27 August 2019

Leveraged Loans—A Tale of Two Markets

By Ryan Kohan

Many of the recent headlines about leveraged loans have highlighted the 40-week streak of retail fund outflows from the loan asset class, according to Lipper. The outflows have been driven by investors’ views that rates will continue to fall. While this technical has affected the loan market, retail funds now comprise approximately 12% of the overall investor base in leveraged loans, down from 17% at its peak in October 2018, according to J.P.Morgan. Thus, the impact on loan asset demand has been more muted than most articles would suggest. In fact, what has primarily occurred is a bifurcation of credit quality returns. A key additional driver in this split of the market has been the steady continued issuance of CLOs, which now comprise approximately 68% of the loan market and drive a significant portion of demand. Given the various tests that CLOs must comply with—including weighted average rating factor (WARF), weighted average spread (WAS), diversity and minimum tranche size—the CLO buyer base generally skews toward higher quality, larger tranche deals.

As a result, we have seen a technically driven bifurcation in the loan market that has led to heightened demand for B+ and above rated corporate deals (CLO demand), while B/B- and lower rated corporate deals have not had the same market value appreciation since the December 2018 dip (e.g., traditionally retail funds, high-yield crossover accounts, institutional accounts).

To put this in context, since the beginning of 2019, BB loan bids have improved 3.58 points to 98.88% versus single B loan bids, which have only traded up 1.96 points to 96.58%. YTD total returns for BBs have been approximately 6.98% versus 5.96% for single-B loans.

Looking to recent fundamental results, we continue to believe this is primarily driven by the technicals, and creates an opportunity within the market. Observing 2Q19 results, we see low single digit EBITDA growth and ample cash flow coverage metrics from borrowers within the broader index. While we consider markets to be later in the credit cycle, the stable current fundamental backdrop, a muted near-term default rate outlook and a current loan index yield of 6.1% suggest that an attractive investment opportunity exists within the loan market.

We anticipate investors with single-B capacity will look to take advantage of this opportunity focused on the names with the strongest underlying fundamentals if any of the following factors transpire:

  1. High-yield crossover accounts return to the loan market due to relative yield attractiveness,
  2. Retail outflows moderate due to rate stabilization, or
  3. CLO issuance increases during September to print before year-end 2019, which requires vehicles to ramp loan assets through the remaining months of the year.

As we look to the beginning of September, we will be very focused on these aforementioned factors gaining momentum, and we will selectively position funds to seek to take advantage of the most attractive secondary opportunities.