Leveraged Loan Index Declines for First Time Since December 2008

The leveraged loan market is poised to post its first loss since December 2008, with the benchmark S&P/LSTZA Leveraged Loan index down 2.33% for the month. While modest relative to the equity markets, the index had posted 16 straight months of positive performance and has risen over 50% from its December 17, 2008 trough. Unlike the equity markets, the leveraged loan market generally shows a great deal of stability so a 2.3% decline represents a meaningful change.

As I have reported on several occasions, the loan market has gotten very pricey, with leveraged buyers driving incremental demand. Many hedge funds have employed total return swaps (“TRS”) to leverage their positions (essentially, borrowing a meaningful portion of the purchase price from investment banks). With LIBOR less than 50bps and current yields of only 3-4%, the only way to generate mid-teens returns (the hurdle for most credit funds), was to employ meaningful leverage in one’s book. An improving economy and significant liquidity in the credit markets enabled leveraged buyers to outperform the market. Many of those trades are breaking down and should continue to do so as credit spreads widen.

While we have gotten a bit of a reprieve over the last few days, liquidity in the market remains very low and suggests that a great deal of caution is warranted as investors look to bargain hunt. As is often the case, a slowdown in liquidity generally precedes true price discovery in the credit markets and I firmly believe that the worst is far from over. While we could get a bounce in credit over the next few weeks given May’s sharp selloff, rallies should be used as opportunities to lighten positions rather than increase exposure.

Another data point that should signal caution is the sizable outflows in high yield we have experienced over the last three weeks. Last week we saw a massive $1.4bn exit from the high yield markets, on top of a cumulative $2bn withdrawal over the prior two weeks. Cumulative year-to-date inflows are now only $534mm vs. the nearly $4bn we had seen before problems in Greece began making front page headlines.

Here is a good chart from BofA that shows the weekly flows into high yield since late last year. With the exception of two weeks of declines in Mid-February, we have experienced consistently strong inflows into the riskiest parts of credit.