Episode 2: Summer of Volatility

Episode 2 July 06, 2022 00:09:27
Episode 2: Summer of Volatility
LPC - Lending Lowdown Series
Episode 2: Summer of Volatility

Jul 06 2022 | 00:09:27

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Show Notes

Taking a look at current market dynamics in the leveraged lending space amidst volatility, inflation, and how loans are performing versus other asset classes. 

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Episode Transcript

Speaker 1 00:00:13 Welcome to the Lending Lowdown. I'm Iana Barza, head of Market Analysis, and I'm joined by CJ Doherty, director of Analysis. We're excited to host our second podcast together. Second quarter wraps up on the heels of the Fed's 75 basis point rate hike. We wanna set the stage for what might lie ahead with the stalled primary loan market and a deeply discounted secondary. So thank you everybody for tuning in. Cj, this was the biggest hike since 1994. Speaker 2 00:00:44 Thanks Iana. Uh, and yes, it was a big one and there are more hikes to come. Um, you know, rising inflation is prompted a more aggressive monetary tightening by the Fed, and in turn, we have seen a, you know, a big pickup in volatility in recent weeks. A and while rising rates are perceived to be a good thing for loans as they're floating rate assets, there are concerns that the Fed might increase rates to an extent that it hurts economic growth and causes a recession and hits credit quality. A And so the, the Fed is a balancing act to do increasing interest rates to try and control inflation, but not hurt the economy too much. So not an easy thing to do. Speaker 1 00:01:20 No, it's not. And in this environment, most asset classes have come under pressure, although performance varies widely, of course, but I think you might say there's been no escape for any asset classes, including leverage loans. Speaker 2 00:01:36 Yeah. There's been a repricing of risk across markets and there's a lot of caution among lenders. Um, well, we've definitely, uh, you know, been hit leverage loans, you know, have fared better than other asset classes like bonds and equities loans. Outperformance has been due to their, their floating rate nature versus the predominantly fixed rate bond market. Um, and to put some numbers on year-to-date performance, US leverage loans have lost 3.7% on a total return basis in comparison to investment grade corporate bonds, which are down 15%, and high yield bonds have lost 13%. And on the equity side, the s and p 500 is down 19% year to date. Um, however, as you know, you know, loans have, have not been able to escape the broader market negative sentiment in recent weeks. Speaker 1 00:02:22 I mean, look, loan returns when we, when we see those numbers, they're not as hard hit, but it is still quite negative for loans and they're really dragged down by that volatility in the secondary. Speaker 2 00:02:34 Yes, absolutely. You know, secondary loan prices have gyrated this year and are down significantly, you know, initially hitting a low in mid-March, then regaining some loss ground before starting to tr to, uh, head lower again in late April, early May, and are now at their lowest level this year. Um, on the other hand, you know, some investors who have money to put to work are examining opportunities to pick up paper at a discount, you know, given that the, the average loan bid is now in the area of 93 cents on the dollar, and that's downed from 98 and a half at the start of the year. Speaker 1 00:03:06 That is five points. Uh, anybody who knows the loan asset class, that's, that's a really, that's a significant shift, and it's not surprising. We are seeing this flight from risk and that drag was even bigger for the lower rated credits. Speaker 2 00:03:22 Yeah. You know, looking at triple C loans, they've lost nearly 8% year to date. Single BS are off by 4% and double Bs the, the higher quality segment of, of the leverage loan market, they've outperformed other rating categories, but are still down two and a half percent. Speaker 1 00:03:38 And then talking about the hardest hit the cyclical sectors. I mean, Speaker 2 00:03:42 Yes, indeed, you know, retail and automotive have led the, the sector loan market lower posting declines of seven points and five points respectively this year. On the other hand, commodity prices have provided support for oil and gas and, and the mining sectors with both down less than one point. Uh, though they, they make up a very small share of the leverage loan market. Um, but if we look at the, the biggest sectors in the, in the secondary market, the like of technology, healthcare, and financial services, they're all down over four points. Speaker 1 00:04:13 Well, as one underwriter said, this is the time to be brave and step in, there are opportunities with a lot of potential upside, but not just in the secondary, in the primary. We've seen originally issued discounts or OITs in the low to mid nineties. And to be fair, there's, you know, there's very little in the way of new issue and we expect a slow summer as banks are working on that paper, they've underwritten before. You know, condition shift is so dramatically so this might be buying us sometime as the CLOs, the biggest buyers of loans, they've also been affected Speaker 2 00:04:48 AAA spreads are now in the 200 basis point area, and that's 40 to 50 basis points wider in the last month. And, and there was more bifurcation between managers as well. Um, and, and you might argue, you know, the wider the CLO spreads are the more attractive for AAA investors, but on a relative value basis, spreads have widened in other securitized products too. Speaker 1 00:05:08 Yeah. And, and if you think about on an opportunistic note, market conditions have created these opportunities for the CLO managers to build par. So they're buying loans, they at sizable discounts in the secondary market. Speaker 2 00:05:20 Yeah. And that's why we've seen CLO print and sprint deals recently. Um, also I would add, you know, CLO warehouses can potentially absorb some of the supply on offer in the secondary loan market, but some warehouses have a significant amount of underwater assets. Um, and that's because market conditions are so different today compared to when they bought these assets. So you do have warehouses and there, and there's quite a few that are hampered in, in taking advantage of these market conditions. Speaker 1 00:05:46 Yeah. And that makes it really hard to predict what, what the new issue CLO numbers are gonna do. Uh, and we've, we've all noticed these forecasts being adjusted down right. Uh, for the year. And they're also really wide ranging. So some research channels say 90 billion for the year, all the way to 140 billion now. So CLOs very mixed in the outlook, but retail loan funds, we have seen a very clear and major reversal. Speaker 2 00:06:14 Yeah, we certainly have. You, you know, typically the, the rising rate environment is good for leverage loan funds due to their, their floating rate nature. And we've seen this a lot in recent times, you know, through the first four months of this year, uh, loan retail funds pulled in 25 billion. Uh, and this came on the heels of 46 billion of inflows last year. Uh, and also there was a sizeable relocation of money into leverage loans from Helo Bonds earlier in the year. Um, but with the broader market volatility and falling loan prices in the secondary market recently, you know, loan fund inflows have turned to outflows. And since the beginning of May, outflows have totaled over 7 billion. So Speaker 1 00:06:51 We enter this third quarter with so much uncertainty. Investors are scrutinizing every credit. What if there's a downturn? How is this credit gonna behave? What is a reasonable estimate of EBITDA shortfall if we enter a recession? Speaker 2 00:07:08 Yeah. Um, although it's not quite fundamentals, you know, not yet at least, you know, defaults remain low, though they're expected to climb from current levels, though, not necessarily spike. Um, but there are signs of deterioration, you know, in inflation and supply chain issues are having an impact on a swath of, of companies. And as a result, downgrades outpaced upgrades in May and June. Um, and even looking forward, you know, a as we touched on the expectation is that the summer will be quiet in terms of leverage, loan deal flow. Um, the first thing is for banks to try and clear loans in the pipeline that they've already underwritten. Speaker 1 00:07:43 Well, you know, and Oh no, CJ I was just gonna say, as deals work through the market, right? I mean, private credit's a pocket of capital. So direct lenders, they have money to put to work. They've had a lot of strong fundraising in these recent years, and also they're not marketing to market. Speaker 2 00:07:59 Yeah. Direct lenders have been able to, to step in on both smaller and larger deals with several mega unitranche deals in the second quarter, including the newest one, the 5 billion deal for Zendesk. Um, and, and that said, you know, they, along with, you know, bank underwriters continue to navigate, uh, a very challenging, uh, market. Um, you know, what happens with large scale m and a related deals, you know, the likes of Citrix Tenco, for example, you know, when it's their time. Speaker 1 00:08:26 Well, the, you know, the way the market responds, I think to those deals is gonna give us a lot of insight. So what else are lenders watching as we head into three q? Well, I invite you to check out our three Q outlook and our lender survey [email protected]. And I wanna thank you for joining us. I'm Iana Barza and here with CJ Doherty. CJ, thank you so much for doing this. And again, we wanna thank all of you for listening to our second episode. Subscribe to the lending lowdown on your favorite podcast platform. Speaker 4 00:09:00 When you contribute your fixed income deals to Refinitiv, they'll reach over half a million buy and sell side professionals around the world and be included in our industry leading league table rankings. To ensure we're capturing your entire deal flow, visit contribute.refinitiv.com/fi signup or contact our [email protected]. Make your deal count.

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