Credit Market Update and Outlook: Modest Start to 2020

By February 11, 2020May 4th, 2020Market Commentary

Loan and High Yield Market Review and Outlook

In January, the loan index1 and high yield bonds2 started the year at 0.53% and -0.02%, respectively. Investment grade bonds3 began 2020 at 2.3%.

Leveraged loan issuance started the year with $123 billion in activity. High yield bond activity registered as the second highest January ever at $39 billion. January 2020 was also the highest month in volume since September 2017. Net CLO issuance in the month of January was $8 billion.

Default activity started 2020 with two defaults, totaling $1.6 billion. This is an increase over the same time last year that had one default totaling $240 million.

In January, the par-weighted default rates for loans began the year at 1.7%.  The par-weighted default rate for high yield bonds remained below the long-term average of 3.4%, at 2.7%, a slight increase since December 2019.

Risk Assessment

Valuation

The strengthening of the loan market continued into January before succumbing to coronavirus pressure along with the other risk markets.  Average loan prices were up roughly 60 bps to 97.35 but finished the month just under 97.  Loans outperformed high yield during January, providing a 0.53% positive return against a loss of 0.02%.  Despite the price volatility, market tone remained improved, and lower quality outperformance continued (split-B/CCC’s provided a 1.45% return versus 0.64% and 0.28% for single and double-B’s, respectively).  Given the disparate performance during January, the YTM/YTW of loans is now about 20 bps inside of high yield, which makes high yield slightly more favorable in this environment, especially if the Fed decides to cut rates further in response to virus-related economic softness.

Technicals

Similar to December, loan technicals remained broadly firmer during January.  Gross loan issuance of $123 billion was a record high during the month.  Approximately $106 billion of that figure consisted of refinancing and repricing activity, which was a testament to the healthy demand environment.  We also experienced the first month of retail inflows into the asset class since September of 2018.  However, we have some concerns that this trend may revert if recent market volatility persists and further rate cuts are anticipated.  Monthly CLO volume was relatively modest, but January tends to be the lowest issuance month.

Fundamentals

We have begun to receive some results for the fourth quarter.  Thus far, there haven’t been any significant surprises, but expectations are also relatively modest given some of the trade-induced weakness experienced near the end of last year.  Investors are now mostly concerned with how quickly the coronavirus can be contained and its ultimate impact on global growth.  There were two defaults during January (Constellis, a security services company, and newspaper publisher McClatchy), but similar to the others previously, these have been driven by idiosyncratic factors and not the result of weakening economic fundamentals.  Fundamentals of CLO collateral were mixed month over month with an improvement in Market Value Coverage, while we saw a deterioration in the minimum OC test from trading losses and defaults.

CLO Market Outlook

CLO tranche performance was positive in January, with returns between 0.03% and 6.0%. The post-crisis AAA tranche lagged, at 0.03% compared to the BB and B CLO tranches, which began the year at 2.6% and 6.0%, respectively, per the J.P. Morgan CLOIE Index.

In January, the primary market was lower MoM with $8.5bn in US and €0.9bn in Euro deals pricing in the market. In the US market, deals being refinanced picked up dramatically as $3.5bn of the $8.5bn priced were refinancings. Managers seemed to be taking advantage of the quick tightening of spreads that occurred in December of 2019. AAA spreads for primary new issue deals remained in the 130 area for better managers. Lower mezz continued to tighten for primary deals as well, with BBs in the mid 600s. In the secondary, while there was tightening across most mezz bonds. We continued to see a bifurcation in these bonds and BB’s with “clean” stats traded in the 600s, and bonds with “not-so-clean” stats, traded into the 900s. BB rated bond BWIC activity picked up dramatically during the month, as these spreads continued to tighten from December well into January.

Looking Ahead

As it stands now, uncertainty surrounding the coronavirus is buffeting the markets much like the U.S.-China trade negotiations did in 2019.  We are obviously hopeful that the virus is contained in short order, but until that happens, broader risk appetite is going to remain subdued.  Absent this uncertainty, the underlying economic fundamentals appear relatively sound.  However, those are likely to deteriorate the longer it takes for containment to be achieved.  In this regard, we also have concerns about the interest rate environment and its impact on loans.  After steadying near the end of the year, Treasury yields declined further during January and now reside close to their recent lows.  Unless we start to see reductions in infection rates, the Fed may be moved to cut rates further as a precautionary move, especially given how loose monetary policy is globally.  This could, of course, have negative implications for loan retail flows and price levels.  Bottom line is that we remain optimistic.  However, cautiousness is warranted, and it’s too early to determine how this saga will end.

Data as of 12/31/2019.  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