Loans rebound in 2009, but outlook remains uncertain
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By Colm Doherty
After a difficult 2008 during which loan returns hit never before seen lows, the market has regained some lost ground. Year to date through April 15, loans have returned 15.5%, according to the S&P/LSTA Leveraged Loan Index. While not enough to make up for last year’s fall, it has helped investors to recoup some of the losses suffered last year. Alternatively, it’s a nice return for those who may have timed the market well and bought in the secondary earlier this year.
One notable aspect of market performance this year is that loan returns are outpacing that of other asset classes. The 15.5% return for leveraged loans easily exceeds that of cash pay high yield bonds (11.4%), high-grade corporate bonds (0.38%) and equities (-3%) (Fig. 1). Traditionally not an asset class associated with outsized returns, the dismal performance of the loan market last year has translated into far more room for upside gain compared to that seen in the past.
Loans returned 9.8% in 1Q09 specifically, their best quarterly performance ever (though it’s still overshadowed by the 23% loss of 4Q08) (Fig. 2).
January was the best month from a return perspective, hitting 7.4%, compared to 0.78% in February and 1.44% in March. The second quarter has started strongly as well, with loans returning 5.16% through April 15 (Fig. 3).
In comparison, there was more variation in cash pay high yield bond returns, as they moved from 5.32% in January to -3.35% in February and 3.4% in March. This brought the 1Q09 return to 5.3%. The second quarter also started off well for high yield bonds as they have returned 5.8% through April 16. As for equities, after a bad start to the year when returns hit -8.57% in January and -10.99% in February, the S&P 500 has rebounded strongly in recent weeks, returning 8.54% in March and 8.5% so far in April. But whether this means a bottom has been reached, or if it’s simply an indication of a bear market rally, remains to be seen, as the broader macroeconomic figures have shown no real improvement.
Coming back to loans, rising secondary prices have been the primary driver of the strong overall returns. Flow names are up 12 points, compared to 5 points for high yield bonds (Fig. 4). Looking at the components of loan returns, the market value return in the year to date through April 10 is 11.58%, while the interest return is 1.76% (Fig. 5).
Large pay-downs by the likes of Alltel and Allied Waste, along with a slowdown in portfolio sales, provided the impetus for loan bids to move up early in the year. Throughout the quarter, loan prices were driven higher by the large, liquid, and better quality market segments. From a ratings perspective in 1Q09, BB rated loan returns outpaced B rated credits by 13.55% to 9.62%, as investors focused on higher quality assets. However, the gap between BB and B rated credits has narrowed in early April. Year to date, BB rated loans have now returned 18.64%, versus 17.49% for B rated loans. At the bottom of the risk spectrum, CCC rated loans were generally avoided, falling 7.61% in 1Q09. Also at the riskier end of the market, multi-quote second-lien loans are at distressed levels, with the average bid now at 38.99.
CLO demand for better quality, higher priced assets is another factor at play this year. CLOs have more incentive to buy loans priced above 80 – since these assets generally don’t have to be marked to market – and so loans bid in this area have benefited from this CLO demand. Looking at the distribution of SMi100 loan bids illustrates the sharp increase in the share of loans in the higher price point categories. At the beginning of the year, 28% of credits were bid in the 80-plus range. Currently, however, 57% are bid in this range, with the majority (37%) bid above 90 (Fig. 6).
Delving further into loan performance, we see differences by vintage. Bids on more recent loans remain above those of older vintage deals. In turn, the median yield on multi-quote institutional loans issued prior to 2007 is currently 13.1%, similar to the 13.2% for loans issued in 2007. However, loans issued since the beginning of 2008 have a median yield of 12% (Fig. 7). Their more conservative structures and higher spreads have made them relatively more attractive to investors.
Additionally, there has been a notable difference in the performance of flow names versus the broader market. The more liquid SMi100 has climbed twice as much as the broader market, 12 points versus 5.7 points. Moreover, some individual credits have experienced very large increases. Of the loans that currently comprise the SMi100, 42 have climbed by more than 15 points in the year to date, with 23 of them having increased by more than 20 points. The vast majority (86) have gained at least 5 points (Fig. 8).
Still it’s not all smooth sailing. While this year’s rally has provided welcome relief to loan holders after a tumultuous 2008, loans remain at deeply discounted levels, with the SMi100 now at 77.13, and the overall market at an even more depressed 65.95. Questions remain over whether the upward momentum will continue or whether it is running out of steam in the face of the weak economic outlook. Credit quality concerns remain and defaults are expected to keep rising. For the moment, however, advancers continue to easily outpace decliners. The current advancer to decliner ratio shows that advancers hold the upper hand at 81% in the last week while decliners are at 7%.
Given the difficult credit environment, rising default rates, and expected lower recoveries, many investors are waiting for signs as to when defaults will peak. Unfortunately, the trend still points in the other direction. Looking at credit quality, the Moody’s U.S. speculative-grade default rate rose to 7.45% in March, up from 4.53% in December. During 1Q09, 79 issuers defaulted, of which 55 were U.S.-based. The U.S. default rate is forecast to reach a high of 14.1% in November.
Focusing specifically on leveraged loans, the default rate ended March at 4.54% on an issuer weighted basis, up from 1.52% a year ago, according to Moody’s (Fig. 9), and it’s expected to continue climbing. In addition, 1Q09 was also marked by a surge in amendments, with around $70 billion of leveraged loans being amended. In turn, this climb in amendments leads to expectations of a higher default rate going forward.
Ultimately, while loans are off to a good start this year, it remains to be seen if it will be maintained and if loan returns can continue to outpace other asset classes. According to a LoanConnector poll, opinions are mixed as to which asset class will finish the year with the best return. Thirty-four percent of respondents believe high-grade corporate bonds will lead the way, despite the fact that they currently lag leveraged loans and high yield bonds. At the same time, 29% see leveraged loans maintaining their lead through the rest of the year. Then come equities at 22% – no doubt buoyed by the recent surge in equity prices – and high yield bonds, which garnered 16% of the votes.