Loan Review – April 2017

Monthly Commentary

May 16, 2017

In April, the loan market was still digesting a record setting re-pricing wave, which occurred in the first quarter. Geopolitical risk remained high with North Korea’s constant saber rattling and defiant missile launches. Concerns surrounding the French election remained ever present but did not weigh on the market like other recent political events as Macron’s win was largely expected. Finally, WTI Crude prices remained weak during the month. A good portion of the loan market’s lower-rated, higher-beta borrowers are dependent on WTI prices. Interestingly, this weakness did not overwhelm the market and Energy remained the top performing sector as it has during much of the last year. Despite a growing number of global political risks and the domestic political situation, which seems mired in gridlock, loan prices were largely flat with nearly 70% of loans finishing the month at par or above.

Re-pricing risk appears to have moderated, particularly in lower-rated loans. Higherrated loans continue to tighten but at a more reasonable pace than earlier in the year. Loan returns continue to be stable, slightly outpacing their coupon but lagging other fixed income markets and in particular, high yield.

Performance

In April 2017, the Credit Suisse Leveraged Loan Index (“CS LLI”) and the S&P Leveraged Loan Index (“S&P/LSTA”) were both up 0.44%.

  • Year-to-date ending April 30, 2017, the CS LLI was up 1.64% and the S&P/LSTA was up 1.59%.
  • For the twelve months ending April 30, 2017, the CS LLI was up 8.16% and the S&P/LSTA was up 8.06%.

Sector Performance

All sectors had positive returns with the exception of he Utility sector, which was negatively impacted by a number of factors. First, renewable energy continues to pressure traditional independent power producers creating overcapacity in markets and contributing to disappointing earnings. The ERCOT region in Texas has been plagued by overcapacity and one loan borrower, Exgen Texas, dropped in price as it nears a restructuring event. Another region, Midwest ISO, reported capacity auction results for 2017/2018, which dropped year-overyear to $1.50/megawatt per day from $72/ megawatt per day. Finally, Dynegy also contributed to the bad news in the sector by providing disappointing results.

Total Return by Sector

Source: Credit Suisse Leveraged Loan Index

Energy, Manufacturing and Information Technology were the top performing sectors for the month of April with returns of 0.97%, 0.64%, and 0.61% respectively. Surprisingly, retail had its best month of the year bouncing back with a return of 0.45% after posting three negative months in a row.

Utility, Metals/Minerals and Transportation were the worst performing sectors for the month of April with returns of -0.52%, 0.10% and 0.18% respectively.

Year-to-date, Energy (+5.6%), Metals/Minerals (+3.3%) and Services (+2.3%) are outperforming, while Retail (-2.0%) stands out as significantly underperforming.

One interesting data point on retailers, which the New York Times highlighted, is that weak earnings of traditional retailers may be partially obfuscated by loyalty credit cards that provide a steady stream of payments at very high interest rates. However, if consumer delinquencies begin to increase, profits could take a dramatic step down as payments are missed.

While energy remained the highest yielding sector, retail is beginning to close that gap, as can be seen in the chart below.

Energy Remains the Highest Yielding Loan Sector

Source: Credit Suisse

The flow-name prices in the S&P Index below illustrate overall index performance during the month. Prices backed up for most of the month before showing signs of stabilization. Much of the weakness was driven simply by loans which dropped closer to par after being repriced.

Average Loan Flow-Name Bid

Source: S&P Leveraged Loan Index

Interestingly, initial secondary prices on credits post new issuance show the latest example of how the market is less exuberant than it was in the first quarter. Break prices dipped to 100.20 in April, from 100.44 in March, the lowest level since 100.05 last November, according to LCD.

Technical Conditions

CLO new issue supply reached $10.2 billion in April for the largest inflow of CLO monthly demand on the year. Retail inflows declined to their lowest total since October 2016. Slowing retail inflows ($2.4 billion) reflect a change in sentiment concerning the prospect of rising rates. As rising rate fears moderate, so too do the inflows to retail loan funds. New issue volumes dropped to $60.1 billion from $70.9 billion in the previous month.

Leveraged Loan Volume

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

Acquisitions and leveraged buyouts contributed to a little over half of the last month’s institutional new issue volume. The remaining portion was largely made up of opportunistic transactions, borrowers’ extending maturities, repricing coupons and taking dividends.

April New Issue Volume by Purpose

Source: LevFin Quarterly

While the retail market has slowed, CLO flows continue to contribute to overall demand. With $10.0 billion of the total $12.6 billion of inflows in April, CLO demand provided a stable environment to produce positive returns. As inflows have remained stable during the last 12 months so have monthly returns. As inflows have moderated in 2017, monthly returns have become more coupon dependent and less driven by price increases.

Inflows and Returns

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

Spreads continue to tighten, particularly at the BB level, for which investors seem to have an insatiable appetite. Year-over-year, single B loans show only a 12% tightening and are slightly wider year-to-date. However, it is interesting to note that nearly 70% of April’s loan issuance was single B, and in order for the market to digest it, it came at slightly wider spreads than either March 2017 or early results in May 2017.

Spread Changes

Source: LCD Loanstats TrendLines

Average new issue yields continue to grind tighter and BB and Single B yields are roughly 31 and 27 basis points tighter than in the beginning of the year, respectively.

Average New-Issue Yields

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

There have been 19 defaults in the last twelve months. Payless Shoesource was the sole loan to default in April. The LTM default rate increased slightly from 1.36% to 1.37%, based on a number of defaults while the default rate decreased from 1.49% to 1.43% based on par amount outstanding. Regardless of measurement, default rates remain very low on a historical basis.

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

Commodity sectors continue to be the largest contributors to the default rate as eight of 19 defaults that have occurred in the last 12 months are Energy and Metals related borrowers. Retail/Restaurants is the second largest contributor with four defaults.

Shadow default activity remains very low, suggesting that there will not be any broad-based increase in the next 12 months.

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 440 basis points and 4 basis points tighter than the prior month.

The DM spread differential between double Bs and single Bs has tightened from May 2016 to April 2017 by 86.6 basis points. It is also 37.9 basis points tight of the historical spread differential.

3-Year Discount Margin Differential Between BBs and Single Bs

Source: Credit Suisse Leveraged Loan Index

CS LLI Snapshot

Source: Credit Suisse Leveraged Loan Index

Summary

As of April 30, the S&P/LSTA Index imputed default rate was 1.94%, the lowest level since December 2007. It remained considerably below the multi-year high in February 2016 of 7.3%. The spread tightening that has taken place in the last 12 months suggests that loans’ earnings are improving dramatically; however, there has not been a concurrent level of earnings improvement. Year-to-date, re-pricing activity has been aggressive and underwriting standards have declined. There has been an increase in lower-single B issuance as purchase price multiples continue to increase and debt to finance the higher purchase prices increase in a corresponding amount. However, despite elevated leverage levels and weakening underwriting standards, default activity remains very low and is projected to remain low in the next 6-12 months. As a result of these credit expectations, demand for loans has remained robust.

 

 

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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