Actively managed, ultra-short duration floating-rate income strategy that invests primarily in privately syndicated, below investment grade senior secured corporate loans.
- The Morningstar® LSTA ® US Leveraged Loan Index (the Index) returned 3.46% during the quarter.
- On a net asset value (NAV) basis, Class I shares of the Fund underperformed the Index.
- Looking ahead, we expect technical factors to remain supportive in the near term due to persistent collateralized loan obligations creation, a positive reversal in retail fund flows, and still light (albeit increasing) new-issue supply volume.
The third quarter of 2023 contained an abundance of strong data, as the prospect of a soft landing gained credibility. Inflation continued to trend in the right direction, as Core Personal Consumption Expenditures Price Index , which at its peak was running at a year over year rate of 5.6%, fell to 3.8% by the end of August. Meanwhile, the economy continued to add jobs at a fast pace. The combination of falling inflation and a strong labor market allowed consumers to continue spending, creating a tailwind for gross domestic product growth. Maintaining a data dependent stance, the U.S. Federal Reserve responded to this better-than-expected data by hiking rates at their July meeting. In September, the Fed kept rates unchanged, however their updated dot plot projection reinforced a “higher for longer” message. This led to a broad sell-off across rates, leading to disappointing returns across both fixed income and equities. Despite the weaker tone in risk assets, senior loans remained resilient.
The Index returned 3.46% during the quarter (the highest quarterly return since 4Q20). Rising coupons, driven by an increase in base rates and stable nominal spreads, continue to be a large contributor to positive returns alongside a slow uptick in price appreciation. The average Index bid price moved higher by 132 basis points (bp), closing out September at 95.56. On a year-to-date basis, the Index has now returned 10.16% (the strongest return since Global Financial Crisis). Lower-rated names continued to outperform their higher quality counterparts. For context, CCC, B and BB rated loans posted gains of 6.05%, 3.85%, and 2.21% respectively.
Unlike 2Q23, issuance in the primary market picked up this quarter. Total supply for the quarter was $76.3 billion, marking the highest quarterly issuance since early 2022, which was the start of the Fed’s aggressive rate hike campaign. The size of the loan market, as represented by total Index outstandings, grew by $14.1 billion in 3Q23 to $1.41 trillion. On the demand front, investors had a strong appetite for the asset class. CLO issuance increased in 3Q23, as liability spreads tightened throughout the debt stack, creating opportunities for issuance. The total volume grew to $28 billion from $22.4 billion last quarter but down 15.7% from last year’s level of $33.2 billion. Meanwhile, retail loan funds reported the first positive quarter since 1Q22 with an inflow of $1.04 billion.
On a NAV basis, Class I shares of the Fund underperformed the Index. By ratings, the Fund was negatively impacted by selection in CCC rated loans, followed by selection in BB rated loans. From an industry perspective, the main challenges were selection in consumer staples distribution and retail, as well as specialty retail. The former was entirely driven by an overweight allocation to Save-A-Lot (posted weak quarterly earnings), while the latter largely resulted from an overweight allocation to Jo-Ann Stores, Inc., which experienced macro-related challenges and softer demand for its products. On the other hand, the Fund benefited from its small exposure to the defaulted and non-rated loan categories. This was primarily driven by an overweight allocation to a few distressed names that disproportionately benefited from the firmer market backdrop, including the likes of Diamond Sports Group, LLC, Riverbed Technology, Inc. and Yak Mat. Away from loan-level performance, the Fund’s modest exposure to high yield (HY) bonds resulted in a drag, as the HY bond market notably underperformed in 3Q23 relative to loans (0.46% return for the Bloomberg U.S. Corporate High Yield Index).
Portfolio and positioning changes were both mostly minimal during the period. The number of individual names in the portfolio increased from 375 to 400 as the portfolio added positions in both the primary and secondary markets on a selective basis, while the average spread level of the Fund increased slightly to 362 bp (versus 361 bp in the prior quarter).
Current strategy and outlook
We expect macro-related volatility to remain a prominent theme in the near term, as the “higher-for-longer” rates backdrop and uncertain path to lower inflation will continue to influence market sentiment. While the U.S. economic outlook has been favorable and appears to have de coupled from the rest of the world, policy rates remain highly restrictive in the medium term and there are risks that consumer spending eventually weakens as the builtup excess savings from the pandemic diminish, credit conditions tighten further, and student loan repayments resume. The Fed is expected to remain firmly data-dependent and hold a hawkish bias until there is high conviction that inflation is firmly under control.
Supported by healthy technical factors and a historically high level of interest carry, performance in the loan market has been resilient despite some increased volatility in other asset classes. Looking ahead, we expect technical factors to remain supportive in the near term due to persistent CLO creation, a positive reversal in retail fund flows, and still light (albeit increasing) new-issue supply volume. Key concerns are centered around the impact on cash flows and coverage ratios for weaker and lower-rated credit profiles in a “higher for longer” interest rate environment, as we have seen a notable pick up in borrowing costs on a sequential and last 12 months basis. In addition, we expect dispersion in performance among borrowers to remain a theme and pockets of stress to emerge as the cycle matures. As such, our focus will be on security selection and finding pockets of value in a continuously dispersed market.
Companies mentioned in this report – percentage of Fund investments, as of 9/30/23: Save-A-Lot 0.87%, Jo-Ann Stores, Inc. 0.07%, Diamond Sports Group, LLC 0.05%, Riverbed Technology, Inc. 0.16% and Yak Mat 0.52%; 0% indicates that the security is no longer in the portfolio. Portfolio holdings are subject to change on a daily basis.