Credit Market Update and Outlook: March Lows Make Protracted Recovery Likely

By April 8, 2020May 4th, 2020Market Commentary

Loan and High Yield Market Review and Outlook

In March, the loan index1 was down -12.37%, bringing year-to-date performance to -13.05%.  High yield bonds2 were also down in the month of March at -11.46%, bringing the year-to-date performance to -12.68%. Investment grade bonds3 decreased to -7.09% at the end of the month of March, bringing the year-to-date performance to -3.63%.

Leveraged loan issuance decreased to $4 billion in activity. Year-to-date gross loan issuance was $199 billion at the end of the month, up from $70 billion during the same time last year. High yield bond activity decreased to $6 billion at the end of Mach, bringing the year-to-date issuance to about $75 billion. Net CLO issuance fell since the month of February, ending the month at $4 billion, bringing the year-to-date issuance to $42 billion, up still compared to $40 billion the same time last year.

Default activity increased in the month of March, with five defaults totaling $19 billion. This is the sixth highest monthly default volume on record. Leading the way was Frontier Communication’s default of $17 billion.

In March, the par-weighted default rates for loans increased to 1.87%, up 13bp from February. The par-weighted default rate for high yield bonds increased to 3.35%, up from 2.30% in February and a three-year high.

Risk Assessment

Valuation

The credit markets were relatively steady for the first two months of the year, as investors largely ignored the COVID crisis intensifying in China, but as we know, that all changed near the end of February and into March.  After declining to about 95 at the end of February, the average loan price in the S&P/LSTA Leveraged Loan Price Index declined by nearly 20 points at its trough before rallying to about 83 at month end.  Since the March lows, the broader risk markets have reacted positively to the extraordinary level of monetary and fiscal policy response we have witnessed.  However, loan prices remain at levels not seen since the financial crisis.  As could be expected, the flight to quality trade reemerged amongst the market turmoil.  BB and B-rated loans substantially outperformed their split B/CCC-rated counterparts, -10.17% and -13.92% versus -26.87%, respectively.  Loan valuations remain at attractive levels from a longer-term investment horizon, but there are obviously a number of macro concerns during the near-term that are likely to temper significant gains in further price improvement.

Technicals

Not surprisingly, loan technicals deteriorated substantially during March.  After experiencing one of the lightest outflow months in recent history during January, outflows began increasing again in February to $2.6 billion before hitting $9.0 billion in March.  Although this level was below the $11.7 billion in the four weeks ending 2018, the March outflow exceeded this figure in terms of percentage of AUM.  Loan funds now only hold about $74 billion of assets, which is the lowest level since January 2013, and this should provide some buffer against sustained, large outflows in the near-term.  Due to the market turmoil, both net loan and CLO issuance essentially came to a halt during the last couple weeks of the month.

Fundamentals

We are entering the first quarter reporting period and continue to receive fourth quarter figures from a number of our private issuers.  However, these results have lost much of their meaning given the current environment and the precipitous fall of economic activity worldwide.  Nonetheless, we continue to focus on each issuer’s ability to navigate the current environment and to do so for a potentially longer period of time, as we expect the recovery to be more prolonged and not V-shaped.  Loan default rates have begun to creep upwards, increasing 82 bps to 1.87% on a trailing 12-month basis.  However, the circumstances driving these defaults are primarily related to idiosyncratic issuer headwinds and/or weaker commodity pricing.  Post COVID, we certainly now anticipate an appreciable rise in the default rate in the near-term, especially within high yield given the proportionately larger exposure to the energy sector.  Nonetheless, we do not expect default rates to exceed those experienced during the financial crisis. Fundamentals of CLO collateral were down month over month with a deterioration in the minimum OC test from trading losses and defaults, MVOC and WARF.

CLO Market Outlook

CLO tranche performance was down across the board in March, with returns between -33.29% and -5.00%. The post-crisis BB tranche lagged, at -33.29% compared to AAA tranche, which ended at 5.00% at the end of the month of March, per the J.P. Morgan CLOIE Index.

In March, the primary issuance was lower MoM with $3.4bn in US and €1.2bn in Euro deals pricing in the market, while the number of deals being refinanced came to a near halt with only $0.4bn. Like most of the broad market, there was massive widening across the full capital stack, including a historic widening at the AAA level, as forced selling due to the market effects of COVID-19 turned the CLO market upside down. Large volumes of AAA rated tranches traded during the month as many investors were forced to raise cash, causing AAAs to trade wider than AAs in many instances. Across the stack, tranches became dislocated and were largely trading off dollar price without regard to spread. The LSTA US Leveraged Loan Price Index started the month at $95.18 and due to the COVID-19 pandemic, ended March at $82.85. This violent decrease in loan prices drove market value overcollateralization of debt tranches to be underwater in many CLOs up to the single-A tranche. Looking ahead, loan rating downgrades and defaults are expected to cause OC Test failures and interest diversion across much of the market in the upcoming quarters.

Looking Ahead

The current state of the markets is about as uncertain as it has been since the financial crisis.  About the only positive thing to emerge for loans over the past two weeks is that investors no longer have to worry about further Fed interest rate cuts in the near-term.  The Fed and the U.S. government have responded to this crisis with an unprecedented amount of stimulus in short order.  These actions are obviously supportive of risk assets and should ultimately support higher rates sometime in the future.  However, we fully expect the Fed to remain extremely accommodative until there is clearer resolution on a path towards a firm economic recovery.

Like many, we remain optimistic that this too shall pass.  However, we do not believe that we are in store for a V-shaped recovery.  No one obviously knows at this point, but the nature of this situation would seem to reinforce the notion that some level of uncertainty is likely to persist during the near-term, which could prevent risk markets from quickly regaining their previous strength.  Even if we are fortunate to have infection rates subside over the next month or so, many investors will obviously be looking forward to the fall and winter for a potential reemergence.  If the economy does not vigorously recover, what does this mean for the upcoming presidential election and an alternate Executive Branch agenda being put in place?  How are consumer behaviors going to change, even after the virus recedes?  The P/E of the market may look attractive, but no one really knows what “E” is this year or next year for that matter.  The markets always have to cope with some level of uncertainty.  However, these are certainly uncertain times, and we believe that a recovery is likely to be protracted.

Data as of 3/31/2020.  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