Loan Review – January 2017

Monthly Commentary

February 13, 2017

The new year ushered in the largest monthly repricing wave in the history of the leveraged loan market. Simply put, the LIBOR spreads paid by borrowers in January 2017 have dramatically tightened. As can be seen in the chart below, LIBOR spreads contracted approximately 11% for Double Bs and 7.5% for Single Bs from the fourth quarter of 2016.

New Issue S&P LSTA LLI LIBOR Spread Contraction

Source: S&P Global Market Intelligence

However, what is most astounding is the magnitude of the change. Total repricing volume was $100.2 billion in January, more than doubling the previous record of $48.6 billion in 2013. January’s gross repricing activity, combined with the past six months, totals over $173 billion and equates to 19% of the leveraged loan universe.

The forward looking new issue calendar offers scant evidence of a break in this trend as there is little net new issue being generated. Issuance actually providing new paper, excluding refinancings and repricings, is a fraction of demand.

The chart above shows the aggregate new issue spread contraction for double Bs and single Bs. The average spread savings for borrowers who repriced their deals in January was approximately 84 basis points. That’s up from 75 basis points in 2016’s fourth quarter. That is a difficult proposition for a borrower base that is not seeing a concomitant improvement in earnings. It is more a reflection of investors’ desire to have exposure to floating rate credit.

Performance

In January 2017, the Credit Suisse Leveraged Loan Index (“CS LLI”) was up 0.53% and the S&P Leveraged Loan Index (“S&P/ LSTA”) was up 0.56%.

  • For the twelve months ending January 31, 2016, the CS LLI was up 11.27% and the S&P/LSTA was up 11.50%.

Sector Performance

Higher dollar-priced loans drifted closer to par as investors acknowledged the risk of refinancing for loans trading above par. Lower dollar-priced loans rallied as investors continued to look to add high beta and higher yielding paper to their portfolios. Consequently, lower-priced industries such as Energy, Metals/Minerals and Transportation led all categories and posted returns of 4.93%, 1.13% and 0.94%, respectively. By no coincidence, these same three sectors represent three of the four sectors with the lowest average prices.

Total Return by Sector

Source: Credit Suisse Leveraged Loan Index

Food and Drug, Consumer Non-Durables and Retail were the worst performing sectors in January with returns of .08% .08%, and -1.34% respectively. Food and Drug underperformed the broader universe as it has the second highest average price and several deals in the sector repriced during the month. Consumer Products also underperformed but that was more idiosyncratic. It is a small segment of the index with one borrower representing nearly 38% of the sector. That borrower traded down approximately 1% in sympathy with a comparable business that reported weak results. Retail was the sole sector to produce a negative return in the month and this was the second consecutive month that occurred. Early results for traditional bricks and mortar businesses, during holiday sales, were weak. There continues to be a consistent drumbeat of negative retail news and the concern regarding bricks and mortar businesses has only escalated. Several distressed retail stores apparently have the ability to move trademarks to unrestricted subsidiaries. Consequently, weak credit agreements within the troubled sector have further contributed to investor fears.

The top sector returns in the last twelve month period were Energy, Metals/Minerals and Gaming, with returns of 60.49%, 54.28% and 12.28%, respectively. Interestingly, only four sectors provided returns in excess of the index return for the year. This includes the three sectors listed above as well as Manufacturing. Sixteen of the 20 sectors in the CS Index have underperformed the Index, which demonstrates the impact of Energy’s and Metals’ returns on overall performance.

Triple Cs outperformed other performing assets in January, gaining approximately 3.4% this month and an impressive +34.3% in the last 12 months. Single-Bs outperformed double BBs in January (+0.51% vs +0.08%) and single-Bs (+10.88%) also outperformed double BBs (+7.18%) for the last 12 months.

Total Return By Rating

Source: Credit Suisse Leveraged Loan Index

As the repricing wave unfolded and the rally in credit and equity waned at the end of January, the percentage of loans trading above par began to drift from its highs. While the month finished with roughly 71% of loans above par, it had declined from the recent highs of over 74%. This decline in loans trading above par has continued into February.

The average bid price for the S&P LSTA Leveraged Loan Index at month-end was 97.49 up from the price twelve months prior (February 2016) of 89.46.

Average Price

Source: S&P Leveraged Loan Index

However, flow names probably represent current trends more accurately than the broader index as changes there often occur first. As can be seen below, the average flow name has declined from 99.5 at the beginning of December to 98.58 in the beginning of February. This is largely a result of the repricing wave and high dollar priced loans reverting to par.

Average Loan Flow – Name Bid

Source: LCD, an offering of S&P Global Market Intelligence

Technical Conditions

January CLO issuance was extremely quiet with just two deals pricing, representing approximately $1.0 billion in total inflows. The dramatic slowdown is primarily a result of tightening collateral spreads as well as risk retention rules.

CLO Volume

Source: LCD, an offering of S&P Global Market Intelligence

As the CLO market has slowed dramatically, retail fund flows continue to pour into the loan market, and drive overall demand. With $6.7 billion of retail inflows and continued inflows from separate accounts (which are difficult to ascertain actual volumes), loans continued to provide a stable environment and produce positive returns, which can be seen on next page.

Inflows vs. Returns ($ Billions)

Source: S&P Leveraged Loan Index

New issuance ballooned in January 2017 led by over $100 billion of repricing/refinancing transactions.

Repricing Volume

Source: LCD, an offering of S&P Global Market Intelligence

M&A activity remained low to start the year. There was approximately $70 billion of institutional new issue, of which acquisitions, LBOs and mergers only represented one-third of the activity. 44% of the institutional new issuance was repricing/refinancing. Most of the repricing activity was driven via amendment and not captured in actual new issue volumes.

Total New Issue Loan Volume YTD

Source: LoanStats Weekly

Fundamentals

Single-B new issue yield-to-maturity tightened 48 basis points from December while double-B new issue tightened 46 basis points in the month. During the last 12 months Single-B new issue yield-to-maturity tightened 156 basis points and double-B new issue tightened 184 basis points.

Average New Issue Yields

Source: LCD, an offering of S&P Global Market Intelligence

Vanguard Natural Resources and Avaya defaulted in January. The LTM default rate continued to decrease to 1.56%, based on a par amount outstanding from 2.06%.The default rate based on unique issuers also declined to 1.77%.

Lagging 12-Month Default Rates

Source: LCD Loan Stats
* Shadow default rate includes potential defaults, including those companies that have engaged bankruptcy advisors, performing loans with SD or D corporate rating and those paying default interest

Overall default rates remain low and are concentrated in commodity sectors. Thirteen of 25 defaults that have occurred in the last twelve months are Energy and Metals related borrowers. Shadow default activity suggests the commodity sector will continue to drive the default rate during the next 12-18 months. However, the rally in crude may change the recovery profile for many of these borrowers. The number of retail borrowers now trading below 90 suggests we may begin to see some increased default activity in that sector.

Valuation

Since 1992, the average 3-year discount margin (“DM”) for the CS LLI, is 463 basis points. If the global financial crisis (2008 & 2009) is excluded, the 3-year discount margin for the CS LLI is 416 basis points. At month end, the 3-year DM was tight to the historical average, at 454 basis points and 7 basis points tighter than the prior month.

The DM spread differential between double Bs and single Bs has tightened from February 2016 to January 2017 by 179.6 basis points. It is also 23.6 basis points tight of the historical spread differential.

 3-Year Discount Margin Differential Between BBs and Single Vs

Source: LCD Loan Stats

CS LLI Snapshot

Source: LCD Loan Stats

Source: Credit Suisse Leveraged Loan Index

Summary

As of January 31, the S&P/LSTA Index imputed default rate was 2.72%, down from the prior month. It remained considerably below the multi-year high in February 2016 of 7.3%. While the imputed rate implies that the market will see an increase in defaults, it is not implying a very high overall default rate. While spread tightening that has taken place in the last 12 months suggests that loans earnings are improving dramatically, we have not yet seen concurrent improvement. Default activity does remain very low from a historical perspective. Defaults are concentrated within sectors tied to commodities. However, the rally in both the loan market and in WTI Crude prices will allow for higher recoveries of companies entering bankruptcy today as compared to 12 months prior.

Technical characteristics dominated headlines in January. Loan repricing dramatically reduced overall spreads in the loan market and perhaps has created a risk of future volatility. Increasing LIBOR and the fear of the Federal Reserve increasing interest rates are pushing investors into the loan asset class. While demand has increased, supply is anemic. Merger and acquisition driven supply has declined. However, because investors continued to want to have exposure to floating rate credit risk, and demand is outstripping supply, investors are accepting tighter loan spreads at a rate never experienced before.

 

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This material is for general information purposes only and does not constitute an offer to sell, or a solicitation of an offer to buy, any security. TCW, its officers, directors, employees or clients may have positions in securities or investments mentioned in this publication, which positions may change at any time, without notice. While the information and statistical data contained herein are based on sources believed to be reliable, we do not represent that it is accurate and should not be relied on as such or be the basis for an investment decision. The information contained herein may include preliminary information and/or "forward-looking statements." Due to numerous factors, actual events may differ substantially from those presented. TCW assumes no duty to update any forward-looking statements or opinions in this document. Any opinions expressed herein are current only as of the time made and are subject to change without notice. Past performance is no guarantee of future results. © 2017 TCW