Actively managed, ultra-short duration floating-rate income strategy that invests primarily in privately syndicated, below investment grade senior secured corporate loans.
An Attractive Income Option for a Strategic Allocation
- In 2Q22, a confluence of macro risks weighed on investor sentiment in the loan market, leading to notable weakness in the secondary market, muted new loan issuance and outflows from retail loan funds and exchange-traded funds (ETFs).
- Against this backdrop, the S&P/LSTA Leveraged Loan index (the “index”) lost 4.45% for the quarter.
- Market technical factors reversed the healthy dynamics seen in 1Q22, as new loan supply was muted in the last two months and totaled just $56 billion for the quarter, a 50% reduction from 1Q22
- For the quarter, the Fund return underperformed the index
Current Strategy and Outlook
In 2Q22, a confluence of macro risks weighed on investor sentiment in the loan market, leading to notable weakness in the secondary market, muted new loan issuance and outflows from retail loan funds and ETFs. Against this backdrop, the index lost 4.45% for the quarter. The average index bid price fell by 544 basis points (bp) from March levels to 92.16, a level not seen since August 2020 during the Covid-19 recovery phase. Not surprisingly, the market was firmly in risk-off mode with returns for BB-, single-B- and CCC-rated loans coming in at -3.11%, -4.91% and -7.69%, respectively. The dislocation amongst different ratings buckets and liquidity profiles increased in June with better-rated and liquid areas holding better, as lower quality and illiquid names starting to come under pressure. On a relative basis, loans still meaningfully outperformed other risk assets during the quarter such as investment-grade (IG) bonds, high-yield (HY) bonds and equities, which have all registered double-digit losses for the year-to-date (YTD) period.
Market technical factors reversed the healthy dynamics seen in 1Q22, as new loan supply was muted in the last two months and totaled just $56 billion for the quarter, a 50% reduction from 1Q22. On a YTD basis, total issuance volumes amounted to $168.3 billion, which is tracking only half of last year’s pace for the comparable period. Average clearing yields in the primary market increased well above 7% for the quarter due to wider original issue discounts amid the challenging conditions for new-issue, as well as a function of rising base rates. Dissecting new-issue volume by financing needs for issuers, merger and acquisition-related paper represented the bulk of transactions during the quarter, followed by refinancing activity, while dividend recapitalizations were largely sporadic. On the investor demand front, collateralized loan obligation issuance remained active given prevalence of opportunistic “print-and-sprint” deals, which are priced with only partially ramped portfolios and typically have short-dated or static (non-reinvestment) terms. Total formation in 2Q22 was $38.3 billion, reflective of a 25% increase from the first quarter. YTD formation through June has amounted to $71.4 billion, a respectable figure considering the macro developments. In contrast, the retail base redeemed an aggregate $3.8 billion from loan funds and ETFs, while YTD flows still remain positive at $18.2 billion.
There were two defaults in the index during the quarter (Talen Energy Supply and Revlon Consumer Products). As a result, the trailing 12-month default rate by principal amount experienced a small uptick of 9 bp and closed out the quarter at 0.28%, which is well below the long-term historical average for the asset class.
As we look ahead, we expect the macro backdrop to remain the main source of uncertainty and any broad market volatility. Recession risk has risen globally, as inflation and tightening monetary policy have led to a deceleration in economic growth. Higher food and commodity prices will remain a headwind for consumers and a challenge to policy makers, although impact will vary globally with Europe most at-risk, given higher reliance on foreign energy. May CPI print amplified Federal Reserve’s hawkish stance and raised terminal rate projections to 3.25-3.5% by yearend 2022. Policy outlook reflects a strong commitment to lowering inflation, but path to soft landing has narrowed considerably. Specific to loans, the outlook in the medium term will continue to be driven by both technical factors, primarily, and fundamentals, secondarily, given the still supportive backdrop going into 2Q22 earnings season. Beyond the visible forward calendar (which is relatively concentrated), near term new issue activity is expected to remain sporadic until the backdrop improves. General expectation, assuming no meaningful improvement in macro over the summer, is for spreads to reflect higher risk premiums; however, no significant pick-up in corporate defaults is anticipated over the next 12 months from the current low levels. Downgrade activity is likely to be a bigger concern for the loan market over the medium term, as compared to elevated defaults. Given the uncertain backdrop, we continue to closely monitor our credit selection and positioning given the prospects of sector and rating dispersion as we head into the typical pockets of summer illiquidity amidst macro uncertainty and a likely weaker earnings environment.
Class I shares of the Fund underperformed the index, which reflects no cash allocation or fee expenses. From a rating perspective, relative detractors included selection and underweight among BB-rated loans, selection within single-Brated loans, selection and overweight among CCC-rated loans and an underweight in BBB-rated loans. By industry, the Fund was primarily weighed down by selection in electronics and electrical, and to a lesser extent, selection in radio and television, business equipment and services, building and development, chemicals and plastics and forest products. Looking at individual loan drivers, top relative laggards included overweights to Riverbed Technology, Inc., Diamond Sports Group, LLC, Logmein, Inc. and Yak Mat. Riverbed Technology, Inc. and Logmein, Inc. both experienced some pricing pressure after announcing quarterly results that were below market expectations. Trading levels in the second-lien loan of Diamond Sports Group, LLC and firstlien of Yak Mat moved disproportionately lower to the rest of the market, as CCC-rated loans’ price performance across the entire loan market was weak during the quarter, given ongoing risk-off sentiment and broader market volatility. Conversely, the Fund was helped by selection in leisure goods, activities and movies. At an issuer level, an overweight to 24 Hour Fitness Worldwide, Inc. helped boost relative returns, as the company benefited from an improved outlook in the fitness center space. Away from loan-level performance, the Fund’s modest exposure to HY bonds had a negative impact on performance given the outsized losses experienced by the HY bond market in 2Q22.
The Fund did not experience any defaults during the quarter, as compared to two defaults within the index. Diversification measures in the portfolio remain robust with 58 industries and 432 individual issuers represented at the end of the period.
Companies mentioned in this report – percentage of Fund investments, as of 06/30/22: Riverbed Technology, Inc. 0.19%, Diamond Sports Group, LLC 0.33%, Logmein, Inc. 0.39%, Yak Mat 0.50% and 24 Hour Fitness Worldwide, Inc. 0.39%; 0% indicates that the security is no longer in the portfolio. Portfolio holdings are subject to change on a daily basis.