SPDR® Blackstone Senior Loan ETF (SRLN) – Q1 2023 Commentary

Performance

Despite a positive first quarter return, SRLN underperformed its benchmarks primarily due to credit selection within loans. The fund’s strategic allocation to high yield bonds was also a slight detractor. SRLN modestly added back to risk assets in the first quarter. The fund continues to maintain an overweight to higher-quality credits while maintaining a yield similar to the benchmark.

The top contributors to total return in the first quarter were Asurion LLC, LBM Acquisition LLC, and HUB International Ltd. The top detractors were Lumen Technologies Inc, Carestream Health Holdings Inc, and Triton Water Holdings Inc.

Retail demand for loans remained soft during the quarter likely due to investor concerns about slowing economic growth. Loan mutual funds and ETFs experienced $10.9 billion in net outflows with $1.0 billion leaving ETFs and $10.0 billion leaving mutual funds. SRLN recorded $833 million in outflows during the quarter but remains the largest loan ETF.²

As of March 31, 2023, the top ten holdings accounted for 16.33% of the fund’s investments. The Fund Top Holdings are as of the date indicated, are subject to change, and should not be relied upon as current thereafter.

Fund Performance

Source: State Street Global Advisors and Invesco Senior Loan ETF Factsheet, as of March 31, 2023. Past performance is not a reliable indicator of future performance. Investment return and principal value will fluctuate, so you may have a gain or loss when shares are sold. Current performance maybe higher or lower than that quoted. All results are historical and assume the reinvestment of dividends and capital gains. Visit ssga.com for most recent month-end performance. The gross expense ratio is the fund’s total annual operating expense ratio. It is gross of any fee waivers or expense reimbursements. Performance returns for periods of less than one year are not annualized. The market price used to calculate the Market Value return is the midpoint between the highest bid and the lowest offer on the exchange on which the shares of the fund are listed for trading, as of the time that the fund’s NAV is calculated. If you trade your shares at another time, you returns may differ.

The gross expense ratio is the fund’s total annual operating expenses ratio. It is gross of any fee waivers or expense reimbursements. It can be found in the fund’s most recent prospectus.

Quarter in Review

A risk-on rally ensured a strong start for the loan market in 2023, only to be stymied by the March banking sector stress. Loans performed in line with other key fixed income asset classes with a 3.2% return for the quarter.³

Performance came against a backdrop of ongoing interest rate volatility as the Federal Reserve (Fed) continued to take base rates higher to tamp down persistent inflation. The Fed is expected to ease the pace of hikes in the face of financial sector stress, and followed December’s 50 bps hike with two smaller 25 bps hikes in the first quarter. The market is now pricing in a terminal rate under 5% and rate cuts before the end of the year, although we remain of the view that rates will need to stay at higher levels for longer.⁴

Loan market issuance improved at the start of the quarter, pushing supply to $49.5 billion versus $35.7 billion in the fourth quarter and $21.1 billion in the third quarter.⁵ Despite this uptick, this was still the lightest first quarter issuance since 2016.⁶ Issuers used amend-to-extend transactions to address near-term maturities and reduce the elevated amount of institutional loans due to mature in the next two to three years.⁷

In terms of demand, collateralized loan obligation (CLO) supply started strongly in 2023 with issuers pricing $33.6 billion across 77 deals, ahead of last year’s pace.⁸ Demand for CLO AAAs from major Japanese investors has not yet returned, but other buyers have picked up the slack with many of the AAA tranches being syndicated across multiple accounts.⁹ However, the demand technical wasn’t all constructive given $10.9 billion leaving loan funds throughout the first quarter, on top of the $12.7 billion in the prior quarter.¹⁰

The March weakness tested the resolve of the loan market as average loan prices fell by 2 points to their lowest level since 2022 but were able to retrace a point in the final week to close at $93.40.¹¹

Additionally, the dispersion theme experienced in 2022 reemerged as risk-off sentiment returned with the banking sector fallout. Buyers returned as contagion concerns subsided towards the end of the month, although we remain vigilant for additional volatility.

Portfolio Positioning and Outlook

To put the first quarter of 2023 in context, we’re reminded of the quote “if there’s one thing that is certain, it is uncertainty.” A quarter that was defined by regional bank failures, including Silicon Valley Bank (SVB) and Signature Bank, and a merger of duress between Credit Suisse and UBS, was also marked by stubbornly high core inflation. Prior to those events however, the risk rally was on, with CCC assets flipping the narrative from 2022, outperforming higher-rated credits.¹² While this is still the case at the end of the quarter, the returns have taken a sharp turn back.

Yet, it is during these periods of uncertainty where the right strategy may drive consistent and attractive returns. We note that based on historical precedent, floating rate loans tend to outperform both fixed rate and equities during Fed hiking periods.¹³

We believe the Fed and European Central Bank (ECB) have further to go to combat inflation, supported by observations from across our investment portfolio. Blackstone regularly surveys the CEOs of our portfolio companies to get an aggregate view of current market conditions. Notably, we continue to see wage inflation, which, while down from last year, remains higher than pre-COVID averages. Also, in certain circumstances we are beginning to see sellers accept lower prices in exchange for certainty of orders—which is a turn from a year ago. In looking through to our ports and warehouses, we observe ongoing and exceptionally strong warehouse performance, while the flow of goods continues to build, adding to the potential for excess inventory, which is also deflationary. Suffice to say, we don’t believe a Fed cut is necessarily imminent and continue to focus on investing in the highest quality businesses.

That said, the contraction in credit conditions due to the banking stress could, in our view, bring forward the point of peak interest rates, while also accelerating a potential recession in the US and Europe.

As downgrades continue to outpace upgrades, it is the exposure to CCCs that could become an issue for loan portfolios. That is why our exposure to lower-rated credits priced less than $80 is less than that of the loan index.¹⁴

Technicals will remain a key driver of performance in our view, although the picture here remains unclear. Primary loan and high yield supply is expected to remain subdued over the near term, with the focus on amend-to-extends.¹⁵

In our view senior secured loans, which are first in line for repayment, remain both defensive and attractive; yields are compelling.¹⁶

We continue to believe robust credit selection underpinned by our fundamental bottom-up approach to investing will help us preserve capital as we reposition portfolios, rotate into higher quality issuers and prune risk. Importantly, we believe these challenges and market dispersion will bring new opportunities to deploy capital and drive performance.