The leveraged loan market continued to recover in the third quarter of 2020, posting a 3.47% gain and pushing the year-to-date return to approximately breakeven. The loan price improvement witnessed in June continued in the third quarter and was driven by several positive factors, particularly the increase in demand from CLO buyers. A meaningful compression in AAA CLO spreads led to a sharp increase in CLO issuance, which—in September—reached the highest level seen since April 2016. Additional factors driving loan market performance during the quarter included encouraging news on COVID-19 treatment protocols and vaccine research, the Fed’s push for a second round of fiscal support, and an earnings picture that proved to be less dire than feared.
The loan market recovered in the quarter, though it slightly lagged the V-shaped recovery of the high yield bond market. The J.P. Morgan U.S. Leveraged Loan Index began the second quarter at a weighted average price of $91.37 and ended the third quarter at $94.54, posting a 3.47% gain and bringing the index’s year-to-date return to -0.57%. The index ended the quarter with a 575-basis point spread to a 3-year takeout, exceeding the 11-year median of 495 basis points.
Default rates are a point of focus for both high yield and leveraged loan investors, as issuers’ balance sheets may lack the flexibility needed to navigate the challenges brought on by COVID-19. In the third quarter, the par-weighted default rate in the leveraged loan market increased to 4.26% at quarter-end, up from 3.96% at the end of June and 2.84% a year ago. The pace of defaults has slowed in recent weeks, leading some sell-side research teams to lower their default rate forecasts.
The reopening of the U.S. and European CLO markets led to an increase in new issue volume in the leveraged finance market during the third quarter. In the U.S., institutional loan new issue volume totaled $330.4 billion year-to-date and $129.9 billion net of refinancing, a year-over-year increase of 25% and decrease of 17%, respectively. September’s $33.7 billion of issuance was the heaviest activity since February 2020.
We witnessed bullishness in the credit and equity markets in the third quarter, though this was coupled with rising concerns about new spikes in COVID-19 cases and a potentially contested U.S. presidential election—both of which persist. In this environment, we believe prudent leveraged loan investors should be focused on monitoring the liquidity runway of underlying borrowers. In the event of a prolonged shutdown, companies that can manage their cost structure and that have access to sufficient liquidity will have the flexibility needed to navigate the 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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While default rates have increased, they are nowhere close to post-GFC levels.
While downgrade activity in the loan market has slowed, there is still the possibility for further downgrades in sectors with high exposure to COVID-19-related risk.
Loans have recovered but not to pre-pandemic levels.
The reopening of the new issue CLO market is a positive catalyst for the primary leveraged loan market.