Insights

SPDR® Blackstone Senior Loan ETF (SRLN) – Q3 2022 Commentary

Loans outperformed high yield bonds in the third quarter of 2022. SRLN returned -0.16% at NAV.



Performance

SRLN underperformed its benchmarks in the third quarter primarily due to credit selection and its overweight exposure to lower-rated positions. SRLN’s allocation to high yield bonds also detracted from performance. SRLN continued to de-risk and diversify the portfolio during the quarter, reducing commodity and lower-rated exposure while rotating into higher-quality credits.

The top contributors to total return in the second quarter were Envision Healthcare, US LBM, and Level 3, while the top detractors were Asurion, Quest Software, and Carestream Health.

Retail demand for loans declined during the quarter, likely due to investor concerns about slowing economic growth. Loan mutual funds and ETFs experienced $15.1 billion in net outflows, with $4.4 billion leaving from ETFs and $10.7 billion leaving mutual funds.1 SRLN recorded $1.5 billion in outflows during the quarter but remains the largest loan ETF.2

For the trailing five years, SRLN has outperformed the Morningstar bank loan mutual fund peer average by 330 bps.3

Standard Performance

SRLN Performance

Quarter in Review

Macro volatility again drove loan market performance over the third quarter as recession fears joined the already lengthy list of headwinds pummeling markets this year. Markets grappled with an increasingly hawkish Federal Reserve (Fed), which rolled out two more 75 basis point rate hikes over the quarter in efforts to dampen stubbornly high inflation.4

Fed chairman Jerome Powell’s determination to crush inflation even if it brings economic pain brought recession risk to the fore, implied by the yield curve inversion and a downtrend in leading economic indicators.5

Markets subsequently turned bullish, betting on a Fed-pivot while a generally better-than-feared second quarter earnings season contributed to the risk-on sentiment. A subsequent mid-summer rally enabled average loan prices to recover losses incurred through June’s selloff. However, macro volatility returned in September, culminating in a severe month-end downdraft following the announcement of the UK’s “mini-budget”, pushing prices back to $91.92, just above June’s annual low.6

The 2.27% loss for September erased all the summer’s gains, leaving year-to-date returns at -3.25% through the end of the third quarter. That said, the asset class continued to materially outperform other markets year-to-date.7

The volatility drove $15.1 billion of outflows from loan retail funds over the third quarter, reversing almost all of the first quarter inflows.8

As before, continued demand from collateralized loan obligation (CLO) buyers partially offset the outflows with US managers pricing $33 billion of new CLO transactions over the quarter.9 Creation slowed versus the second quarter, however, as the July price rally reduced the estimated benefit of managers buying discounted assets for CLO equity investors.

Rising credit risk amid lower growth expectations prompted an up-in-quality bias among investors, especially CLOs, and greater dispersion as credit spreads widened. That left returns for CCC-loans lower, at -10.16% YTD through September 30, compared with -0.90% for BB-loans.10

Primary market activity was another victim of the increasing choppiness as banks and issuers stepped back. The $23 billion in institutional loan issuance for the third quarter lags the previous quarter by 59% and is an 85% decrease from the same period in 2021, a year that set issuance records. Additionally, it is the lowest figure since the fourth quarter of 2009, when the loan market ground to a halt in the aftermath of the Global Financial Crisis.11

YTD Returns of Major US Indices

Portfolio Positioning and Outlook

SRLN’s Historical Ratings Distribution

SRLN Historical Dis

We expect macro volatility to continue to drive credit markets during the final quarter of the year. Rather than dissipating, macroeconomic and geopolitical headwinds instead seem to be gathering, and they are coming from new, unpredictable directions. That leaves open the potential for plenty more ups and downs ahead until inflation is tamed and rate volatility moderates. Ongoing strength in the US labor market means the Fed is likely to keep hiking rates in an attempt to win its battle against inflation over the near term.

As well, tailwinds to growth are fading and we are mindful that recession combined with higher rates could impact borrower performance as earnings contract and interest costs rise. We will continue to evaluate and reposition our loan portfolio in response to the changing macro backdrop. Loan defaults have started to rise (to 1.63% in September) and are forecast to rise to 2.75% in 2023, although this remains inside historical averages.12

As has become our mantra in recent months, these more volatile markets call for a more defensive strategy, with a resolute focus on seniority, borrower scale, margin trends and sector selection. But for long-term investors, we also believe that market dislocations bring with them opportunities to put money to work given our belief in the fundamental value of liquid loans. In our view, the renewed September selloff left average prices and spreads at levels that more than fairly compensated investors for the credit risk plus a risk premium, offering another opportunity to add credit exposure at attractive levels and generate outsized returns.13

Floating-rate, senior-secured loans continue to benefit from higher base rates, and we note that loans, together with high yield, have outperformed other traditional fixed income during Fed hiking cycles.

There are many other positives to highlight, not least that recovery rates remain high, the near-term maturity wall is manageable, and high interest coverage ratios provides a good cushion against higher base rates.14 The technical backdrop is also supportive, and we believe that limited primary issuance and ongoing CLO demand may underpin secondary market prices. Finally, looking further afield, the US leveraged market is largely domestic, insulating US-centric business from the slowdown in Europe and Asia (China) and the strong dollar.


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