Credit Market Update and Outlook: Credit Selection Remains Important

By December 6, 2019May 4th, 2020Market Commentary

Loan and High Yield Market Review and Outlook

In November, the loan index1 was up 0.6%, bringing year-to-date performance to 6.9%. High yield bonds2 were up 0.3%, bringing year-to-date performance to 12.1%.  Investment grade bonds3 were up 0.3%, bringing year-to-date performance to 14.2%.

Leveraged loan issuance surpassed October’s 12-month high, with $56 billion of gross volume issued. Year-to-date gross loan issuance was $357 billion at the end of the month; 49% lighter than the same period last year.  High yield bond activity reached an all-time high since September 2017, with $37 billion of gross issuance in November, bringing year-to-date issuance to $271 billion; an increase of 45% compared to the same period last year.  Net CLO issuance was remained steady compared to the previous month, with $10 billion in CLOs issued in November, bringing year-to-date net US CLO issuance to $110 billion.

Default activity decreased in November, with four defaults totaling $2 billion in bonds and $2.5 billion in loans. The largest default was energy service company McDermott International at $3.5 billion. McDermott International’s default is the fourth largest this year. Dean Foods, the largest milk company, had the second largest default of the month, at $700 million. The Energy sector continues to lead the market in defaults, comprising 44% of defaults year-to-date.

In November, the par-weighted default rates for loans ended the month at 2.2%.  The par-weighted default rate for high yield bonds remained below the long-term average of 3.5%, at 2.6%, a small increase since October.

Risk Assessment

Valuation

Following a difficult October, the loan market stabilized and improved somewhat during the month in concert with the broader equity markets.  Average loan prices increased by 16 bps month-over-month, ending November at 95.58.  This level is still lower compared to much of this year, but the tone of the market was certainly improved.  Loans outperformed high yield by 0.18%, a slight reversal from the 0.57% underperformance in October.  The theme of higher quality outperformance persisted for both loans and high yield during the month.  The YTM/YTW for loans and high yield are now at the same level (6.35%).

Technicals

Loan technicals improved during November.  Net loan issuance remains down over 30% year-to-date and was down slightly month-over-month.  However, gross issuance was the highest of the year, which is reflective of the continued repricing activity during November for higher rated issuers.  Perhaps more importantly, retail outflows moderated to $1.3 billion, which was the lowest monthly level of the year.  Net CLO issuance was down a bit during the month, but the other aforementioned positive factors provided support for the overall market, a stark reversal from November of last year.  For the past couple of months, we seemed to experience some forced selling in the market as other funds were exiting stressed/distressed positions, but that pressure abated as we moved through November.

Fundamentals

We are currently in the midst of receiving 3Q results for many of our private issuers. Following the completion of the 3Q period, we now find ourselves in the financial reporting lull until early next year.  Asset underperformance continues to be largely driven by idiosyncratic factors and not indicative of a broad softening in economic activity.  There were four defaults during November, but the dollar volume was lower than the elevated levels experienced in October.  Energy continues to lead the way in terms of number of defaults – half of the figure in November and 40% of the total year-to-date.  Fundamentals of CLO collateral were mixed month over month with an improvement in equity NAVs and a decrease in WARF, while we saw an increase in percent of loans trading below 80.

CLO Market Outlook

CLO tranche performance was positive in November, with returns between 0.3% and 2.0%. The post-crisis AAA tranche lagged, up 0.3% compared to the BB and B CLO tranches, which were both up 2.0% per the J.P. Morgan CLOIE Index.

In November, the primary market was slightly lower MoM with $9.7bn in US and €2.8bn in Euro deals pricing in the market. Similar to previous months, AAA’s for better managers that issue deals remained in the 130-140 range. In the secondary, we saw spreads tighten from the recent wides that occurred in October. We believe this was driven by investors deciding the massive widening was overdone and created a buying opportunity. In addition to new buyers coming in the market, loans saw rebound in price as the S&P Leveraged Loan Price Index increased from 95.42 to 95.58. On-the-run BBs tightened as much as 100 basis points to the m700s. We believe this momentum will continue into December, and believe there will be a continuation of the rally in CLO spreads into the end of the year.

Looking Ahead

The trade discussions certainly became more constructive during November, which contributed to the gains that we experienced in the broader risk markets.  Although a “grand deal” remains elusive at this point, the market has rightfully found comfort in a potential phase 1 deal and the cessation of tariff escalations.  The elimination of some of this uncertainty should boost investor and business confidence, reducing the likelihood of a prolonged stand-off that leads to even slower (or potentially negative) economic growth.  High yield spreads remain low, but CCC-rated spreads are still elevated.  This is an important metric to continue monitoring, but we currently do not believe it is a harbinger of imminent economic softness ahead.  Rather, we think that it is indicative of the current dynamics in the credit markets, where credit selection remains increasingly important.

Data as of 11/30/2019. 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.