Optimism reigned supreme in the second quarter as the recovery from the pandemic continued. Risk appetites remained high on the heels of record stimulus and all of this helped drive the loan and CLO markets. The fi rst six months of 2021 we saw the loan market operate at a torrid pace. New issue loan volumes were enormous as M&A activity approached near all-time highs.

U.S. Leveraged Loan Volume

Data through June 30, 2021
Source: LCD, an offering of S&P Global Market Intelligence

There was no issue in absorbing the supply as CLO issuance is pacing to set an all-time record in 2021. On the heels of all the government stimulus, rising rates remain a central theme for investors. This focus has helped to drive over $25 billion of retail fund infl ows YTD. Dealers also report that CLO warehouse activity is also very large. All of these factors combined mean the fi rst half of 2021 was as busy as in any year we have seen.

Source: J.P. Morgan

The loan market was up 3.28% in the fi rst six months but Q2 returns slowed from the fi rst quarter’s pace with a 1.47% return. Earnings from Q1 (reported in Q2) were largely very good as COVID-centric industries rebounded. Travel continued to increase, hotel vacancies declined and movie theaters, leisure parks and gaming destinations all showed sharp improvements. As the economy showed signs of a rebound, we saw the rating agencies respond with upgrades.

Rolling 3-month Count of Loan Rating Upgrades & Downgrades

Data through June 30, 2021
Source: LCD, an offering of S&P Global Market Intelligence

Performance – Loans

In June 2021, the Credit Suisse Leveraged Loan Index (CS LLI) was up 0.37% and the S&P Leveraged Loan Index (S&P/LSTA) was up 0.41%. Q2 2021 and YTD returns for the CS LLI and S&P/LSTA Index both advanced 1.47%/3.28% and 1.44%/3.48%, respectively.

For the 12 months ending June 30, the CS LLI was up 11.65% and the S&P/LSTA was up 11.67%.

Triple C returns continued to outpace all categories in June with a 1.77% return. In the second quarter, investors were rewarded for taking risk as triple C and single B returns considerably outpaced double Bs. While distressed results lagged in Q2, on a year-to-date basis they led all results with a 15% return followed by triple Cs with a 12% return.

Improving fundamentals and upgrades both helped to push prices significantly higher in the lower quality portion of the index.

On an LTM basis, triple Cs led all categories with nearly a 35% return. Single Bs produced a 10.81% return and double Bs returned 6.52%.

Total Return by Rating

Source: Credit Suisse Leveraged Loan Index

Sector Performance

In June, 17 of the 20 sectors produced positive returns in the CS LLI with dispersion between the top performing sector and the bottom performing sector at 255 basis points (bps). Metals/Mining led all categories followed by Energy and Aerospace. The bottom performing sectors were Retail, Consumer Durables and Utility with total returns of -0.04%, -0.12% and -0.85%, respectively. Utilities continues to lag the broader index and in June was negatively impacted by one significant downgrade as well as a weaker than anticipated PJM auction.

In the last 12 months, Energy, Metals/Minerals and Consumer Non-Durables have led all sectors with total returns of 24.5%, 20.73% and 19.43%, respectively. Forest Products, Financials and Utility provided the worst performing sector returns: 9.08%, 7.79% and 3.67%, respectively.

Industry Returns

Source: Credit Suisse Leveraged Loan Index

The average bid of the S&P LCD flow-name loan composite declined from 99.34 in early June to 99.23 by July 1. Large, liquid loans underperformed the broader CS LLI as it increased 13 bps in June. As the new issue calendar remained busy in June, many investors raised cash from liquid deals, particularly liquid deals with smaller coupons in order to have cash for the primary.

Average Loan Flow-Name Bid

Source: LCD, an offering of S&P Global Market Intelligence

Performance – CLOs

As in May, CLO performance continued to be flat in June with the primary market taking the bulk of investor attention. Carry provided the majority of returns over the month with prices/spreads unchanged from May in most tranches and with BBs/ Bs seeing some weakness. CLOs returned a mere 16 bps over the month, underperforming IG (+1.5%), HY (+1.34%) and Loans (+0.37%). With rates rallying over 10 bps, IG and HY credit outperformed their floating rate counterparts significantly. Year to date, CLOs are returning 1.52% outperforming IG credit (-1.28%) and underperforming HY (+3.62%) and Loans (+3.28%).

AAA, AA and single A spreads were flat over the month with shorter, out-of-reinvest bonds trading in the 80-95 DM range and longer duration in the 110-115 DM context for AAAs. AA and single A spreads stayed in the 150s and 180s discount margin (DM) respectively. Given that most bonds in secondary are trading at a premium and many are out of their non-call periods, there is not much room for spreads to tighten further up the stack. Secondary AAA supply did increase over the month but was met with enough demand to keep spreads unchanged.

BB spreads widened slightly over the month due to increased supply in primary. High quality, short spread duration BBs remained in the H 500s to low 600s DM but lower quality BBs widened 10-15 bps. The relative value between HY credit and CLO BBs continues to favor CLO BBs and the increase in CLO supply via new issue, refis and resets is keeping CLO BB spreads wide to historical averages vs. HY.

Secondary equity trading declined by 50% from May. Valuations look full as many investors are running equity to very benign scenarios and fully pricing in the refi/reset option. Trading was also quiet as investors await July quarterly payment data to assess how managers are navigating the tighter loan spread environment.

Trading volumes declined with monthly BWIC volume at $2.7 billion and overall TRACE volume at $10 billion vs. $11 billion in May. Trading activity moved from equity to AAAs in June as accounts sold AAAs and rotated into wider new issue. However, there was enough demand for secondary AAAs from shorter duration buyers that dealers ended the month lighter by $250 million.

Secondary CLO 2.0 Total Returns

Source: J.P. Morgan CLOIE Index

Secondary CLO 2.0 Spreads (DM)

Source: TCW

Technical Conditions – CLO Primary

CLO primary activity increased significantly month over month at $16.5 billion across 30 new issue deals, making June issuance the second highest in history. Refi and reset activity increased as well, continuing to grow year to date total supply percentages to $173 million of refis and $129 million of resets. New issue CLO spreads were wider across tranches, with Tier 1 AAAs 2 bps wider at L+112 bps. Similar to last month, many new issue deals utilized the Sr/Jr AAA structure to price tighter Sr AAAs and increase credit enhancement. The rest of the stack was also weaker with AAs 5 bps wider, As 10 bps wider, BBBs 25 bps wider, and BBs 10 bps wider due to continued high CLO supply. Notably, with high yield credit tightening over the month and CLO BBs widening, the CLO BB/HY ratio increased to record highs.

Refi and reset volumes increased with a total of 25 refis and 30 resets pricing over the month, versus 20 refis and 18 resets in May marking a significant increase on the reset side. Refis and resets remain attractive to investors, keeping equity holders invested in a high carry asset, but we also see that pipeline capacity issues have the ability to push investors toward liquidations. Regarding liquidations, there has been an uptick in liquidations since April due to high quantities of CLOs out of their non-call periods and limited ability to refi/reset due to pipeline and rating agency constraints. In Q2 2021 there were over 30 liquidations vs. 25 in Q1. As 2020 post-COVID deals exit their non-call periods (and with 78% of the CLO market expected to be outside of call-protected periods by year end), we will likely also see a continuation of increases in CLO refis and resets and widening spreads from the increased supply. Moving forward into Q3, we may witness a decline in new issuance, as wider spreads could make the arb unattractive to price a deal. We could also see the comeback of shorter reinvestment period deals such as 3nc1s in order to reduce debt costs and preserve optionality for tighter spreads in the future.

CLO New Issuance

Source: TCW

Tier 1 New Issue Spreads (5nc2)

Source: TCW

New Issue BSL AAA DM – June 2021

Source: TCW

Technical Conditions- Loans

In June, we saw institutional new issue increase 68% to $58.4 billion from the prior month’s issuance of $34.6 billion. June represented the third busiest syndication month for loans in 2021. As we look at the net forward calendar, we can see that while the net amount remains negative, post the July 4th holiday, new issue announcements have brought the net amount almost back to zero after a recent low of nearly $11 billion.

Summary Institutional Loan Data – ($ in millions)

Source: Credit Suisse Distribution

Leveraged loan funds reported 25 consecutive weekly inflows for the asset class. AUM for retail loan funds stood at $97 billion at the end of June as compared to $69 billion at year-end and $154 billion in October 2018. Inflows for retail loan funds total +$26.8 billion YTD following outflows in 2020 totaling -$27.0 billion.

The strong monthly retail and CLO demand during the last 12 months has helped contribute to the historically high returns.

Inflows vs. Returns

Source: LCD, an offering of S&P Global Market Intelligence

Fundamentals – Loans

Lagging 12-Month Default Rates

*Shadow default rate includes potential defaults, including those companies that have engaged bankruptcy advisors, performing loans with SD or D corporate rating and those paying default interest.
Source: LCD, an offering of S&P Global Market Intelligence

There were no defaults in March, April, May or June and the last 12-month default tally for the S&P/LSTA is only 19. Retail/ Restaurants and Oil & Gas led all industries in defaults, both with four.

The default rate of the S&P/LSTA, by issuer count, dropped from 1.99% to 0.88% while the default rate based on par outstanding declined from 1.73% to 0.58%.

Fundamentals – CLOs

CLO fundamentals improved as more CCC loans were upgraded over the month. The percent of CCC rated loans in CLOs declined another 10 bps to below 6% and Weighted Average Rating Factor (WARF) declined 32 points with the median CLO WARF now below 3,000. Equity NAVs also increased to above $60 as loan prices increased over a quarter point. In addition, exposure to distressed loans declined with the percent of CLO collateral trading below $90 now under 3%.

Valuation

Since 1992, the average 3-year discount margin (DM) for the CS LLI is 466 bps. If the global financial crisis (2008 & 2009) is excluded, the 3-year discount margin for the CS LLI is 427 bps. The 3-year DM finished the month at 443 bps, which was flat from the prior month.

The DM spread differential between Double Bs and Single Bs is 67 bps tighter from July 2020 to June 2021 and 57 bps tighter than the historical differential since inception.

3-Year Discount Margin Differential Between BBs and Single Bs

Source: Credit Suisse Leveraged Loan Index

CS LLI Snapshot

Source: Credit Suisse Leveraged Loan Index

Summary and Looking Forward

As the loan market has shown few signs of weakness year-to-date and warehouse activity remains high, it feels like there is little to prevent loans from tightening. However, during the last decade, only 2017 did not have a month where the market did not have one down month of at least 49 bps. Typically, during the last decade, the index has had at least two monthly declines per year as it is also rare when we do not see some degree of unforeseen volatility. As we look forward into the summer months, institutional loan supply has slowed and loan demand remains robust. This would suggest loans should grind higher in the summer, particularly, with the traditional slow weeks in the back half of August and the first half of September. Will the loan market retrace some of the gains we have seen YTD in the summer or fall? If the CLO calendar continues to operate at the rate we have seen in the first half of the year, it is hard to imagine. Warehouse activity suggests managers are preparing for a very busy fall of new deals.