For those equity traders who think they've been plunged into the darkest circle of hell with all the recent violent moves in the S&P, we dare you to take one look at the chart below and say which is worse.
Ominously, the slide in leveraged loan prices - which have collapsed in the past 6 weeks as a result of the events we described recently in "Wheels Come Off The Leveraged Loan Market: Banks Unable To Offload Loans Amid Record Outflows" - has trekked steadily downward in the past month even when stocks and high-yield bonds rebounded as they did on December 26 and 27. The liquidation has been so furious, that the S&P/LSTA Leveraged Loan Price Index has not had a gain in any trading session since Nov. 1.
And as prices fell, they created a feedback loop whereby lower prices led to accelerating outflows, and said outflows resulted in even more liquidation sales.
Last week was no different, as investors continued to pull money out of U.S. leveraged loan funds at a historical pace, withdrawing $3.5 billion in the week ended Dec. 26 (split between $2.9BN in mutual funds and $626 million in ETFs), the third straight week of record setting withdrawals, following last week's then-record $3.3 billion and $2.5 billion the week prior.
According to Lipper data this is the longest string of consecutive outflows exceeding $1 billion on record.
Much of the capital that had poured into leveraged loans this year - where demand was prompted by floating yields that offered protections against rate hikes - has reversed and loan funds now stand with less than $1 billion in inflows year-to-date following $13.4 billion in total fund withdrawals since November 21, according to Bloomberg calculations.
The sliding prices, together with outflows, will likely persist well into 2019, reflecting a reset of interest rate views lower, coupled with trade-war tensions, slowing growth and energy price declines. The bearish sentiment followed a rout in equities and high-yield bonds that began in early October.
The persistent downdraft in prices and fund flows has eroded what was formerly a standout among credits as loans are currently clinging to a 0.38 percent positive return for the year, according to the benchmark index. Leveraged loan returns had been above 4 percent this year through early October.
As Bloomberg reports, the outflow-induced volatility has made it more difficult for the biggest buyers of loans, collateralized loan obligations, to step in to fill the gap. The swooning prices are also scaring other institutional investors away with the CLO market effectively frozen in December.
"Normally, if you have retail outflows, CLOs would fill the gap, but with the exception of a couple of print and sprint, a lot of deals aren’t happening," said Andrew Carlino, managing director and portfolio Manager of Bain Capital Credit. New CLO issuance has slowed, and likely won’t fully come back till late January or even February, Brian Juliano, head of U.S. bank loan portfolios at PGIM Fixed Income, said last week.
Meanwhile, as very little trading activity occurs in the days preceding and following the Christmas day closure, some money managers sold loans in big chunks earlier this month in anticipation of the liquidity squeeze and to manage redemptions, adding further pressure to both prices and outflows.
Finally, the collapse in demand has also crippled the primary market and hobbled efforts by banks to offload loans they’ve underwritten but not yet sold to investors. As we noted previously, lenders including Wells Fargo, Barclays and Goldman Sachs have taken the rare step of holding on to loans in hopes that they can resell them to investors next year when the market stabilizes, leaving banks stuck with about $1.6 billion of unwanted loans heading into 2019.
Yet despite clear signs the market has frozen up, some investors remain optimistic and claim the recent market softness is merely a buying opportunity, especially once volatility dissipates.
"If you are a high-yield manager, loans yielding 8% is attractive," Carlino said. "You are starting to see cross-over buyers and that will only increase. It’s only a matter of time before institutional investors and cross-over buyers come back to the market."
Of course, that's what the optimists said in late 2007 and early 2008, when the LSTA loan index was trading exactly where it is now. 12 months later, during the depths of the credit crisis, it had imploded to 62 cents on the dollar, and only the Fed's bailout of the financial system prevented it from going to zero. We hope this time will be different.