
Rising inflation has prompted a more aggressive monetary tightening by the Fed, and in turn we have seen a big pick up in volatility in recent weeks. And while rising rates are perceived to be a good thing for loans, as they are floating rate assets, there are concerns that the Fed might increase rates to an extent that it hurts economic growth and causes a recession and hits credit quality. And so, the Fed have a balancing act to do – increasing interest rates to try and control inflation but not hurt the economy too much. So not an easy thing to do.
Ioana Barza: It’s not and in this environment, most asset classes have come under pressure. Although performance varies widely of course, I think you might say there has been no escape for any asset classes, including leveraged loans.
CJ Doherty: Yes, there has been a repricing of risk across markets. And there is a lot of caution among lenders. While they have definitely been hit, leveraged loans have fared better than other asset classes like bonds and equities. Loans outperformance has been due to their floating rate nature versus the predominantly fixed rate bond market. To put some numbers on year-to-date performance, US leveraged loans have lost 3.7% on a total return basis, in comparison investment grade corporate bonds which are down 15% and high yield bonds have lost 13%. And on the equity side the S&P 500 is down 19% year-to-date. However, as you note, loans have not been able to escape the broader market negative sentiment in recent weeks.
Ioana Barza: I mean look, loan returns when we see those numbers they are not as hard hit, but it is still quite negative for loans and they are really down by volatility in secondary.
CJ Doherty: Yes, absolutely you know secondary loan prices have gyrated this year and are down significantly, initially hitting a low in mid-March, then regaining some lost ground, before starting to head lower again in late April/early May and are now at their lowest level this year. On the other hand, some investors who have money to put to work are examining opportunities to pick up paper at a discount – given the average loan bid is now in the area of 93 cents on the dollar, down from 98.5 at the start of the year.
Ioana Barza: That is 5 points, anybody who knows the loan asset class that is a really significant shift. And it’s not surprising, we are seeing this flight from risk, thT drag was even bigger for lower rated credits
CJ Doherty: Yes, looking at CCC loans they have lost nearly 8% year-to-date, single-Bs are off by 4%, and BB’s – the higher quality segment of the leveraged loan market- they have outperformed other rating categories, but are still down 2.5%.
Ioana Barza: And then talking about the hardest hit, the cyclical sectors
CJ Doherty: Yes indeed, retail and automotive have led the secondary loan market lower, posting declines of 7 points and 5 points, respectively, this year. On the other hand, commodity prices have provided support for the oil & gas and mining sectors, with both down less than 1 point, though they make up a very small share of the leveraged loan market. But if we look at the biggest sectors in the secondary market, the likes of technology, healthcare and financial services, they are all down over 4 points.
Ioana Barza: Well as one underwriter said, this is the time to be brave and step in, there are opportunities with a lot of potential upside. But not just in the secondary. In the primary, we’ve seen original issue discounts, or OIDs, in the low to mid 90s. To be fair, there is also very little in the way of new issue, and we expect a slow summer as banks are working on the paper they have underwritten before market conditions shifted so dramatically. So, this may be buying us some time, as CLOs, the biggest buyers of loans, have been affected.
CJ Doherty: AAA spreads are now in the 200 basis points – that’s 40 to 50 basis points wider in the last month. And there is more bifurcation between managers as well. And you might argue, the wider the CLO spreads are, the more attractive for AAA investors, but on a relative value basis, spreads have widened in other securitized products too.
Ioana Barza: And if you think about on an opportunistic note, market conditions have created these opportunities for CLO managers to build par by buying loans at sizeable discounts in the secondary market.
CJ Doherty: Yes, and that’s why we have seen CLO print and sprint deals recently. Also, I would add CLO warehouses can potentially absorb some of the supply on offer in the secondary loan market, but some warehouses have a significant amount of underwater assets and that’s because market conditions are so different today compared to when they bought these assets, so you do have warehouses and there are quite a few that are hampered in taking advantage of these market conditions.
Ioana Barza: Yes, and that makes it really hard to predict what the new issue CLO numbers are going to do. We have all noticed these forecasts being adjusted down right for the year and they are also really wide ranging so some research analysts say $90 billion for the year all the way to $140 billion. So, CLOs very mixed in the outlook, but retail loan funds we have seen a very clear and major reversal.
CJ Doherty: Yes, we certainly have, you know typically the rising rate environment is good for leveraged loan funds due to their floating rate nature. And we have seen this a lot in recent times. Through the first four months of this year, loan retail funds pulled in $25bn and this came on the heels of $46 billion of inflows last year. And also there was a sizeable reallocation of money into leveraged loans from high yield bonds earlier in the year. But with the broader market volatility and falling loan prices in the secondary market recently, loan fund inflows have turned to outflows and since the beginning of May, outflows have totaled over $7 billion.
Ioana Barza: So, we enter this third quarter with so much uncertainty. Investors are scrutinizing every credit, What if there is a downturn, how is this credit going to behave? What is a reasonable estimate of ebitda shortfall if we enter a recession?
CJ Doherty: Yes, although it’s not quite fundamentals, not yet at least. Defaults remain low though they are expected to climb from current levels though not necessarily spike. But there are signs of deterioration. Inflation and supply chain issues are having an impact on a swathe of companies and as a result, downgrades outpaced upgrades in May and June. And even looking forward as we touched on, the expectation is that the summer will be quiet in terms of leveraged loan deal flow. The first thing is for banks to try and clear loans in the pipeline that they have already underwritten.
Ioana Barza: CJ I was just going to say as deals work through market right, I mean private credit is a pocket of capital. Direct lenders, they have money to put to work, they have had a lot of strong fundraising in these recent years and also they are not marking to market.
CJ Doherty: Yes direct lenders have been able to step in on both smaller and larger deals, with several mega-unitranche deals in the second quarter including the newest one, the $5 billion deal for Zendesk. And that said, they along with bank underwriters continue to navigate a very challenging market. What happens with large scale M&A related deals, the likes of Citrix, Tenneco for example when it’s their time?
Ioana Barza: Well you know the way the market responds to those deals I think to them will give us a lot of insight. So what else are lenders watching into 3Q? I invite you to check out our 3Q outlook and our lender survey results at loanconnector.com. And I want to thank you for joining us. I'm Ioana Barza and here with CJ Doherty. CJ, thank you so much for doing this. And again we want to thank all of you for listening to our second episode. Subscribe to the Lending Lowdown on your favorite podcast platform.