U.S. leveraged loan investors in February faced the highest monthly supply shortage on record, despite what feels like the busiest primary market in over a year.
With technical market conditions still firmly favoring issuers, prices on leveraged loans in the trading market extended their rally, led by the riskiest levels of debt, as investors continued to reach deeper into the market in search of yield. With bids for paper pushing past pre-COVID-19 levels, the discounted spread-to-maturity on outstanding loans dipped to the lowest point since May 2019, while the yield-to-maturity fell to its lowest point since April 2004, according to S&P/LSTA Leveraged Loan Index.
It has been a year since the credit markets began their unprecedented, pandemic-induced sell-off, with the weighted average bid of the index hitting rock bottom on March 23, at 76.23. Not only have prices fully recovered, but they stand about a point higher than a year ago. By the end of February, the weighted average bid of the S&P/LSTA Leveraged Loan Index was 97.79, the highest reading since November 2018, 159 basis points higher than at the end of 2020 and 103 bps higher than Feb. 23, 2020.
The impressive gains in the last two months came about despite the second-highest issuance volume of new leveraged loans for January and February. There has been some $110 billion issued so far this year, just slightly below the U.S. record of $112 billion for the first two months of 2017, a year that featured a record $502 billion of institutional loan issuance. No other year has had $100 billion in the first two months.
Add in repricings — in which a borrower lowers the coupon on an existing loan through an amendment process, taking advantage of investor demand — and total loan market activity rises to $225 billion in January and February combined. This is the busiest two-month period in four years and tops the pace in 2020 by 17%.
And yet with so many transactions keeping investors busy, the gap between supply and demand widened further in February. Why?
Record supply shortage
While total new-issue loan volume (excluding repricings) is up 25% year over year, this growth is fueled by opportunistic transactions that do not add to net supply. The bulk of this year's activity comes from repricings — which do not count as new money transactions — along with refinancings and recaps, in which new debt typically replaces existing debt. Indeed, refinancings and dividend recap deals are up 67% from last year. At the same time, issuance to fund leveraged buyouts and M&A — a crucial driver of net supply — is down 10% year over year.
LCD measures net loan supply as the change in outstandings, per the S&P/LSTA Index, or newly issued loans joining the index, minus loans being repaid. The par amount outstanding tracked by the index contracted by $7.5 billion in February, the second consecutive decline, totaling $16.4 billion over the last two months. This brought the total par amount outstanding to $1.188 trillion, the lowest reading since October 2019. The index has contracted by $7.2 billion since last April — as the primary market rebounded after the March shutdown — meaning that all loans issued over this period did not fully cover repayments, leaving no net supply.
On the bright side, higher-yielding M&A-related issuance has been on an upward trajectory since the summer, with issuance stepping up in each of the last four months. February's total of $23.8 billion is the 13-month high, up from a relatively slim $10.8 billion average between April and December 2020. However, repayments stepped up as well, reaching $41.1 billion in February, a 12-month high, more than double the trailing-12-month average, at $18.4 billion.
A large chunk of February's tally came from the repayment of the Refinitiv US Holdings Inc. term loan B — the largest loan in the index — in connection with the company's acquisition by the London Stock Exchange. At the time of its repricing in December 2019, the term loan totaled $6.451 billion. Away from Refinitiv, refinancings accounted for close to half of February's repayments, including from five borrowers that replaced term loans with high-yield bonds. For example, Party City Holdings Inc. recently placed $750 million of five-year secured first-lien notes to repay in full the borrower's $720 million term loan B due August 2022.
Turning to demand: LCD defines investor demand as collateralized loan obligation issuance combined with retail cash flows to U.S. loan funds. Robust demand for CLO exposure sent liability spreads to yet another COVID-19-era low, as the U.S. CLO market priced 26 vehicles in February, totaling $12.7 billion, a four-month high. The year-to-date issuance is $21.2 billion, compared with $14.5 billion in the same period last year and just a hair below the record pace of 2018, at $21.4 billion.
At the same time, U.S. retail funds investing in leveraged loans continued their inflow streak, totaling $6.9 billion in the 12 weeks through Feb. 24, according to Lipper weekly reporters. For February alone, the tally stands at $3.1 billion, roughly on par with January, which had the highest inflows since March 2017. This follows a year in which cash redemptions at these funds and exchange-traded funds totaled $19.1 billion, on top of the bruising $27.7 billion withdrawn from the asset class in 2019.
More broadly, LCD estimates $4.4 billion of inflows into retail loan funds in January, the third consecutive monthly inflow. The sum of these retail loan fund investments and CLO issuance ($12.7 billion) stands at $17.1 billion, the second-highest monthly measure of investor demand since the Great Financial Crisis, behind $17.9 billion in March 2013.
Combining the $7.5 billion decrease in outstandings — the proxy for supply — with $17.1 billion of measurable demand leaves the market with a $24.6 billion supply shortage, a record high, up from a $22.0 billion shortage in January. Looking at the period from April 2020 through February 2021, measurable demand exceeded supply to the tune of $109.6 billion. The signs of this massive imbalance are evident in the rise of a host of hot-market trends, including a resurgence of riskier, second-lien loans, the decline in new-issue spreads for B-minus borrowers, and the current spike in repricings and dividend recaps.
Against the backdrop of such a dramatic technical imbalance, the S&P/LSTA Leveraged Loan Index gained 0.59% in February, down from 1.19% in January but ahead of the historical average pre-pandemic return (37 bps between 2015 and 2019). The market value return, which measures the increase or decrease in secondary prices, was up 0.28%, a four-month low, though it topped the average from 2015-2019, at negative 0.06%.
For the year through February, U.S. loans gained 1.78%, the second-highest reading for any comparable period in nine years, behind 4.18% in 2019, when the index rebounded from a 3.45% loss in the fourth quarter of 2018.
As in the previous few months, riskier leveraged loans outperformed in February, as investors' hunt for yield continues. The CCC rated portion of the index returned 1.89% in February, compared to just 0.52% and 0.29% for the single-B and double-B rated cohorts, respectively. (The rated subsets of the S&P/LSTA Leveraged Loan Index represent facility-level ratings). For the year-to-date, triple-CCCs are up 5.51%, outperforming higher-rated assets in the Index (1.63% for single-Bs and 1.03% for double-Bs).
In another illustration of the frothy conditions in U.S. credit markets last month, those second-lien terms loans — which are repaid after first-lien debt, in cases of default — outperformed first-lien loans, at 1.35% to 0.57%. During the March 2020 plunge in the global financial markets, when the riskiest assets were punished most severely, second-lien loans cratered by nearly 17%, compared to losses of 12% for first-lien loans. In the subsequent recovery, second-lien has outpaced first-lien in every month except for April.
Yields at record lows
As secondary prices rallied, the discounted spread-to-maturity of loans tracked by the index fell to L+407 at the end of February, the lowest reading since June 2019, down from L+443 at the end of December and from a 2020 high of L+1,071 on March 23. The average nominal spread has not changed significantly in the last four months, at about L+375, so the decline in discounted spread-to-maturity is purely secondary price-driven.
At the same time, the index yield-to-maturity retreated to 4.33%, the lowest since April 2004 and 8 basis points away from the all-time low of 4.25% in March 2004. The current level is about 40 bps below the end-of-2020 reading and is a long way from the pandemic peak of 12.87% last March.
Looking at February loan market performance of the largest industry segments (those with at least a 2% share in the index), all sectors posted gains except Radio & TV (down 0.61%). Leisure outperformed last month, gaining 1.47%; this segment has gained more than 4% year-to-date. Recall that these loans lost 5.33% in 2020 on the back of social distancing measures and the economic impact of the pandemic. Automotive and Oil & Gas also outperformed in February and have outperformed in the year to date.
On the flip side, defensive sectors that led last year's rally have underperformed so far in 2021. The two biggest sectors in the loan market, namely Electronics/Electrical and Healthcare, slightly underperformed the overall index return, with those segments up 1.59% and 1.78%, respectively.
Other asset classes
With a 0.59% gain in February, U.S. loans were in the middle of the pack of all the asset classes LCD tracks for this analysis. Ten-year Treasurys and high-grade bonds both posted losses last month, while equities rallied by 2.76%. Loans outperformed high-yield bonds, which were up 0.36%. For the year through Feb. 28, loans led all classes LCD tracks for this analysis.
As lower-rated credit continues to outperform in 2021, seven of the top 10 advancers in the S&P/LSTA Leveraged Loan Index in February were courtesy of triple-C rated issuers. Topping the list was Lumileds, a developer of core lighting and LED technology serving the automotive industry, closely followed by movie theater operator Cineworld Group PLC. Cineworld at the beginning of the month backed down in a dispute with lenders over an interest bill stemming, from a mistake in its credit agreement regarding the Libor floor. Both of the top two advancers have issuer ratings of CCC.
Moving the other way, Sinclair Broadcast Group Inc. topped the list of decliners, as its subsidiary Diamond Sports Holdings LLC reported weaker-than-expected earnings results. Diamond Sports first-lien term debt due August 2026 (L+325, 0% Libor floor) dropped to 75/77 by month-end, from an 84/86 context at the start of the month.
While the triple-C rated portion of the index outperformed in February, returning 1.89% for the month, four of the top 10 decliners were in the triple-C band, including Peabody Energy Corp., Glass Mountain Pipeline LLC, The J. Jill Group Inc. and GTT Communications Inc..
Article amended at 12:55 p.m. ET on March 8, 2021, to reflect the correct issuance volume for January-February 2017.