US Leveraged Loan Wrap: Market rally continues as returns soar, dividends emerge

August was another strong month for the leveraged loan asset class, as the Morningstar LSTA US Leveraged Loan Index returned 1.17%.

With riskier, lower-rated names continuing to outperform, the index's return through month-end rose to 9.11%, keeping the leveraged loan segment on pace for its strongest year since the Global Financial Crisis. Improving market conditions led to the busiest August for loan issuance in six years, including plenty of opportunistic activity, such as loans funding the repricings of existing credits, as well as dividends to private equity sponsors sponsors.

Loans have been on a tear in the last three months, gaining 4.79% cumulatively over this time, the highest return for any comparable period since January 2021. For reference, the average quarterly return since the end of the Global Financial Crisis is 1.21%. Loans gained over 3% in each of the first two quarters of 2023.

The weighted average bid of the index advanced by 53 bps in August to a new intra-year high of 95.36, crossing over 95 for the first time in 12 months. In addition, this was the third consecutive month-on-month advance for the average bid following a prolonged period of market volatility. In fact, the last time the average bid gained for three months in a row was April through June of 2021, but the overall gain was lower then, at 83 bps, versus 247 bps now.

The market value return — which measures changes in secondary prices — was 0.37% in August, the weakest of the last three months. However, cumulatively, the market value gain is 2.38% since the end of May, after just a roughly 40 bps gain in the first five months of 2023.

Advancers outnumbered decliners in 78% of the market sessions in August, up from 65% in July but down from 90% in June. For every loan that declined, 2.2 advanced, on average, in August, down from 3.2 in July.

As prices advanced, so did the share of performing loans priced at par and higher. By the end of August, 12% of performing loans were in that bucket, up from 8% in July. For reference, a year ago, less than 1% of loans were in this category. Forty-one percent of loans now sit between 99 and just under par, and 81% are priced at 95 or higher. At the same time, only 12% of index names were bid below 90, the lowest reading since September 2022.

Amid the secondary market rally, the primary market launch calendar ballooned to its busiest level in six years. August featured a combined $31 billion of new supply, amend-and-extend deals and repricings via an amendment (the latter two categories do not count as new-issue volume). This was the highest reading for any August since 2017, up from just $5.9 billion for the month in 2022 and $20.6 billion for the month in 2021, when the annual new-issue record was set.

Notably, more than half of last month’s activity supported maturity extensions or amendments that lower the spread of outstanding loans, and neither category represents net supply for investors. Even within the $13 billion of August new-issue volume, $9.3 billion supported refinancings and just $2.5 billion M&A. Through August this year, loan volume to finance LBOs, acquisitions and mergers has totaled just $34 billion, the slowest pace in 13 years.

This dearth of new leveraged loan supply combined with improving secondary market conditions has put dividend-related loan issuance back in play. Volume totals $9.9 billion in the year to date, surpassing comparable periods in two of the past three years and edging past the full-year total of $5.8 billion for 2022.

Similarly, repricing volume (via both amendments and new money) is $29.5 billion in the year to Aug. 31, including $13.7 billion from August alone, the busiest month this year. In fact, last month’s tally already exceeds the $9.8 billion completed in all of 2022. For some perspective, current repricing levels are still low relative to 2021 peak, when borrowers lowered spreads on nearly $200 billion of loans between January and August. Nonetheless, the $13.7 billion tally was the first double digit reading since November 2021.

With that said, repricing activity remained limited to higher-rated borrowers. Out of the ten deals tracked by LCD, nine had a double-B rating by at least one ratings agency. B-minus borrowers remain shut out of the opportunistic activity amid investor risk aversion — LCD has not tracked any repricings from this ratings bucket over the last 19 months.

Triple-Cs outperform
Although financing opportunities remain very limited for the riskiest names within the new-issue broadly syndicated loan market, lower-rated names outperformed in the secondary market last month.

Triple-C rated loans, which account for roughly 7% of the index, were up 2.01% in August, the fifth consecutive monthly gain, down from 2.32% in July but ahead of the 1.58% average so far in 2023. In the year to date this cohort has gained 13.23%, putting it far ahead of double-B and single B sub-indices, and recovering from the 12.24% loss in 2022.

In fact, three out of the five biggest gainers last month came from borrowers with triple-C rated loans — Air Medical Group, Finastra, and Team Health — and the other two fall into the B-minus bucket (SFR and Zayo Group). These five companies accounted for 11 bps out of the total 1.17% monthly gain for the index. Some of the biggest gainers have maturities coming due next year, such as Finastra and Team Health. Indeed, the upcoming landmark $5.3 billion financing for Finastra is the largest takeout of an institutional loan by private credit on record. Private credit providers have not shied away from riskier credits and structures this year, and could provide refinancing options to lower-rated borrowers with near-term maturities.

Turning back to loan returns, loans falling into the broad single-B category outperformed the double-B rated cohort for the third month in a row, up 1.30% and 0.76%, respectively. The single-B rated sub-index accounts for the bulk of outstanding loans, with a 61% share. The lower-rated cohort’s relative outperformance stemmed from a higher market value return, at 0.48% in August, versus 0.05% for double-B names. Through August this year, single-B loans are up 10.14% on a total return basis, outperforming the double-B sub-index (6.60%).

Looking at the data by borrower rating, the gap between secondary pricing of the companies with a B-minus and a B-flat rating has contracted from July levels. On Aug. 31, loans to B-minus borrowers had an average bid of 93.91, the highest reading in 15 months, versus 97.99 for the B-flat cohort (16-month high). The resulting gap of 408 bps is lower than in July (456 bps) and is down significantly from 555 bps at the end of 2022. Nonetheless, the current premium is more than double the year-ago level of 181 bps. Given the macro-economic backdrop, the lower-rated cohort has advanced more cautiously for much of the last 12 months — its average bid gained 46 bps, or 0.5%, while the B-flat average bid rose by 272 bps, or 2.9%.

The trend is similar when looking at the secondary spread-to-maturity (STM) data. STM takes into account the nominal spread and bid price of the loan. On Aug. 31, the weighted average STM on loans issued to B-minus borrowers narrowed to 584 bps, 136 bps below the closing level for 2022. Meanwhile, STM of the B-flat cohort fell by 69 bps over the same period, to 448 bps. As a result, the gap between the two ratings buckets shrank to 136 bps in August, a ten-month low, from 202 bps at the end of 2022.

For the broader single-B bucket, the average STM fell to 487 bps on Aug. 31, its lowest level since May 2022. The current reading is roughly a point below December levels. At the same time, yield-to-maturity, which also takes into account the base rate, declined to 10.4% on Aug. 31, from a recent high of 11.0% in May. However, thanks to the rapidly rising base rate over the last 12 months, yields have risen by roughly three points since July 2022.

Technicals
Looking at market technicals, leveraged loan investors have not seen any meaningful net supply so far this year, worsening the supply shortage created last year.

LCD measures net loan supply as the change in outstandings, per the Morningstar LSTA US Leveraged Loan Index, or newly issued loans joining the index, minus loans being repaid. LCD defines investor demand as CLO issuance combined with cash inflows/outflows at retail investor loan funds.

About that supply: The par amount outstanding tracked by the index fell by $1.7 billion last month, the sixth decline in the last eight months, bringing the size of the index to $1.4 trillion. Cumulatively, the index has contracted by $26.1 billion, or 1.8% in the last 12 months. So far this year the index has shed $16 billion. As discussed earlier, although firmer conditions in the secondary market resulted in a flurry of activity in the primary last month, net new-money supply remains limited.

At the same time, repayments — which subtract from outstandings — rose to $25.6 billion last month, from $14.3 billion in July. On average, $18.9 billion of loans have been repaid per month this year, up from a $15.3 billion average in 2022. Refinancing activity continued to drive repayments last month, including jumbo transactions for Citadel Securities, BrandSafway and Carnival Corp.

As a result of these refinancing efforts, combined with amend-to-extend activity, borrowers reduced 2024 maturities by 67% in the year to Aug. 31, to $24.7 billion, and 2025 maturities by 35%, to $129 billion. Looking further out, loans coming due in 2026 currently total $215 billion, down 8% from December.

Turning to demand, which LCD defines as CLO issuance combined with retail cash flows to US loan funds: The CLO market printed $11.47 billion of new transactions in August across 27 deals, its busiest month since February. In the year to date, CLO issuance is $74.4 billion, 20% behind last year’s pace of $93.38 billion through Aug. 31. The trend diverges between BSL and MM CLOs, though, with the issuance in the former down 32% year-over-year ($58 billion) while the latter has more than doubled in the same period ($16.3 billion).

At the same time, the retail investor retreat from the leveraged loan asset class moderated with a mix of inflows and outflows last month. In fact, the nine weeks through Aug. 30 alternated between redemptions and investments. For August overall, investors withdrew just $321 million from the asset class, the second lowest amount since November 2020, behind a $28 million withdrawal in July. This brought the year-to-date outflow to $14.6 billion, versus a $6 billion inflow at the same time last year, based on weekly data.

More broadly, LCD estimates $459 million of outflows from retail loan funds in August (including monthly reporters), an increase from the $181 million outflow in July. August marks the 16th consecutive month of withdrawals, after a 17-month inflow streak. Adding this to CLO issuance ($11.47 billion) results in a total measurable demand of $11 billion, up from $6.8 billion July. Measurable investor demand averaged $6.1 billion in the last 12 months.

Combining the $1.7 billion decrease in outstandings in August — the proxy for supply — with $11 billion of measurable demand leaves the market with a $12.7 billion supply shortage. Demand has exceeded supply in 10 of the last 11 months. For 2023 overall, measurable demand has exceeded supply by $72 billion.

Other asset classes
Despite net positive inflows, and despite expectations for the end of the Fed hiking cycle, fixed-rate high-yield bonds underperformed leveraged loans in August, with the asset class gaining 0.28%, per Morningstar. That’s compared to a gain of 1.17% for loans.

Meantime, while multiple Street analysts upgraded year-end targets for the S&P 500 in August, including Citi and Jefferies, the S&P 500 lost 1.59% for the month, reducing the YTD return to 15.94%, from nearly 21% in July.

Biggest movers
One of the only top decliners in August that was not in the triple-C rated portion of the index was CenturyLink. The issuer’s term loan B due March 2027 (L+225, 0% floor) plunged to a 64.75/66 context by month-end, from around 69.5/71 at the beginning of the month, after the term loan was downgraded by S&P Global Ratings to B, from BB-, on weak performance and an unsustainable capital structure. Meanwhile, eight of the ten largest decliners last month were rated triple-C or lower, including Cano Health, which was downgraded last month.

Moving the other way, seven of the top ten advancers in August belonged to either the Healthcare or Diversified Telecommunication Services sectors, with Air Medical Group Holdings leading the way. Also among the top advancers last month was Misys (Finastra) whose term loans jumped following news that the company will have a $4.8 billion unitranche credit facility that will be used to repay the issuer’s previously syndicated term loans. The unitranche loan represents the largest private credit loan on record, excluding add-ons to initial loans, based on LCD reporting. The repayment will be the second largest for the Morningstar LSTA US Leveraged Loan Index in 2023.

This article originally appeared on PitchBook News