CIFC’s Market Summary
- Loans continued to enjoy a grind higher in price during May, outperforming fixed income peers
- These core investment themes remain => Inflation, Interest Rates, Policy and Recovery
- Low quality risk such as CCC, Energy, Metals & Mining and less liquid issues continue to outperform
- The Fed continues to insist that they will hold front end rates steady however, even if loan coupons do not increase, the risk of low rates and higher duration in traditional fixed income asset classes has built to elevated levels. As rates in the belly and long end of the curve climb, many fixed income sub sectors have been impacted.
- See table below for YTD performance of various Barclays Agg sub-sectors:
May kicked off with a stunning miss on the previous month’s employment report which came in at a disappointing 266k and confirmed recent anecdotal evidence from across the economy that if the government incentivizes its labor force to stay home, it will do just that. The weaker than expected data challenged investor views on growth, inflation and monetary policy but also revived the “bad news is good news” dynamic that had ruled market action before the arrival of the pandemic. Investors saw a recovery that was on track but not so strong that the Federal Reserve’s support for the market would require recalibration in the near term. On the other hand, growing wage pressures kept the inflation debate front and center and ultimately drove volatility to spike periodically during the month. This was further punctuated by upside surprises to monthly CPI, PPI and PCE reports. Questions regarding the permanence of inflation proved to be a constraint on the markets in May, with growth assets taking the brunt of the beating. The NASDAQ fell -1.2% while the S&P 500 managed to hold on to a mere 0.7% gain.
On the other hand, credit was once again largely immune from the choppy trading seen across other asset classes in May. U.S. leveraged loans outperformed their fixed income peers and only slightly underperformed the S&P amid the heightened inflation worries, heavy retail inflows and healthy CLO origination. The S&P LSTA Leveraged Loan Index gained another 0.53%, having rallied approximately 22% over the past 14 months with positive returns in every month but March. The strength of the rally has declined recently, however, as we head into the lull of the summer. Lower quality loans continue to outperform better rated loans. Higher rated loans have trailed both the B and CCC sub-index returns in every month since April 2020 as declining yields across the fixed income spectrum have fueled demand for higher-yielding (and higher risk) assets. As a result, the gap between prices of lower-rated and higher-rated names shrank drastically in a relatively short period of time. In fact, there is now just a 31bps gap in the average bid between B-minus rated issuers and B-plus rated issuers. Overall, prices continued to grind higher, closing out the month at $98.09.
Inflation has certainly been a focus for corporate America as well as portfolio investors in recent months, with corporates assessing the impact of input price growth. Our own work with issuers in the loan market suggests that while some sectors are likely to experience notable input price inflation, they do have enough pricing power of their own to neutralize most of the effect on margins, although perhaps with a bit of lag. Sharply growing revenue is currently the dominant variable across nearly all our cyclical issuers. The second most dominant variable is the structural cost cuts made by many as well, which will also serve to cushion the effect of input price inflation. In our portfolios, we continue to favor issues with a sensitivity to the economic cycle and given secondary prices are now above pre-pandemic levels, we are also actively engaging primary markets, which offer more attractive relative value opportunities in many instances.
Having said that, eye-catching economic data throughout the month kept the inflation debate boiling as investors continued to weigh the numerous inflationary signals against dovish reassurances from the Fed. Even the record miss on the April employment report was viewed as inflationary by the market with brewing wage pressures becoming apparent. Nervousness that the central bank will be late in their policy response, not that they will begin early, kept price action across equity and bond markets erratic and volatile. In fact, hints that members of the FOMC are beginning to “think about thinking” of tapering monetary stimulus was surprisingly well received. Nevertheless, loans proved resilient again in the face of these bouts of elevated volatility in many other asset classes. Spreads were impressively invulnerable to the stomach-churning intra-day swings in stocks over the past month, demonstrating once again the now indispensable role of the loan asset class in investor portfolios. The inflation worries that have roiled the markets to date are likely to persist as investors try to gauge whether inflationary pressures are truly transitory, as the Fed believes, or if they will become a more permanent feature of the economic landscape. Taper and rate concerns are also likely to challenge traditional fixed income markets while loans look significantly better set up for this investing backdrop.
The fear is outweighed by the positive prospects. The macro and economic conditions are supportive of credit, which we think provides both excellent excess return potential and diversification benefits for investors today. The credit cycle has been reset, and as fundamentals continue to improve, leverage is declining, and the risks of default and losses are subsiding (reminder: everyone likes to discuss the end of the credit cycle. Rarely do we discuss the beginning of the credit cycle which is where we believe we are today). The pace of loan defaults has fallen sharply since September 2020, as economic backdrop improves. For investors who cannot assume the volatility associated with traditional equity products or the risky duration and low income profile of traditional fixed income assets, this environment favors short duration, income producing, spread products (Loans!).