January High Yield Credit Update

Monthly Commentary

February 15, 2019

Don’t call it a comeback…or maybe that is an apropos characterization for the resurgence in global risk asset prices in January. High yield bonds in particular enjoyed substantial gains to start the year (having earned a +5.25% total return as of the date of this memo), as the Powell Put, Powell Pause, or Powell Pivot (pick your flavor) calmed investor anxiety over slowing global growth, elevated corporate leverage and an inflection in the credit cycle. At least for the moment. Indeed, while the sharp bounce off the lows (wides) has the familiar features of a “bear market rally,” investor psychology has clearly swung from fear of capital loss to fear of missing out. If the -130 basis point (bp) remediation in risk premiums was not evidence enough of this regime shift in investor sentiment, the return earlier this week of the first sponsor-led dividend recap since the third quarter of last year is a clear signal risk tolerance in on the rise. Said another way, capital markets activity which would never have been permitted amid the volatility in the fourth quarter are once again being accommodated.

With approximately half of the spread widening since the October 3rd tights recaptured thus far this year, valuations are seemingly at a crossroads, with the path forward uncertain. As far as TCW is concerned, the fundamental risks underpinning the re-pricing in the fourth quarter (those mentioned above to name a few) remain in effect, and therefore taking advantage of this aggressive remediation to take profits and preserve liquidity to re-deploy as valuations improve seems prudent.

Market Performance

High yield bonds regained substantial ground in January, retracing effectively all of the December sell-off and generating stellar returns to start the year. Benchmark spreads tightened -103 bps leading to a massive total return for the high yield asset class of +4.52% for the month.

High Yield Spreads Completely Retraced the December Widening in January

Source: Bloomberg

The composition of the rebound is interesting, particularly when deconstructed by credit quality / rating. Though higher beta Single-B and CCC-rated bonds modestly outperformed on a total return basis during the month, at the forefront of the rally has been high quality, BB-rated credit. Indeed, on a risk-adjusted basis, BBs have outperformed year-to-date with many non-cyclical, high quality capital structures trading well above (inside) their pre-December prices (spreads) and converging on their October 3rd highs (tights). On a relative basis, higher risk credits have lagged, leading to a sizeable decompression across the quality spectrum. Moreover, lingering fallen angel fears and adverse technicals, respectively, have led IG credit and loans to trail BBs in the recovery as well. Simply put, BB-rated bonds have been the standout performer of 2019.

Source: Bloomberg, Barclays

Lingering Decompression Across the Quality Spectrum as BBs Have Led the Recovery

Source: Bloomberg

BB Valuations Have Converged Towards that of BBB-Rated Credit

Source: Bloomberg

Though the quality divergence has been the principal distinction of the rally this year, certain sector themes are of note. Principally, the worst performing sectors in December, Oil Field Services, Independents and Pharmaceuticals are the best performing sectors in January. Simply put, amid the general market rebound, those sectors / credits which were pressured the most (were the most “oversold”) had the greatest snap-back potential. Rebounding oil prices supported the reflation of the Energy complex, though with spot WTI trending in the low-$50/bbl, the recovery in the securities has arguably outpaced the recovery in the commodity.

Source: Bloomberg, Barclays

Fund flows inflected sharply as capital flooded back into the high yield market in January following a record exodus in December (-$7.2bn), Q4 (-$21.9bn) and the whole of 2018 (-$46.9bn). High yield funds reported net inflows of +$5bn in January and as of mid- February, ~$9bn of capital has flowed into the high yield marketplace year to date as momentum builds and the ‘FOMO’ consciousness envelopes the market. Of note, the technicals contrast with those in the leveraged loan market where retail money continues to leave, a reversal of the strong demand for floating rate exposure sought by investors for the better part of last year. As cash builds in the face of growing, though manageable, supply (see below), the undercurrent for prices remains favorable.

High Yield Fund Flows Inflected Positive in 2019 While the Loan Market Continues to See Outflows

Source: Credit Suisse, EPFR

Following a record 42-day hiatus, the recovery in high yield bond prices / spreads incentivized a return of primary market activity. January saw ~$17bn in USD-denominated issuance during the month, comprised principally of large, high credit quality, benchmark issuers accessing the capital markets to refinance near-maturing debt or previously announced M&A (i.e. compulsory financings rather than opportunistic deals). A successful reboot of the primary market (from the perspective of both issuers that received good execution and investors that saw newly minted bonds perform well in secondary trading) snowballed into further issuance with opportunistic deals eventually re-emerging, most recently the Ascend Learning dividend recap highlighted above. Interestingly, the representation of secured bonds in the financing mix thus far this year has been elevated relative to historical averages. Presented with the option of raising secured debt in the bond or loan market, issuers this year have thus far favored bonds, given the more attractive financing terms currently available. Dun & Bradstreet, for example, issued first lien secured bonds into the high yield market at a yield that was over 100 bps lower than where the loan market cleared their pari passu first lien secured loan. TransDigm, which had originally contemplated issuing in the loan market to finance its acquisition of Esterline, scratched its plans and raised the full financing package in bond form. CommScope, which raised capital in early February to finance its acquisition of ARRIS, reduced the size of its loan tranche in favor of bonds during the marketing process, given relatively more attractive terms. This is evidence of the prevailing dislocation (and now attractive relative value) of loans versus bonds following the substantial recovery in the latter thus far this year.

Issuers Favored Raising Secured Debt in the Bond Market Rather than the Loan Market in January

Source: Barclays

Fundamental Trends

The high yield marketplace had no borrowers default on obligations or file for bankruptcy in January…the investment grade marketplace, on the other hand, saw its bellwether utility issuer, Pacific Gas & Electric (PCG), elect bankruptcy protection from its mounting California wildfire-related liabilities. Unique in many regards, most notable the prevailing consensus that substantial equity value continues to exist (indeed, the market capitalization of the “bankrupt” enterprise is currently around $8bn), the PCG case promises to be a complex, protracted and politically charged restructuring. Very little default activity has occurred over the last twelve months with the trailing default rate through January at cyclical lows (1.38%, 0.77% excluding iHeart).

Trailing Twelve Month Default Rate Back At Cycle 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