As the longest economic expansion in U.S. history came to an abrupt end in March, the record credit cycle, during which the U.S. leveraged loan asset class doubled in size and became a dominant player in the capital markets, likewise collapsed.

Putting it mildly, last month's loan market upheaval and resulting volatility were devastating. The U.S. leveraged loan asset class plunged 12.37% in March, the second-steepest monthly decline in the 23-year history of the S&P/LSTA Leveraged Loan Index. Before COVID-19 swept the globe, the top three biggest losses for loans were during the global financial crisis following the Lehman Brothers bankruptcy in September 2008.

Prices in the usually staid loan market gyrated wildly last month. On March 18, the Index declined by 3.74%, the biggest daily loss on record. In fact, in the history of the Index, there are only four instances of daily losses exceeding 3% — all of them last month. Likewise, there are only nine days on record when loans lost more than 2% per day. Six of these days were last month — the other four were in October and November 2008.

That said, the biggest daily gain for the Index also was last month — 3.33% on March 26, which followed a 2.05% gain on March 25, the third-biggest daily gain on record.

As a result, secondary market volatility — as measured by the standard deviation of daily returns — spiked to all-time highs. The rolling 30-day standard deviation of these returns typically ranges from one to five basis points, with spikes over 20 bps extremely rare. During the global financial crisis, this measure peaked at 86 bps (Nov. 5, 2008), and following the U.S. sovereign debt downgrade in the summer of 2011, it reached 40 basis points. By the end of March 2020, the standard deviation had surged to 165 bps, almost double the prior record high.

The unprecedented losses brought the weighted average bid of the Index down to 76.23, a postcrisis low, and a decline of more than 20 points over a 30-day period. The bid recovered slightly by month-end, closing March at 82.85.

While the current level is still above the all-time lows seen during the global financial crisis — loan prices bottomed out at 60.33 on Dec. 17, 2008 — the speed at which secondary prices declined this time was unmatched. The 10-point drop in the weighted average bid in the seven days to March 20 is the largest on record.

During the 2008–09 global financial crisis, the sharpest weekly drop was during the seven days through Oct. 10, 2008, when the average bid of the Index fell by 672 bps. In 2011, during the U.S. debt ceiling/downgrade crisis, the biggest weekly decline was about 3.5 points, and in December 2014, following a crude oil price plunge, the Index fell 171 basis points in a week.

Looking at the most recent period of extreme volatility prior to this year, in the fourth quarter of 2018, during the global risk-off rout, the biggest seven-day drop in the average bid was 123 bps on Dec 23. In addition, there were only seven days in December 2018 when the average bid of the Index lost more than a point, on a rolling seven-day basis, and only five of those days were consecutive. In contrast, during the current rout, the market has now had 27 consecutive days with the bid losing over a point in the rolling-seven-day period, and on 17 days there were losses of three points or more (again, on a rolling seven-day basis).

In a matter of weeks, sharp declines across the board dramatically reshaped the distribution of prices within the Index. At the beginning of March, 55% of the loan market was priced between 98 and just under par, with approximately 30% between 90 and 98. By the third week of March, 40% of the Index occupied the 80–90 range, with another 42% at 70–80.

Looking at the data another way, virtually none of the Index constituents were priced at 98 or higher at the end of March and about 25% were below 80, a metric frequently used as a measure of distress. The last time the 98-plus share was at zero while the distress ratio was close to current levels was during the 2008–09 financial crisis.

Plunging secondary prices sent the average discounted spread-to-maturity of performing loans to L+1,066 on March 24, the highest level since 2009, more than doubling the L+451 at the end of February and L+417 at the end of January. Spreads then retreated some as prices rebounded in late March, to L+822. The underlying average nominal spread has been unchanged during this time, at around L+350.

Looking at the first quarter overall, U.S. loans declined by 13.05%, the second-worst quarter on record, behind the approximately 23% loss during the final three months of 2008. Needless to say, this puts 2020 behind any first quarter since the inception of the Index. For reference, loans gained 4% in the first quarter of 2019.

Credit quality
Throughout most of March, BB rated and B rated loans declined almost hand-in-hand, although in the final days of the month higher-rated names recovered more ground than their lower-rated counterparts.

As a result, the double-B sub-index lost 9.86% last month, versus a 13.18% loss for the single-B sub-index (based on facility rating). CCC rated loans, however, consistently underperformed, dropping a whopping 22.20% in the month.

Similarly, the size of the loan did not make a difference in performance in the first half of March, with the overall Index and the LL100 moving in sync.

After March 15, however, the largest 100 names in the Index fell more sharply but also regained more ground in the final days of the month. In all, the LL100 lost 8.30% in March, versus 12.37% for the overall Index.

Sector performance
The knockdown effect of the COVID-19 pandemic was so severe that no sector stayed out of the red in March. Taking a closer look at those that fared better or worse than average (reflected by the line in the table below): Underperformance has centered in industries tied to the price of oil, China, and now those particularly affected by social-distancing measures, while defensives sectors have outperformed.

Topping the worst-performers list: Oil & Gas — already reeling from reduced demand from the world's largest industrial producer — lost a staggering 31.95% last month, as the unforeseen oil price war added to recessionary fears. In addition to Oil & Gas, sectors taking a big hit include Retail, Leisure, and Lodging & Casinos. Each of these four sectors accounts for about 4% of the Index, based on par amount outstanding. Other underperforming industries have an even smaller individual footprint in the loan market.

Electronics/Electrical (LCD's proxy for the Tech sector) and Healthcare together command the biggest slice of the loan market, accounting for nearly a quarter of outstanding loans. Both of these sectors outperformed the average, down 10.0% and 11.6%, respectively. Cable TV, Food Products, Drugs, and Telecom were among the "best" performers in March.

Of course, collateralized loan obligation investors are concerned with the growing risk of tripping CCC limits in their portfolios, and this risk varies from sector to sector. For example, as of March 31, Cable TV had the highest share of better-rated issuers, relative to other sectors, with none of the performing loans falling into the B– bucket (based on issuer rating). Meanwhile, the Hotels/Motels/Casinos industry has taken a big hit and, indeed, five Index constituents from this sector were downgraded in March. However, the concentration of loan borrowers in the sector rated B– remained far below average, at 6% versus 21% for the entire Index.

The biggest number of downgrades within the Index came from borrowers in the Leisure sector. That said, its share of B– issuers remained below average at the end of March, at 11%. Conversely, Oil & Gas was the third-biggest sector for Index downgrades (across all rating categories) and has an elevated concentration of lower-rated borrowers, with 27% rated B– (on top of another 22% already in the CCC/CC bucket).

The Tech sector, which accounts for the biggest share of loans in the Index, has a very sizable B– bucket, at 41%, as does Business Equipment and Services, at 43%. However, these sectors remained in the middle of the pack in terms of overall downgrades in March.

Technical talk
Amid the upheaval, supply/demand dynamics resulted in a supply surplus in the leveraged loan market for the first time since November.

Supply is measured as the net change in outstandings, per the S&P/LSTA Index. LCD defines investor demand as CLO issuance combined with retail loan fund flows.

Starting with supply: The par amount outstanding tracked by the Index rose by $11.3 billion in March, the first increase since November. As of March 31, the par amount of the Index outstanding totaled $1.203 trillion, slightly short of the record-high $1.204 trillion in June 2019. However, the current increase is purely due to February business. With an overflow of grim metrics in the secondary loan market, the window for new issues slammed shut in March, which produced no new institutional loan volume, the first time that has happened in a month since December 2008. Moreover, $14.4 billion of loans were pulled or postponed last month. As a result, only three loans allocated in March, all February launches.

At the same time, repayments fell to $11.4 billion in March from $45.5 billion, which was the third-highest monthly total on record. Refinancings accounted for a majority of February’s repayments, including bond-for-loan takeouts. With leveraged loan and high-yield bond markets virtually shut down in March, the source of refinancing-related paydowns dried up.

Turning to demand: Primary CLO markets in the U.S. ground to a halt in mid-March with no new-issue, reset, or refi deals pricing. The first two weeks of the month produced $3.4 billion of vehicles, down from $9.9 billion in February. That is the lowest reading in three years. For the year overall, CLO issuance stands at $17.4 billion, trailing 2019 by 41% and 2018 by 46%.

At the same time, U.S. retail funds investing in leveraged loans saw four consecutive weeks of more than $2 billion in redemptions in March. The $3.5 billion withdrawn in the week through March 18 was the largest outflow since the final week of 2018, according to Lipper weekly reporters.

These outflows came after a steep cut in interest rates from the Federal Reserve, in response to the COVID-19 pandemic. The total for the last four weeks is nearly $10 billion. To put this number in perspective, recall that retail investors withdrew $27.7 billion from the asset class in all of 2019.

More broadly, LCD estimates $14 billion of outflows from retail loan funds in March, a 15-month high, after a $2.5 billion outflow in February. The net effect of this increase in retail loan fund withdrawals, and a decline in CLO issuance (to $3.4 billion), resulted in a decrease in overall investor demand last month, to negative $10.5 billion, from positive $7.4 billion in February. Combining the $11.3 billion increase in outstandings — the proxy for supply — with negative $10.5 billion of measurable demand leaves the market with a $21.8 billion supply surplus, after a $9 billion shortage in February.

Other asset classes
With a 12.37% loss, U.S. loans underperformed all other asset classes LCD tracks for this analysis in March. Leading the pack was 10-year Treasuries, up 4.16% last month, the highest return since August 2019. Bonds and equities were a sea of red, obviously, but a rebound in the final week of March put them ahead of loans.

It is not uncommon for loans to lag behind both high-yield bonds and equities. Looking at monthly returns over the last 10 years, this has happened 49% of the time.

March 2020, however, was unusual in that the three asset classes all fell.

Prior to the COVID-19 related rout, this happened in just 17% of the months over the last 10 years, with the most recent examples in May 2019 and December 2018.

Looking at just these cases of broad sell-offs, March 2020 was the first time since the end of the 2008/2009 crisis that loans underperformed when all three asset classes were in the red. For the year-to-date, loans have outperformed equities and high-yield bonds, which lost 19.60% and 13.12%, respectively, but underperformed all the other asset classes LCD tracks for this analysis.

This analysis was written by Marina Lukatsky, who oversees research for LCD.