Credit Market Update and Outlook: Hesitant Fed, Attractive Loans

By January 10, 2020 February 7th, 2020 Market Commentary

Loan and High Yield Market Review and Outlook

In December, the loan index1 was up 1.6%, bringing year-to-date performance to 8.6%. High yield bonds2 were up 2.0%, bringing year-to-date performance to 14.3%.  Investment grade bonds3 were up 0.3%, bringing year-to-date performance to 14.5%.

Leveraged loan issuance registered third highest in 2019 at $38 billion. Year-to-date gross loan issuance was $392 billion at the end of the year; 44% lighter than 2018’s loan issuance.  High yield bond activity decreased slightly since November, with $20 billion of gross issuance in December, bringing year-to-date issuance to $287 billion; an increase of 53% compared to the year-to-date issuance of 2018.  Net CLO issuance declined compared to the previous month, with $9 billion in CLOs issued in December, bringing year end net US CLO issuance to $161 billion.

Default activity decreased in December, with three defaults totaling $1 billion in bonds and loans, well below the average of $5 billon. In 2019, 53 companies defaulted, 43 in bonds/loans and 10 in distressed exchanges. The Energy and Metals sector contributed to roughly half of the year’s defaults.

In December, the par-weighted default rates for loans ended the year at 1.6%.  The par-weighted default rate for high yield bonds remained below the long-term average of 3.5%, at 2.6%, a slight increase since November.

Risk Assessment

Valuation

Similar to the broader risk markets, the loan market continued to improve in December.  Average loan prices ended the month at 96.72, up over 1 point during the month and at the highest level since that initial leg down in August.  Although high yield outperformed loans (2.29% versus 1.65%), the returns for both asset classes were very good.  The tone of the market also felt better than it had for most of the past six months.  In fact, we finally experienced some reversal of the quality outperformance trade – CCCs returned 5.04% against 0.85% and 1.99% for BB and B-rated issuers, respectively.  However, as evidence of investors’ continued cautiousness, CCC spreads still remain relatively wide.  2019 represented the first time that high yield provided a 5%+ return and CCCs did not outperform BBs.  The YTM/YTW of loans is now wide of high yield by nearly 40 bps.

Technicals

Loan technicals improved further during December.  Net loan and CLO issuance were relatively consistent with previous months.  However, we experienced a further moderation in retail outflows.  The $1 billion outflow in December was significantly lower than the $2.1 and $3.9 billion figures for November and October, respectively.  In addition, that forced selling pressure in stressed/distressed positions that we noted in November seemed to abate as we neared the end of the year.  Given the current interest rate environment and a hesitant Fed, retail outflows are likely to persist during the near-term, but we expect levels to be lower than those in 2019.  Overall, we anticipate a more balanced technical environment for 2020.

Fundamentals

The financial reporting lull between quarters continues.  There were three defaults during December, spread across the energy, healthcare, and services sectors.  Commodity-sensitive issuers continue to account for the majority of the default activity – about half of the defaults in 2019 were related to companies in energy or metals/mining.  Fundamentals of CLO collateral were mixed month over month with an improvement in Market Value Coverage, while we saw an increase in the percent of B3 assets and CCC exposure increasing as well.

CLO Market Outlook

CLO tranche performance was positive in December, with returns between 0.3% and 7.1%. The post-crisis AAA tranche lagged, up 0.3% compared to the BB and B CLO tranches, which were both up 4.4% and 7.1%, respectively, per the J.P. Morgan CLOIE Index.

In December, the Primary market was lower MoM with $7.8bn is the US and €2.8bn in Euro Deals, bringing full-year new issue supply to $118.6bn and €29.8bn, respectively. AAA spreads for primary deals remained flat MoM in the mid 130s, while the primary mezzanine spreads tightened MoM. Secondary spread moved in tandem to primary spreads and continued to tighten during the month, as we expected. The market fundamentals continued to improve as S&P Leveraged Loan Price Index increased from 95.58 to 96.72. This large jump in loan prices led to better Market Value coverage of CLO Mezzanine, which in turn led to the quick tightening of the spreads. New buyers came into the market with the rally of leveraged loans, which was another contributing factor to the strong performance of mezzanine during the month. We expect the buyers to still be there in the beginning of 2020, and expect spreads to continue to tighten during the early part of 2020.

Looking Ahead

As we begin a new year, we are cautiously optimistic about returns in the credit markets, but it will be difficult to replicate 2019.  We expect the positive but relatively low economic growth environment to persist.  We are entering an election year and are likely to continue to be faced with trade headlines, which may constrain growth from accelerating further.  However, this is not necessarily a negative for credit, as a hesitant Fed (combined with easy money globally) should provide a supportive backdrop for risk assets.  Obviously, a reacceleration in growth and a concurrent rise in yields could be a good outcome for loans as well.  Nonetheless, we expect the loan market technical to be more balanced in 2020.  Most expect net loan and CLO issuance to be down 10% to 20% this year.  Continued loan retail outflows are possible, but the magnitude should be smaller going forward.  This may prevent the price discount from narrowing much.  However, we do expect some further reversal of the quality trade experienced for much of last year.  We believe that further upside for double-Bs is likely limited and that investors will increasingly look into the more downtrodden single-Bs for alpha generation.  We do not believe, though, that there will be a widespread rally in CCC credits.  There may be some catalyst-driven instances that have a successful outcome, but there still seems to be some persisting cautiousness amongst credit investors.

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