December High Yield Credit Update

Monthly Commentary

January 18, 2019

Well…that just happened. Of course we are referring both to the collapse in risk asset prices in the final weeks of 2018 as well as their impressive rebound in the first two weeks of 2019, particularly for U.S. high yield bonds. The path for high yield credit spreads (and risk asset prices globally) ultimately proved perilous in 2018, despite relative calm during the first nine months of the year. Average credit spreads in the high yield market trended within a narrow ~60 basis point (bps) band until September, before gapping +223bps wider from the cycle lows of 303bps set on October 3rd to 526bps at the December 31 close. As it’s said, a picture is worth a thousand words, so we selected the below snippet to recap the evolution of the high yield market this past year…

Returns for lower credit quality bonds (i.e. securities rated CCC) outpaced those of safer, BB-rated credits by a substantial margin (+580bps) through September as investor complacency and ample tolerance for risk (or underappreciation thereof) led investment down the quality spectrum. In the 4th quarter, however, the pendulum swung decidedly from complacency to fear on concerns over a cyclical downturn, elevated corporate leverage, central bank tightening, and U.S.-China trade tensions, igniting a flight to quality which laid waste to several fundamentally unstable capital structures. The performance of CCC-rated bonds tells the story as the high-flying cohort retraced nine months of outperformance to end the year returning -143bps less than higher quality constituents.

2018 in a Single Chart – Cumulative Performance of CCCs vs. BBs

Source: Bloomberg

Of course, as we write today, credit spreads have quickly retraced nearly all of the December sell-off, blurring the path forward that much more. With volatility elevated in the 10th year of this cycle, this value investing adage feels prescient – in the short run the market is a voting machine, in the long run it’s a weighing machine. We believe our value discipline will best equip us to avoid pitfalls and identify opportunities on the road ahead.

Market Performance

Negative returns in November were dwarfed by the drawdown in December as credit spreads gapped over 100 bps wider with the benchmark (the Bloomberg / Barclays US HY Index) finishing the year at an option-adjusted spread of 526 bps over Treasuries (the highest since August 2016). High yield bonds returned, on average, -2.14% for the month, with an excess return of -3.66%.

High Yield Spreads Gapped Higher in the Second Half of December Amid a Perfect Storm of Negative Fund Flows, Fear and Illiquidity

Source: Bloomberg

The sharp re-pricing in December proved less discerning than in November with credits across the risk spectrum on sale as dealers and investors shed positions to de-risk balance sheets and meet redemptions. Sponsorship for higher risk / lower credit quality bonds remained poor, and CCC-rated securities continued to lose ground relative to fundamentally more durable credits. CCCs lost, in aggregate, -4.27%, whereas BBs and Bs lost just -1.31% and -2.19%, respectively.

Source: Bloomberg, Barclays

The Energy complex bore the brunt of the Q4 and December sell-off, underpinned by the quick collapse in oil prices. Front month WTI and Brent contract prices declined -44.3% and -41.5%, respectively, peak-to-trough, during the past three months. Even higher credit quality constituents, with acreage positions in the most economically desirable basins, very low balance sheet leverage and ample liquidity, were dragged down with the sector (the proverbial baby being thrown out with the bathwater), creating attractive idiosyncratic investment opportunities. In addition to Energy, sectors which had until December outperformed, such as Pharmaceuticals, came for sale as investors reached for less beaten down credits first when looking to raise capital. Conversely, sectors which had previously underperformed in October and November, such as Automotive and Chemicals, drew down less aggressively having already priced-in much of the elevated risk factors. Relative sector performance for the year was generally characterized by a decompression between cyclical (Energy, Automotive, Basics, Home Construction) and non-cyclical (Healthcare, Cable, Pharmaceuticals, Utilities) risk, with the latter understandably proving more resilient in the face of declining growth expectations and rising end of cycle concerns.

Source: Bloomberg, Barclays

Market technicals inflected in December as capital flight accelerated into year-end. What had been an orderly re-pricing in November, characterized by relatively balanced trading at gradually lower prices (wider spreads), evolved swiftly to a more systemic sprint to the exits in December. High yield funds reported a -$7.2bn net outflow for the month as part of a broader flight to quality trade out of risk assets (stocks, high yield bonds, leveraged loans) and into safer securities (namely, treasuries). Less discerning (i.e. forced) selling, combined with a near evaporation of liquidity (the result of both seasonality and extremely low dealer and investor risk tolerance heading into year-end) forced prices to step function lower. The high yield bond market lost a record -$47bn in assets this past year, though it wasn’t until Q4 that the exodus proved disruptive.

Negative Fund Flows Resulted in Systemic Selling in Both the High Yield Bond and Leveraged Loan Markets

Source: Credit Suisse EPFR

Not since November 2008 (the only other period in history) had an entire month passed without a single high yield issuer syndicating a deal into the marketplace. No deals were brought to market in December with capital markets shuttered by widening credit spreads and escalating volatility / investor anxiety, a seemingly fitting close to a year which saw net issuance collapse -38% year-over-year, resulting in the fewest deals since 2008. The new issue calendar has remained light thus far in 2019 with just one deal pricing after the 42-day drought. However, as credit spreads have remediated off the local wides and as fears abate (for now), we would expect issuers and dealers previously sidelined in hopes of calmer seas to seize the opportunity to raise needed financing.

Primary Issuance Tapered Off Materially in the Fourth Quarter

Source: Barclays

Fundamental Trends

Though credit spreads widened into year-end, embedding expectations of future fundamental stress, realized defaults over the December and full year 2018 periods were extremely mild. Indeed, excluding the bankruptcy filing of iHeart Communications, one of the last men standing of the pre-crisis mega-LBOs, default volumes were down year-over-year and the trailing 12-month default rate ended the year at just 1.08% (1.81% including iHeart). Just one high yield bond issuer (oil and gas driller Parker Drilling Company) defaulted on $585mn of debt in December. Now, trailing data are by definition backward looking, and low credit spreads (and dampened spread volatility) through most of last year ultimately proved consistent with the trailing fundamentals. Market prices, on the other hand, embed expectations about the future, with the current voting machine signaling concern over the fundamental path forward.

Trailing Default Rates, Though Backward Looking by Definition, Are at Cyclical Lows …

Notes: Excluded the record setting defaults of Energy Futures’ $36bn default in April 2014 and Caesar’s $18bn default in December 2014.
Source: JPMorgan

 

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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. © 2019 TCW