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US leveraged loan market gains stall in March, halting 11-month rally

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US leveraged loan market gains stall in March, halting 11-month rally

An 11-month rally in the U.S. leveraged loan market secondary market stalled out in March, as the S&P/LSTA Leveraged Loan Index returns were virtually flat, at -0.0025%, dipping into the red for the first time since the dramatic sell-off a year ago at the onset of the pandemic. However, while higher-rated and more-liquid loans gave back some of their recent gains, the riskiest levels of debt continued to rally, driven by investors' search for yield.

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Last month's loss follows the loan market's remarkable recovery from the 12.37% drubbing in March 2020. Indeed, loans gained in 11 straight months from April 2020 through February 2021, totaling 20.7%. That was the highest return over any 11-month period since the market's rebound from the Great Financial Crisis.

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The market value return, which measures the increase or decrease in secondary prices, drove last month's descent into the red. This metric was down 0.34% in March, the lowest reading since the massive 12.81% loss in March 2020. The market value component of return averaged 1.21% in the last 12 months with just two negative readings (March 2021 and October 2020).

Continuing a trend in 2021, riskier leveraged loans outperformed in March, as the investor search for yield continues. Single-B rated loans, which account for roughly 60% of the $1.2 trillion asset class, dipped into the red for the first time in 12 months, losing 3 basis points last month. BB rated paper, which represents about 20% of all outstanding loans, lost 0.27%, a 12-month low, the second month in the red for this cohort since last March.

At the same time, the riskiest (and higher yielding) names in the Index, namely CCCs, remained in the black, up 0.83% last month. About 9% of all outstanding loans fall into this ratings bucket. The CCC sub-index has now rallied for 12 consecutive months, gaining 43.87% in this period. Recall that these names lost 22.2% in the March 2020 sell-off, as investor demand for triple-C rated debt evaporated. (The rated subsets of the S&P/LSTA Leveraged Loan Index represent facility-level ratings).

In another illustration of the frothy conditions in the U.S. credit markets last month, second-lien terms loans — which are repaid after first-lien debt in case of default — gained 1.45%, while first-lien loans lost 0.04%. Cumulatively, the second-lien sub-index gained 36% in the last 12 months, following a roughly 17% loss in March 2020.

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For the year through March 31, U.S. loans gained 1.78%, the second-highest reading for any comparable period in six years, behind 4% in 2019, when the Index rebounded from a 3.45% loss in the fourth quarter of 2018 amid a broad sell-off in the U.S. capital markets. The highest rated and most liquid names underperformed in the first quarter, while CCCs and second-lien facilities led.

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By the end of March, the weighted average bid of the S&P/LSTA Leveraged Loan Index had declined to 97.55, down 26 bps from the pandemic-era high of 97.81, set on Feb. 25, 2021. That was also the highest reading since November 2018. Despite last month's retreat, the current level is 136 bps higher than at the end of 2020 and 80 bps higher than Feb. 23, 2020, right before the COVID-19-inspired sell-off.

As the secondary loan market softened last month, the share of loans priced at par or higher fell to 10.6% by March 31, from 35% at the end of February and from a recent high of 50% on Jan. 20. The current level is below the year-end 2020 reading of 12.5%. Consequently, as fewer deals priced at par or higher, the volume of leveraged loan repricings declined to $19 billion in March, from a hefty $58.5 billion in February and a whopping $71 billion in January.

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Some 52% of the Index loans now fall into the 99-to-just-below-par price bucket, up from 41% in February, while another 20% are priced between 98 and 98.99, up from 10% in February.

Technicals move closer to equilibrium

The technicals scales finally moved closer to equilibrium in March, although for the quarter a drastic supply shortage persists, despite record-shattering new-issue volume.

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. LCD defines investor demand as CLO issuance combined with retail loan fund flows.

Starting with supply: The par amount outstanding tracked by the Index expanded by $20.6 billion in March, the most since October 2018 and more than triple the $6 billion growth for all of 2020. This follows two consecutive declines, totaling $16.4 billion, over January and February. As a result, the total par amount outstanding in the Index rose to a new record, at $1.208 trillion.

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Higher-yielding M&A-related issuance has been on an upward trajectory since the summer, with each of the last three months producing at least $20 billion of volume. The $27.9 billion in March is a 14-month high. This compares to a relatively slim $10.8 billion average between April and December 2020. In fact, the $73.1 billion tally for the first quarter is the highest reading since the second quarter of 2018. Some of the recent M&A transactions joining the Index included a $2.145 billion first-lien term loan for Peraton Corp., a $1.935 billion first-lien term loan to fund the buyout of Endure Digital and a $1.6 billion term loan B for Horizon Therapeutics PLC.

Looking at overall new-issue activity, beyond M&A, U.S. leveraged loan issuance set a record in the first quarter of 2021, at $180.8 billion, eclipsing the prior high of $171.4 billion in the first quarter of 2017. However, as with four years ago, refinancings accounted for nearly half of this record, resulting in a surge of loan repayments.

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In fact, $91 billion of loans were repaid in the first quarter of 2021, a four-year high, up from $79 billion in the fourth quarter of 2020 and $73 billion in the first quarter last year. In other words, 8% of all loans outstanding at the start of 2021 have been repaid. Add to that the $148.4 billion in loan repricings (this type of activity does not generate a repayment) and roughly 20% of loans have either been paid down or repriced in the first quarter of 2021. This surge has boosted investor demand for higher-yielding paper since it has left investors with lower interest return in their portfolios.

March repayments totaled $28.5 billion, down from $41.1 billion in February but atop the trailing 12-month average of $19.8 billion.

Turning to demand: LCD defines investor demand as CLO issuance combined with cash flows to U.S. loan funds. The U.S. CLO market is off to its strongest start to a year since the Great Financial Crisis, underpinned by a combination of falling liability costs, resurgent leveraged loan issuance, attractive relative value of the vehicles, and pent-up supply from managers after a difficult 2020.

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The 2021 new-issue CLO market has already hosted 81 deals, totaling $39.3 billion. That puts it at a record high by both count and volume. The average first-quarter tally for 2013-20 (inclusive) is 45 deals and $23.1 billion. Issuance in the first quarter this year more than doubles issuance from the first quarter last year.

In March alone, 31 CLO vehicles priced, totaling $14.7 billion, up from the trailing 12-month average of 22 vehicles and $9.5 billion.

At the same time, after two years dominated by outflows, loan mutual funds and ETFs are riding an inflow wave of retail investor cash, prompted by the recent spike in U.S. Treasury yields, as investors seek to lock in interest payments that would correlate with future increases in the underlying benchmark rate. In fact, the only redemption among the weekly reporters to Lipper was during the first week of the year, when a scant $10 million was withdrawn from the segment. There have been net inflows in 15 of the 16 weeks through March 24, totaling $9.8 billion.

For the four weeks through March 24, the tally stands at $2.9 billion, roughly on par with February. This follows a year in which cash redemptions at these funds and ETFs totaled $19.1 billion, on top of a crushing $27.7 billion withdrawn from the asset class in 2019.

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More broadly, LCD estimates $4.1 billion of inflows into retail loan funds in March, the fourth consecutive monthly inflow. The sum of these retail loan fund investments and CLO issuance ($14.7 billion) stands at $18.8 billion, the second-highest monthly measure of investor demand since the Great Financial Crisis, behind $20.3 billion in February 2021.

Combining the $20.6 billion increase in outstandings — the proxy for supply — with $18.8 billion of measurable demand leaves the market with a $1.8 billion supply surplus, the first surplus in seven months, versus a $27.9 billion supply shortage in February. However, looking at the first quarter overall, measurable demand exceeded supply by $48.2 billion.

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Yields near record lows

As secondary prices retreated, the discounted spread-to-maturity of loans tracked by the Index rose to L+414 at the end of March, from L+407 at the end of February, though it remains 29 bps tighter than the L+443 read at the end of December. The average nominal spread has not changed significantly in the last quarter, at roughly L+370, so the increase in discounted spread-to-maturity is purely secondary price-driven.

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At the same time, the Index yield-to-maturity rose slightly, to 4.39%, from 4.33% at the end of February. The yield-to-maturity late in February was at its lowest level since April 2004. The current reading is just 14 bps wider than the all-time low of 4.25% in March 2004 and a long way from the pandemic-era peak of 12.87% last March.

Sector performance

Looking at March loan market performance of the largest industry segments (those with at least a 2% share in the Index), Oil & Gas and Leisure outperformed, up 1.38% and 0.23%, respectively, while the overall index was virtually flat. Since the Pfizer vaccine news last November, both of these sectors have rallied by more than 10%, while the Index as a whole has gained 5.34%.

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, Electronics/Electrical and Healthcare, slightly outperformed the overall index return last month, with the former sector at 0.01% and the latter up 7 basis points.

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Other asset classes

In March, all asset classes LCD tracks for this analysis dipped into the red aside from equities and high-yield. Ten-year Treasuries posted the biggest loss last month (-2.50%), the fourth month in the red and down 7.1% so far this year. Equities rallied by 4.4% in March, bringing the year-to-date return to 6.2% and leading all asset classes LCD tracks for this analysis. Loans ended up in the middle of the pack in March and trail only equities in the first quarter overall.

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Biggest movers

Sinclair Broadcast Group Inc. led the list of decliners in March as subsidiary Diamond Sports Group was downgraded two notches by Moody's, to B3 from B1, with a negative outlook. The downgrade from the rating agency came as the issuer updated its guidance for 2021 EBITDA to $441 million to $709 million, reflecting the high uncertainty over distributor renewals in 2021.

While the overall index eased in March from the impressive gains posted in the first two months of the year, lower-rated credits continued to outperform. Eight of the top 10 advancers in the index during March were rated CCC+ or below, while four of the issuers were in the Oil & Gas industry. Leading the way, though, was Syniverse Technologies, which S&P Global Ratings placed on CreditWatch positive at the beginning of the month after the company announced it entered into a definitive agreement with Twilio to receive up to a $750 million cash investment. Also among the largest advancers was GTT Communications Inc. The company recently extended the expiration date of its forbearance agreement with creditors to April 15.

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