Credit Market Update and Outlook: Credit Selection and Quality in Focus

By November 8, 2019May 4th, 2020Market Commentary

Loan and High Yield Market Review and Outlook

In October, the loan index1 was down (0.5%), bringing year-to-date performance to 6.3%. High yield bonds2 were up 0.3%, bringing year-to-date performance to 11.7%. Investment grade bonds3 were up 0.1%, bringing year-to-date performance to 13.9%.

Leveraged loan issuance posted a 12-month high, with $47 billion of gross volume issued in October. Year-to-date gross loan issuance was $297 billion at the end of the month; 55% lighter than the same period last year. High yield bond activity dropped since September, with $22 billion of gross issuance in October, bringing year-to-date issuance to $230 billion; an increase of 27% compared to the same period last year. Net CLO issuance was slightly lighter than the previous month, with $10 billion in CLOs issued in October, bringing year-to-date net US CLO issuance to $101 billion.

Default activity increased in October, with five defaults totaling $2 billion in bonds and $5.6 billion in loans. The largest default was Acosta at $3 billion. Murray Energy, a coal distributor, had the second largest default at $2.5 billion. These two defaults ranked fifth and sixth largest year-to-date. The Energy sector continues to lead the market in defaults, comprising 41% of defaults year-to-date.

In October, the par-weighted default rates for loans remained below 2.0%, ending the month at 1.7%. The par-weighted default rate for high yield bonds remained below the long-term average of 3.5%, remained at 2.5%, unchanged from September.

Risk Assessment

Valuation

Although broader equity markets strengthened in October as investors became more confident in a positive outcome of the U.S.-China trade negotiations, loan markets were softer. Average loan prices were down about 90 bps month-over-month, ending October near 95.4, a level not experienced since the beginning of the relief rally in early January. As a result, leveraged loans underperformed high yield by a relatively wide margin during the month (-0.38% versus +0.19%, respectively). Weaker technicals were partially a factor as well as higher return dispersion amongst individual issuers. The higher quality outperformance theme continued for both loans and high yield. This was especially true for loans, which saw BB-rated issuances provide a +0.20% return against single-B and split/CCC at -0.70% and -2.49%, respectively. The yield to 3-year takeout for loans is now higher than the YTW for bonds by about 30 bps. The market has progressed into a phase where credit selection is becoming increasingly important.

Technicals

Loan technicals deteriorated somewhat during October. Although loan net issuance is still down over 30% and net CLO creation remains only about 10% lower year-over-year, the slight reacceleration of retail outflows helped contribute to the decline in average loan prices. Following an improvement in September, loan funds reported $2.8 billion of redemptions during October. Although we don’t foresee a return to the outflow numbers experienced at the end of 2018, a reversal of these recent trends is unlikely unless the interest rate environment becomes more conducive. The quality performance disparity was also evident in the new issue market, as higher rated issuances cleared the market relatively easily versus their lower rated peers. In addition, we witnessed a resurgence in repricing activity for higher rated issuers, something that had been dormant for most of this year.

Fundamentals

We are currently in the midst of receiving 3Q results for many of our private issuers, and the trends are generally stable to positive. There have been some instances of management missteps or decelerating performance as companies reinvest/transition certain segments of their businesses, but this is not atypical regardless of the state of the economy. However, what is different now is the loan market’s patience for these situations. As we wrote about last month, investors appear not to be as willing to allow management teams with the necessary time to navigate the issues they might be facing. It’s a shoot first, ask questions later environment, and this is to be expected later cycle and when the technical backdrop is not as strong. Nonetheless, we do not see indications of a substantial slowing in economic activity when viewing the financial performance of issuers. There was an uptick in loan default activity during October, but those were primarily related to issuers with secular end market challenges (Acosta and Deluxe Entertainment) or those with energy exposure (Murray Energy, Foresight Energy, and Sheridan Production Partners). Fundamentals of CLO collateral were down month over month with an increase in percentage of loans trading below 80, as well as an approximately 8-point decrease in CLO equity NAVs, mainly driven by the decrease in loan prices MoM.

CLO Market Outlook

CLO tranche performance varied in October, with returns between 0.1% and (11.1%). The post-crisis B tranche lagged, down (11.1%), while AAA CLOs were up 0.1% per the J.P. Morgan CLOIE Index.

In October, the primary market was up MoM with $10.4bn in US and €4.0bn in Euro deals pricing in the market. AAA’s for these new issue deals remained in the 130-140 range with the tightest print coming in at L+130. In the secondary, spreads widened MoM meaningfully, especially lower in the capital stack and deals with lower MVOCs. The S&P Leveraged Loan Price Index was down from 96.34 to 95.42 during the month, which decreased the coverage of most bonds in the market. BB rated bonds with higher coverage, ~105, were able to outperform, but there was limited supply of these bonds. Similar to previous months, lower covered bonds traded anywhere from 800-1000 dm, depending on the manager and the specific coverage of the bond. We believe this dramatic widening of spreads is overdone and believe things will firm up over the next few months.

Looking Ahead

The market has certainly become more optimistic about a positive outcome on the trade negotiation front, but we think there is still a decent probability that resolution doesn’t proceed as smoothly as many believe. This would of course have the potential of impacting risk assets on a broader scale, including loans and credit overall. We do not believe that current economic conditions are foretelling an enhanced risk of a near-term recession. However, these situations can build on themselves (uncertainty breeding more uncertainty) if not resolved in a timely manner.

We are also becoming concerned about the widening in CCC-rated spreads in the HY market. Is this a harbinger of a deteriorating economic environment or something that is being driven primarily by issues in the energy market and can be contained therein? It’s too early to determine, but it certainly warrants a level of cautiousness in the management of portfolios.

Data as of 9/30/2019. 1. S&P/LSTA Leveraged Loan Index. 2.Bloomberg Barclays U.S. Corporate High Yield Index. 3. Barclays U.S. Corporate Investment Grade Index. Sources: JP Morgan Default Monitor and JP Morgan Credit Strategy Weekly Update.