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August 2022 | Issue 248
Opinion Direct lending

Extreme volatility can push BSL yields close to mid market levels, although that trade never lasts

Randy Schwimmer
Co-head of senior lending Churchill Asset Management
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The two segments of the loan market are on different paths as mid-market volumes rise
A keen market observer has noted that liquidity in broadly syndicated loans can exaggerate credit deterioration, while illiquidity in middle market loans can mask it. Today’s volatility — driven by rising rates, stubborn inflation, and recession worries — is challenging the best portfolio managers in both strategies to extract and maintain loan values.
The contrasting behaviours of BSL versus MM are seen particularly in the dip of the S&P/LSTA Leveraged Loan Index to 92 from 98.5 in February. That implies an 8% loss rate. While default rates rose above 10% during the 2008 financial crisis, 92 at this stage in the cycle is the “worry discount” akin to public equities’ recent swoon.
To compete for buyers in the secondary market, new single B term loan yield has doubled from 4% to 8% since last fall. What’s good for investors, of course, is a drag for issuers. Large cap volume is off about 50% from last year. High yield bond issuance has dropped 75%.
Mid-market loan yields are up modestly
Direct lenders with long-term capital can respond quickly to supply-demand technicals and competitive dynamics — and are not subject to CLO capacity or the fast money of retail cash. At year-end 2021, a sample middle market term loan spread was Sofr plus 475 basis points. Today that same loan would be S+500-to-550bp, depending on leverage. Including the benchmark rate and OID, the all-in yield is around 7.5%.
A lower cost of capital and surer execution are why PE firms are increasingly accessing private credit to finance buyouts and acquisitions. But credit investors see higher large cap yields and wonder, why not take advantage of this opportunity? The illiquidity premium of mid-caps over broadly syndicated loans has averaged 100-200bp for the past two decades. Extreme market volatility can push BSL yields close to MM levels, although that trade never lasts.
The Fed’s battle with inflation will decide when order is restored. June’s 9.1% CPI report dashed hopes that consumer prices had peaked. Whether the next hike is 75bp (as seems likely), or a higher number, the persistence of rising prices is destined to buoy yields in risk assets.
It’s no surprise more cash has exited high yield bond accounts this year than for the same 2021 period ($18 billion versus $14 billion, per Lipper), with fixed income returns taking big hits. More surprising is the exodus from retail loan funds. In the past two months, almost $10 billion has departed. Recessions aren’t helpful for credit. But low leveraged loan prices are attracting buyers.
While bargain shopping has lifted the average flow name bid off its early July lows, the reset in liquid strategies lowers their AUM in portfolios, overweighting allocations in alternatives. This has the consequence of pressuring managers to reduce the very asset that provides healing properties during market volatility. If the threat of a slowdown grows, leveraged loan prices will likely be pressured down and yields up. Middle market loan yields will also rise, though at a more measured pace. Both outcomes are beneficial to loaners.
The big question looming is where economic data heads relative to slowing consumer and commercial demand. While the default rate for the S&P/LSTA Leveraged Loan Index is at record lows (0.28%), the rating upgrade-to-downgrade ratio has swung negative for the first time since early 2021. This could foreshadow a higher default rate if the economy softens.
The flip side of higher all-in coupons is fraught primary issuance as large corporate and sponsored borrowers delay going to market. Broadly syndicated loan volume has declined, leaving few opportunities for managers and buyers.
The popularity of direct lending for sponsors has driven Q2 volume up 42% over Q1, according to Refinitiv. Mid-market spreads are issuer-favourable, thus private credit buyers can deploy cash quickly at attractive yields. Large mid-market structures are also investor-friendly now as cov-lite goes cov-heavy, and with lower leverage.
All of which means assessing relative value between asset classes isn’t just about pricing or yields. It’s also determined by how each performs through cycles, adapts to protect investors and still provides efficient new deal issuance.
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Global credit funds & CLO's
August 2022 | Issue 248
Published in London & New York.
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