Actively managed, ultra-short duration floating-rate income strategy that invests primarily in privately syndicated, below investment grade senior secured corporate loans.
Key takeaways
Key Takeaways
- Despite the volatility and Silicon Valley Bank (SVB) and regional banking crisis that emerged in March, the US loan market closed 1Q23 on a high note, as the Morningstar® LSTA ® US Leveraged Loan Index (Index) returned 3.23% during the quarter.
- The Class I shares of the Fund underperformed the Index in 1Q23 on a net asset value (NAV) basis.
- In the short term, we expect leveraged finance markets to remain impacted by myriad of macro developments, evolving the US Federal Reserve policy, inflation and payroll data, fallout from regional banks and tighter financial conditions, and most importantly – corporate fundamental factors, 1Q23 earnings and forward guidance.
Portfolio review
Despite the volatility and SVB and regional banking crisis that emerged in March, the US loan market closed 1Q23 on a high note, as the Morningstar® LSTA ® US Leveraged Loan Index (the Index) returned 3.23% during the quarter. Overall, the average loan Index bid price increased by 94 bp to 93.38, primarily attributable to strong performance in the first two months of the quarter, as well as the last week of the quarter in which some of the earlier March softness was retraced. For the quarter, loans underperformed equities, investment grade and high yield (HY) bonds, as fixed-rate assets generally outperformed given the sharp rally in Treasuries.
Secondary trading levels were volatile in March, driven by the SVB and other bank-related developments but managed to retrace most of the softness towards the end of the quarter as the broader markets recovered post the Fed and Federal Deposit Insurance Corporation intervention. Lower rated-credits outperformed higher rated-credits in 1Q23, as double-B, single-B and CCC rated loans returned 2.08%, 3.81% and 3.92%, respectively.
New-issue supply remained low, given the less conducive macro backdrop for primary deals to launch. Total volume amounted to $49.5 billion during the quarter, the slowest reading for first-quarter issuance in seven years. The size of the loan market, as represented by total Index outstandings, declined by $14.53 billion in the first quarter to $1.4 trillion. On the demand side, collateralized loan obligation issuance remained in high gear, as managers priced $33.6 billion of new deals in 1Q23 which is ahead of last year’s pace of $31.2 billion for the comparable period. On the other hand, retail loan fund investors continued to exit the market, as $10.77 billion was withdrawn from mutual funds and exchange-traded funds during the quarter.
On an NAV basis, Class I shares of the Fund underperformed the Index. By ratings, the Fund’s exposure to the defaulted loan category and selection in D rated loans detracted from relative returns. From an industry perspective, the primary challenge was selection in software sector, although the bulk of the impact was concentrated in one issuer. Additional but smaller sector-level impacts stemmed from selection in IT services sector, as well as independent power and renewable electricity producers. By issuer, the Fund was negatively impacted by overweights to Avaya Inc., Nautilus Power, LLC. and Diamond Sports Group LLC. All three companies experienced challenges related to weak earnings and liquidity challenges. In contrast, the primary benefit resulted from the Fund’s exposure to the Avaya B3 term loan that received favorable treatment as part of the Restructuring Support Agreement (RSA) struck by approximately 90% of Avaya lenders, which was accretive to Fund performance. However, some of the benefit was partially offset by the Fund’s exposure to the respective Avaya B1 and B2 term loans which did not experience the same recovery as the B3 term loan. Elsewhere, the Fund also benefitted from selection in BB rated loans. Contributions by sectors were primarily due to selection in diversified telecommunication services sector, which was driven by an overweight to Telesat Canada. The company experienced some mean-reversion in the performance of its term loan following underperformance last year. Away from loan-level performance, the Fund’s modest exposure to HY bonds had a positive impact on performance, as the HY bond market outperformed in 1Q23 relative to loans (3.57% return for the Bloomberg U.S. Corporate High Yield Index).
Portfolio and positioning changes were both mostly minimal during the period. The number of individual names in the portfolio increased from 356 to 385, while the average spread level of the Fund decreased to 372 bp (versus 386 bp in the prior quarter). Elsewhere, the Fund experienced three defaults during the period (Yak Mat, Avaya and Diamond Sports Group), as compared to 8 defaults in the Index.
Current strategy and outlook
In the short term, we expect leveraged finance markets to remain impacted by myriad of macro developments, evolving Fed policy, inflation and payroll data, fallout from regional banks and tighter financial conditions, and most importantly — corporate fundamental factors, 1Q23 earnings and forward guidance. Loan fundamental factors, while still favorable, are showing signs of deterioration especially across lower-rated issuers. While overall metrics look favorable versus pre-pandemic levels, the market will be acutely focused on the impact of “higher for longer” rates environment (if sustained) and secondary impact from tighter credit conditions (regional banks), both of which will be a key focus during the next round of quarterly earnings. Unsurprisingly, loans have become more heavily correlated to movements in macro sentiment than is typical for the asset class given the recent developments that have impacted broad risk sentiment. As a result, careful credit selection and monitoring continues to be warranted, as risks remain skewed to the downside.
Holdings Detail
Companies mentioned in this report – percentage of Fund investments, as of 3/31/23: Avaya 0.60%, Yak Mat 0.42%, Diamond Sports Group, LLC 0.13%, Nautilus Power 0.69% and Telesat Canada 0.52%; 0% indicates that the security is no longer in the portfolio. Portfolio holdings are subject to change on a daily basis.