Insights

SPDR® Blackstone Senior Loan ETF (SRLN) – Q2 2022 Commentary

Loans outperformed high yield bonds in the second quarter of 2022. SRLN returned -5.79%, underperforming the Markit iBoxx USD Liquid Leveraged Loan Index by 32bp and the S&P/LSTA U.S. Leveraged Loan 100 Index by 49bp.1



Performance

SRLN underperformed its benchmarks in the second quarter primarily due to its overweight exposure to lower-rated positions. SRLN’s allocation to high yield bonds, which averaged 4.5% of the fund during the quarter, also detracted from performance.2 We continued to de-risk and diversify SRLN during the quarter, reducing commodity and lower-rated exposures while rotating into higher-quality credits.
The top contributors to total return in the second quarter were BCP Raptor, UWH PLLC, and Project Leopard Holdings Inc. The top detractors were Envision Healthcare, Asurion LLC, and LBM Acquisition LLC.

Retail demand for loans declined during the quarter, likely due to investor concerns about slowing economic growth. Loan mutual funds and ETFs experienced $3.1 billion in net outflows, with $2.3 billion coming out of ETFs and $0.8 billion leaving mutual funds.3 SRLN recorded $1.2 billion in outflows during the quarter but remains the largest loan ETF.4

For the trailing five years, SRLN has outperformed its Morningstar loan mutual fund peer’s average by 381 bps and the Invesco Senior Loan ETF (BKLN).5

Standard Performance

Quarter in Review

Macro headwinds mounted over the second quarter as lower growth and recession joined inflation, rising rates, supply chain issues, lockdowns in China, the ongoing war in Ukraine, and the escalating energy crisis in Europe on the list of concerns roiling markets.

Markets also fretted over the increasingly hawkish US Federal Reserve (Fed), which hiked rates twice over the second quarter in an attempt to subdue record-high and persistent inflation. Interest-rate risk morphed into credit risk as investors worried about a policy misstep that might push the economy into recession as economic growth slows.

While loans succumbed to broader market volatility pushing returns into negative territory, the asset class continued to materially outperform other credit markets.

Loan prices fell significantly over the quarter, driven by technical and fundamental factors and dropped below $93 on average for the first time since August 2020.6 Several sharp price drops left average prices at $92.2 through June 30, down from $97.6 at the end of March.7

Flows to loan retail funds turned negative over the second quarter, with $3.1 billion withdrawn from loan funds compared to $18.7 billion in net inflows in the first quarter.8

Retail outflows were partially offset by the ongoing creation of Collateralized Loan Obligations (CLOs), although widening liability spreads and a lack of primary loans pushed managers to focus on “print and sprint,” short-dated and static transactions to take advantage of loans with lower interest rates. At $40.2 billion, CLO origination lagged the 2Q21 amount by 7%, but it improved upon the first quarter’s $30.7 billion.9 Research analysts have, however, begun to pare down full-year issuance estimates, across loans and CLOs.

The price drop contributed to primary market dysfunction which forced arrangers to put syndications on hold and/or offer heavy discounts to sell paper. At $56 billion, institutional loan volume over the second quarter lagged the first quarter by 50%. It was the lowest output since 2Q20, when the market was overcome by the onset of COVID-19.10

Recession concerns increased as the quarter progressed, bringing credit performance into focus. While credit fundamentals for leveraged loan companies continued to exhibit improvement in 1Q22, the pace moderated, and loan downgrades outpaced upgrades in May.11

Increased risk aversion gave rise to a broad-based rotation into higher-rated loans and out of lower-rated loans over the period. That left returns for CCC loans lower at -8.58% YTD through June 30, compared with -3.27% for BB loans. And spreads widened more across lower-rated loans.12

Annual Relative Value in a Rising Rate Environment

Portfolio Positioning and Outlook

Annual Return

The volatility and risk profile of the indices presented is likely to be materially different from that of a Fund. In addition, the indices employ different investment guidelines and criteria than a Fund and do not employ leverage; as a result, the holdings in a Fund and the liquidity of such holdings may differ significantly from the securities that comprise the indices. Past performance is not a reliable indicator of future performance.

The same macro headwinds upsetting markets during the first half of the year are expected to contribute to ongoing volatility over the second half. Monetary policy will also direct markets, given expectations for the Fed to front-load its hiking cycle, with another 50-75 basis point hike anticipated in July.

Floating-rate assets have already started to feel the benefit of higher rates, and further rate increases should underpin demand for loans, pending greater market stability. Banks are also hoping for an improvement in conditions to help unclog the primary markets from the backlog of roughly $40 billion of underwritten loans. Refinancing risk is negligible over the near term, with just $331 billion of loans and bonds set to mature in 2023/2024, but we are mindful that this rises sharply to roughly $1 trillion in 2025/2026.13

Rising rates will, however, also increase the interest burden on leveraged borrowers, which in turn will increase the pressure on interest coverage ratios. We expect this to impact borrowers unevenly; companies with increased earnings power should be able to offset the increased cost of capital, while for others, shrinking EBITDA will amplify the increased costs.

We also expect heavy scrutiny of second-quarter earnings for signs of any further impact of rising input costs on profit margins, given the focus on rising credit risk amid slower economic growth, more restrictive financing rates, and higher interest rates. Default rates have started to increase, moving up to 1.14% by the end of June, leading a number of bank research teams to increase their default forecasts in 2023 and 2024.14 However, we believe the depth of the current selloff is overdone relative to fundamentals.

For these reasons and others, we enter the second half of the year in more cautious mindset. We will rely on active management to navigate through the choppier markets, while taking advantage of opportunities as they arise. We believe that staying up in the capital structure in senior secured loans may provide protection against rising stress, while higher recovery rates, currently at an average of 67%, offer comfort against rising defaults.15

We will continue to evaluate and reposition our loan portfolio in response to the changing macro backdrop. That means focusing on sectors with secular growth tailwinds and companies with free cash flow generation, given our expectations for inflation to remain a concern for longer and in the event that an economic recession materializes.

For now, we believe that loans remain highly attractive at current levels, on a risk-adjusted basis. Although the macro dynamics vary, history suggests that buying loans at these levels should produce compelling returns over the next 12 months, when including the forward curve.16 In addition, we expect loans to benefit further as loan coupons reset and additional rate hikes flow through in the months ahead.

We have already moved in to buy discounted loans and will take advantage of further selloffs to generate additional alpha for the portfolio.


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