Leveraged loans had a tough third quarter, which saw the asset class head into negative territory for the year, but its relatively low exposure to the commodity sector has enabled it to outperform high yield bonds.

• Returns for the Markit iBoxx USD Liquid Leveraged Loan index are now negative for 2015
• Loans continue to outperform HY bonds, with liquid indices outperforming by 2.96% in Q3
• ETFs tracking leveraged loans saw $464m of outflows in Q3 as investors fled risk

View the full quarterly loans market report.

The third quarter has proved challenging for risky assets, and leveraged loans have not been spared. The positive returns delivered by the asset class in the first half year have all been wiped out as fears of a global slowdown have forced investors to de-risk and move into safer assets.

The Markit iBoxx USD Liquid Leveraged Loan index, a barometer for the performance of the 100 most liquid loans, is now negative for 2015 on a total return basis. The index ended Q2 up just over 1.8% for the year, stressing the sharp turn in fortunes over the quarter just passed. The broader Markit iBoxx USD Leveraged Loan index is, however, still positive for 2015, having returned 1.21% so far this way.

Exposure to the commodities sector has been particular denting to leveraged loans returns. Unlike its high yield (HY) bond adversary, leveraged loan returns were relatively sheltered during a period of declining oil prices earlier this year. Loan index returns have finally been dragged down by the recent weakening in commodity prices, but have still managed to outperform HY bonds. Over the last quarter, the Markit iBoxx $ Liquid High Yield index lost 5.41%, in comparison to the Markit iBoxx USD Liquid Leveraged Loan index, which saw returns shaved by 2.45% over Q3.

The outperformance has very much to do with exposure to corporations in the energy/commodities sector. HY bonds have a much higher exposure, around 16%, compared to around 8% for leveraged loans. With commodity prices set to remain low due to weak global fundamentals and lingering concerns over further downside risk, leveraged loans look much better positioned than HY bonds going forward.

Breaking down leveraged loans, longer maturity tenors saw the biggest spread widening over the past quarter. BB and B rated loans saw spreads widen 10% in the 5-yr and 7-yr tenor. In fact, the only cohort which saw any sort of tightening over the past quarter was CCC rated 5-yr leveraged loans. Among sectors, 5-yr energy BB loan spreads (DM) held up much better this quarter in comparison to Q1 2015, even as the price of oil hit new lows. This demonstrated the sector's (especially shale credits) surprising resilience and flexibility in resisting further oil price pressures.

Unsurprisingly, widening spreads and diminishing returns have led investors to flee leveraged loans over the past quarter. ETFs tracking leveraged loan indices saw $464m of outflows in Q3, even after seeing a near $100m inflow in July. Outflows in August alone represented 6.7% of all AUM, with investors ditching risky assets as volatility gripped global markets, culminating in "Black Monday" in late August. ETFs tracking HY bonds saw a similar trend, although June represented the worst outflows as a % of AUM this year for them.

AAA resilient

In the CLO market, primary issuance remains low for the third consecutive month amid heightened market volatility. Leveraged loan issuance is 29% lower than this time last year, increasing demand in the secondary market.

Flight to quality has seen AAA rated securities continue to trade tighter than weaker ratings, being less exposed to weak commodity prices while also benefiting from the slow primary market.

Settlements

Trade settlement times have also held up well over the quarter. Average settlement times for loans settled in the third quarter were more than a day off the average registered in the same period a year ago. The average settlement time for the $148bn in LSTA loans was 20.2 days over the last three months, the lowest such average over the third quarter since 2011. Year to date, average trade settlement time stands at 19.7 days.

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Neil Mehta | Analyst, Fixed Income, Markit
Tel: +44 207 260 2298
Neil.Mehta@markit.com

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This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.