Credit Market Update and Outlook: Default Activity Increases, Uncertainty Remains

By March 9, 2020May 4th, 2020Market Commentary

Loan and High Yield Market Review and Outlook

In February, the loan index1 was down -1.32%, bringing year-to-date performance to -0.77%.  High yield bonds2 were also down in the month of February at -1.41%, bringing the year-to-date performance to -1.38%. Investment grade bonds3 decreased slightly to 1.34% at the end of February, bringing the year-to-date performance to 3.71%.

Leveraged loan issuance decreased to $72 billion in activity, but is still the second highest monthly volume since June 2018. Year-to-date gross loan issuance was $195 billion at the end of the month. High yield bond activity decreased to $30 billion at the end of February, bringing the year-to-date issuance to approximately $69 billion. Net CLO issuance was strong in February, ending the month at $31 billion, bringing the year-to-date issuance to $41 billion compared to $25 the same time last year.

Default activity increased in the month of February, with four defaults totaling $2 billion. The same period last year saw three defaults totaling $6.5 billion. February’s defaults include, American Commercial Lines, RentPath, Pier 1 Imports and VIP Cinema Holdings.

In February, the par-weighted default rates for loans remained the same as January at 1.7%. The par-weighted default rate for high yield bonds remained below the long-term average of 3.4%, at 2.3%, a seven-month-low.

Risk Assessment

Valuation

Much like the broader equity markets, the loan market was performing well until the last week of February when spreading COVID-19 fears began to drastically alter market sentiment.  Average loan prices ended the month down 1.79 points, with most, if not all, of that decline occurring during that last week.  Loans outperformed high yield again in February, but that is much less meaningful due to the market backdrop.  Across rating categories, double-Bs were down just as much as single-Bs, as investors began to reduce risk exposure and to seek liquidity regardless of quality.  Split-B/CCCs actually held in a bit better on a relative basis, which is likely indicative of the type of investors focused on this portion of the market (i.e., more opportunistic credit-like funds).  We believe that the attractiveness of loans has continued to increase over the past few weeks, but there are obviously macro factors that need to be resolved for loans (or any risk asset for that matter) to experience sustained price improvement.

Technicals

Not surprisingly, loan technicals deteriorated during the month, and most of that occurred during the last week.  Following one of the lightest retail outflows in 17 months during January, February experienced $1.6 billion in outflows.  This was compounded by CLO volumes that were more muted than normal and potentially indicative of investors’ growing fears about the pandemic.  During the first three weeks, new loan issuance volume remained relatively robust, but it was not sufficient to mitigate the aforementioned factors.

Fundamentals

Although we are still awaiting results from many private issuers (due to longer reporting time requirements as they complete their annual audit processes), fourth quarter results have been relatively consistent with expectations.  Even before the virus outbreak, many investors were looking past these results due to potential trade-induced weakness.  Now, all focus has shifted to the duration of this episode of severe economic weakness and each company’s ability to navigate the current environment with available liquidity.  There were four defaults during the month (American Commercial Lines, RentPath, Pier 1 Imports, and VIP Cinema), but all of these issuers were obviously encountering unique difficulties prior to the outbreak of COVID-19.  Fundamentals of CLO collateral were mixed month over month with an improvement in the WARF, while we saw a deterioration in Market Value Coverage.

CLO Market Outlook

CLO tranche performance varied in February, with returns between -3.95% and 0.15%. The post-crisis B tranche lagged, at -3.95% compared to AAA tranche, which ended at 0.15% at the end of February, per the J.P. Morgan CLOIE Index.

In February, the primary market was higher MoM with $9.4bn in US and €4.6bn in Euro deals pricing in the market. Mangers in the US market continued to take advantage of the tighter debt markets as they refinanced $11.8bn and reset $8.2bn deals during the month. This month was very much bifurcated to before COVID-19 fears set in and after they set in. During the beginning of the month, secondary spreads continued to rally from their January levels, but as the global markets began to waver, the CLO market followed suit. The LSTA US Leveraged Loan Price Index started the month at $98.24 and ended at $95.90. This quick sell off and volatility in the broader markets led to a quick widening in the CLO spreads, especially lower in the capital stack with BB’s widening out to 725-850 DM context. We expect to see continued widening in the market, as the COVID-19 Pandemic creates more uncertainty into the month of March.

Looking Ahead

It goes without saying, but it’s been quite the whirlwind in the market since the end of February.  In our previous update, we discussed our hope that the virus would be contained in short order, but that has obviously not occurred.  Despite the number of ill and related deaths, we are encouraged that the worst has passed in some areas of the globe, which provides a glimmer of hope to other areas that are beginning to experience their exponential growth phases.  In addition, there is a massive amount of monetary and fiscal stimulus being put in place globally, which should help mitigate the economic fallout from the pandemic.  However, ultimately, the market will need to convince itself that the virus can be contained (via its natural cycle, better isolation measures, novel drug applications, or a combination of these measures) before risk markets can experience a recovery.  We are optimistic this will occur, but like other violent episodes in the financial markets, it may take some time to see the light at the end of the tunnel.  Since February, the Fed has cut interest rates to Financial Crisis era lows in response to the virus outbreak, and we do not expect them to reinitiate tightening any time soon.  The asset class is less about taking a view on interest rates and more about how this crisis resolves itself.  We remain focused, as this too will pass.

Data as of 2/29/2020.  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