Loan Review – February 2016

Monthly Commentary

March 08, 2016

Loan conditions deteriorated for most of February; however, when the broader equity and high yield markets improved during the last week of the month, loan sentiment changed. The crossover bid from high yield began to stabilize and lift loan prices. Despite the rally that took place during the final week of the month, loans still provided negative returns in February and trailed both investment grade and high yield. The Credit Suisse Leveraged Loan Index (“CS LLI”) produced its 7th straight month of negative returns and commodity driven sectors led the underperformance. A supply/demand imbalance has resulted primarily from CLO origination dropping 78% from the prior year. However, it has been compounded by a continued stream of loan new issuance, with over $18 billion syndicated in February. Interestingly, as a result of the high yield crossover buyers, the market has seen larger deals outperform smaller deals by nearly 40 basis points. Term loans over $1.0 billion in size returned -86bps year-to-date. Term loans under $500.0 million returned less than -1.2% yearto- date.

Performance

In February, the CS LLI was down -0.56% and the S&P Leveraged Loan Index (“S&P/ LSTA”) was down -0.53%.

  • For the 12 months ending February 29, 2016, the CS LLI was down -1.28% and the S&P/LSTA was down -1.18%.

Sector Performance

In February, the sectors that generally outperformed were domestic (U.S. –centric) and/or defensive. Gaming/Leisure, Consumer Durables, Food/Tobacco, and Healthcare were the top performing sectors with returns of 0.48%, 0.06%, -0.06%, and -0.16%, respectively.

By Industry Total Return

Source: Credit Suisse Leveraged Loan Index

The worst performing sectors in February were Energy, Utility, Manufacturing, and Aerospace with returns of -4.30%, -2.92%, -0.96%, and -0.85%, respectively.

Excluding November 2008 through March 2009, Energy has now produced the worst 12-month return of any loan sector since the inception of the CS LLI. The super cycle in commodities has resulted in a similar fate for Metals/Minerals, which has produced a return of -29.3% during the last 12 months.

Utilities experienced weakness in February as well. Many Utilities in the Electric Reliability Council of Texas (ERCOT) basin continue to struggle with concerns of oversupply from renewable resources.

By Rating Total Return

Source: Credit Suisse Leveraged Loan Index

There are a few dynamics at play, driving returns by ratings. First, investors have migrated to higher quality loans to remain defensive. Second, there is a large overlap in the borrower universe of loans and high yield. Generally, the senior secured loan will be notched up from the high yield rating as it is secured by the assets of the borrower. Therefore, when triple C bonds sell off, it creates additional pressure on lower single B loans with triple C bonds in the capital structure. Finally, CLOs have seen rating migration lower as Energy, Metals/Minerals, and Retail have experienced negative ratings action from the agencies. As CLO WARF (Weighted Average Rating Factor) scores have weakened and triple C baskets increased, the subsequent demand from CLOs for single B loans is driven down. Together, these 3 factors led to the bifurcation of returns by ratings.

Technicals Conditions

Loans remain challenged by the technical conditions of the market. Simply put, supply is outpacing demand. For February as a whole, net new supply exceeded visible capital formation from CLOs and loan mutual fund flows by $8.3 billion. There was a net increase in loans outstanding of $7.3 billion and a decline in the two primary sources of demand (Retail Floating Rate Funds/Prime Funds, and CLO Issuance) of -$1.0 billion.

Change in Outstanding Loans and Flows

Source: S&P Capital IQ LCD

In February, U.S. CLO origination was $2.07 billion, which compares to $9.4 billion in February 2015. Year-to-date, CLO issuance is down 80% from the prior year based on volume.

Monthly U.S. CLO Issuance

Source: S&P Leveraged Loan Index

Currently, there is only one competitive provider of triple A debt for CLOs, allowing for a compelling equity return. Other traditional providers of triple A debt are at least 15-20 basis points wider, making competitive equity returns difficult. Mezzanine liabilities have become quite expensive and are becoming almost cost prohibitive despite being a small portion of the capital structure. These facts suggest that CLO issuance will remain subdued in the near-term.

The second largest component of leveraged loan demand is derived from retail funds. Retail funds have witnessed persistent outflows in the last 12 months. In fact, there have been 32 consecutive weekly outflows. Outflows year-to-date have been -$5.2 billion. Outflows in 2015 and 2014 were -$25.9 and -$23.8 billion, respectively.

Loan returns have been declining as CLO issuance has waned and retail funds have posted outflows.

S&P/LSTA Leveraged Loan Index Returns and Loan Inflows

Source: S&P Capital IQ LCD

On the supply side of the equation, issuance was evenly split between institutional and pro-rata deals. There has been some increased demand from regional banks so as syndications struggle in the institutional market, dealers have carved out a larger percentage of deals for the pro-rata market. 2016 new issue calendar is dominated by mergers and acquisitions. Consequently, the deals are fully back-stopped and must be syndicated. This has led to consistent issuance despite a lack of demand.

Leveraged Loan Volume

Source: S&P Capital IQ LCD

In order to get institutional investors to buy deals with no true institutional demand, dealers have needed to increase spread and add bigger discounts to par, increasing the overall yield of the deals syndicated. Yields in February 2016 were 185 basis points wider than 12 months prior.

There has also been a widening gap between BBs and single Bs as can be seen below.

Fundamentals

New-Issue First-Lien Yield to Maturity

Source: S&P Capital IQ LCD

S&P Leveraged Loan Index

In February, there were two new defaults, including Paragon Offshore and Noranda Aluminum, which pushed LTM default rate to 1.45% based on a par amount. The default rate based on unique issuers as opposed to par amount reached 1.70% in February.

Lagging 12-Month Default Rates

* 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.
Source: Credit Suisse Leveraged Loan Index

Sixteen of the 25 defaults are in the Energy/Commodity sectors. While defaults generally remain low, they are beginning to increase and commodity sectors will continue to drive the default rate during the next 12-18 months. Shadow default rates are also increasing materially.

However, it should be highlighted that the market is pricing in a high default premium. Given current spreads, loans are implying a default of 5.5% - 7.5% (depending upon underlying assumptions). This implied default rate is materially higher than the shadow default rate, which is slightly above 2.0%.

Valuation

Since 1992, the average 3-year discount margin (“DM”) for the CS LLI, is 461 basis points. If you exclude the global financial crisis (2008 and 2009) the 3-year discount margin for the CS LLI is 411 basis points. At month end, the 3-year DM was wide of the historical average, at 692 basis points.

The DM spread differential between BBs and single Bs has widened significantly from February 2015 to February 2016.

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

The loan market is still suffering from both technical and fundamental issues. Together, these issues have weighed on performance. The absence of dealer balance sheets has left a void in the market that has restricted liquidity compared to prior cycles. The forward calendar for new issuance is significantly higher than anticipated retail inflows and CLO issuance.

Despite this technical reality, loan prices have rallied substantially in the last several sessions. However, it is difficult to believe that a prolonged rally can continue without an improvement in the conditions of the CLO market.

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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