In the second quarter of 2020, the leveraged loan market rebounded sharply from the record lows experienced in March. In the U.S., the impact of government fiscal and monetary support as well as a slowdown in the pace of rating agency downgrades were positive drivers for the leveraged loan market. The J.P. Morgan U.S. Leveraged Loan Index ended the quarter with a weighted average price of $91.37, posting a 9.78% gain, the strongest quarterly return in over a decade. The European leveraged loan market experienced a similar snapback, ending the quarter with a weighted average price of $92.73.
The second quarter began with a wave of COVID-19-related rating downgrades, with S&P downgrade volume in excess of $60 billion during the first week of April. The pace of rating downgrades moderated, falling to slightly below $10 billion during the last week of June. Although more downgrades are to be expected, the pace is likely to slow. However, the $450 billion of debt outstanding with a negative outlook remains a concern and presents an overhang on the leveraged loan market. As social distancing guidelines led to a shutdown of parts of the global economy, the par-weighted default rate in the leveraged loan market ended June at a five-year high of 3.96%.
Looking to new issuance, the second quarter painted a very different picture from the first, with only $46 billion of new issue. The loan market reopened much more slowly than the bond market, with borrowers showing a preference for fixed-rate debt. Limited primary issuance has coincided with weak retail demand, with retail loan funds seeing $640 million of outflows in June, the 21st consecutive monthly outflow of more than $79 billion. A lack of supply in the loan market should benefit secondary prices.
The CLO market – an important source of demand for loans – showed signs of reopening in June. In the U.S., there were 79 new issue deals totaling $35 billion in the first half of 2020, representing a 44% year-over-year decrease in new issue volumes. In Europe, 30 new issue deals totaling $10.1 billion have printed year-to-date through June – a 38% decline year-over-year. The speed at which new CLO creation takes place will partially depend on the cost of CLO spreads, as well as the volume of new loan issuance.
In June, hopes for a gradual reopening of the economy were met with an uptick in new COVID-19 cases in certain parts of the U.S. In this environment, we believe prudent leveraged loan investors are focused on monitoring the liquidity runway of underlying borrowers. Companies that can manage their cost structure and have access to capital will have the flexibility needed to navigate the COVID-19 crisis. Furthermore, we believe a focus on avoiding challenged sectors, such as retail or energy, can help mitigate risk and improve capital preservation.
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Leveraged loans in the U.S. and Europe have rebounded sharply from the lows seen in late March.
Although the loan market reopened much more slowly than the bond market, a lack of supply should benefit secondary prices.
The leveraged loan default rate hit a five-year high in June.
Although the pace of rating downgrades has moderated, the $450 billion of debt outstanding with a negative outlook remains a concern and presents an overhang on the leveraged loan market.