September 12, 2019 - Last month we highlighted that secondary loan prices finally caught a bid in July, following two consecutive months in the red. Well, the rally proved to be short lived as the secondary loan market generated its worst reading of the year in August. The average bid level on the S&P/LSTA Leveraged Loan Index (LLI) decreased 72 basis points, to a six-month low of 96.34. The move lower pushed the August LLI return to an eight-month worst of -0.27%. Market value returns (-0.78% in August) have now been negative for the third time in four months. To be fair, Index year-to-date returns remain a robust 6.58%.
The breadth of the August sell-off was illustrated in the market’s advancer/decliner ratio where three loans declined for every one that advanced. All told, just 22% of loans reported mark-to-market (MTM) price gains while 63% reported losses, a complete reversal from the previous month where advancers totaled a 64% market share and decliners represented just a 20% share. Furthermore, there were a notable percentage of big moves to the downside in August – almost 25% of loans suffered a MTM price decline of 1% or worse while just 4% of loans experienced a price gain of 1% or better. On the sector level, losses were most severe in Oil & Gas (-2.6% return) and Retailers (-1.3% return). But the severity of those losses were not surprising given that the two sectors are forecasted to experience the highest default rates this year – at 5% and 7%, respectively, according to Fitch. A risk-off mentality was also evident across rating cohorts in August as returns worsened alongside lower credit quality. While double-B rated loans reported an average 0.33% decline in market value, single-B and CCC rated loans recorded declines of 0.94% and 2.65%, respectively. But the flight to quality trade wasn’t new to August, as returns on double-B rated loans (1.33%) have decisively outperformed single-B (0.59%) and CCC loans (-1.47%) over the last three months. Complicating this flight to quality trade has been a gradual but steady increase in lower-rated loans over the past 12 months. Through a combination of above average single-B rated issuance and a series of downgrades, the market share of single-B rated loans outstanding increased four percentage points to 56%, while the subset of B- rated loans outstanding increased three percentage points to a 12% share. Both figures represent all-time highs. But it’s not as if the rating agencies are forecasting a sudden and rapid rise in the default rate anytime soon. According to Fitch, the default rate is projected to rise from today’s 1.5% to 2% by year-end 2020, while S&P Global estimates the rate will increase from 1.3% to 2.7%. Still, both forecasted default rates remain within their historical average of around 3%.
But the severity of those losses were not surprising given that the two sectors are forecasted to experience the highest default rates this year – at 5% and 7%, respectively, according to Fitch. A risk-off mentality was also evident across rating cohorts in August as returns worsened alongside lower credit quality. While double-B rated loans reported an average 0.33% decline in market value, single-B and CCC rated loans recorded declines of 0.94% and 2.65%, respectively. But the flight to quality trade wasn’t new to August, as returns on double-B rated loans (1.33%) have decisively outperformed single-B (0.59%) and CCC loans (-1.47%) over the last three months. Complicating this flight to quality trade has been a gradual but steady increase in lower-rated loans over the past 12 months. Through a combination of above average single-B rated issuance and a series of downgrades, the market share of single-B rated loans outstanding increased four percentage points to 56%, while the subset of B- rated loans outstanding increased three percentage points to a 12% share. Both figures represent all-time highs. But it’s not as if the rating agencies are forecasting a sudden and rapid rise in the default rate anytime soon. According to Fitch, the default rate is projected to rise from today’s 1.5% to 2% by year-end 2020, while S&P Global estimates the rate will increase from 1.3% to 2.7%. Still, both forecasted default rates remain within their historical average of around 3%.
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