Loan Review – February 2017

Monthly Commentary

March 13, 2017

Performance

There is so much hyperbole in politics that constituents have begun to become numb to the threat of tragedy or disaster. Similarly, in the last 12 months, there has been a certain prosaicness among loan investors as benchmarks break records. January had the most repricings in loan market history. February yawned briefly and then the index continued higher. By the end of the month, the repricing machine began to crank up again. The obvious incongruity between underlying borrower performance and the enthusiasm of the debt markets is hard to miss. Risks remain the same, however, investors are willing to be paid less for taking that risk.

The three-year discount margin (one measure of loan valuation) is the tightest it has been since the end of 2007. The only time discount margins were lower, LIBOR was generally significantly higher. The three-year yield is hovering close to historical lows at 6.17%. Excluding portions of 2013, 2014 and 2015, when LIBOR was roughly at ~30 basis points, yields were only lower in 2004.

Historical Bank Loan Discount Margin and Yields

Source: Credit Suisse Leveraged Loan Index Data

In February 2017, the Credit Suisse Leverage Loan Index (“CS LLI”) was up 0.59% and the S&P Leveraged Loan Index (“S&P/LSTA”) was up 0.50%.

  • For the twelve months ending February 28, 2017, the CS LLI was up 12.55% and the S&P/LSTA was up 12.66%.

Sector Performance

Lower dollar-priced industries such as Metals/Minerals and Energy continue to post outsized returns up 1.72% and 1.18%, respectively. Nineteen of the twenty sectors in the Credit Suisse LLI posted positive returns for the month.

Total Return by Sector

Source: Credit Suisse Leveraged Loan Index

Gaming/Leisure, Forest Products/Containers and Retail were the worst performing sectors for the month of February with returns of .41% .28%, and -0.30% respectively. Gaming/Leisure and Forest Products/Containers were both impacted by a number of highdollar priced loans being re-priced. In most cases, as the loan spread is reduced, the loan drops in price. Given the number of re-pricings in both sectors, it has led to slight weakness in sector prices. Retail was the sole sector to produce a negative return in the month and this was the fourth consecutive month that has occurred. Weak earnings and concerns of secular change continue to weigh on the sector.

The top sector returns in the last twelve month period were Energy, Metals/Minerals and Gaming/Leisure, with returns of 48.58%, 44.08% and 10.07%, respectively. Interestingly, only four sectors provided returns in excess of the index return for the last 12 months. 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 and Metals’ returns on overall performance.

Triple Cs outperformed other performing assets in February, gaining approximately 2.06% this month and an impressive +30.85% in the last 12 months. Double-Bs outperformed single Bs in February (+0.49% vs +0.44%) while single-Bs (+7.96%) have outperformed double BBs (+6.64%) for the last 12 months.

Total Return By Rating

Source: Credit Suisse Leveraged Loan Index

Meanwhile, the percentage of the JPMorgan Leveraged Loan Index trading above par is 74.1%, marginally up from 71.9% on 12/30/16. For reference, the post crisis high was 86.0% on 5/9/13. This means that despite the re-pricing wave which has produced $121bn of activity year-to-date, the majority of the market still remains at risk for further spread compression. For example, 51% of leveraged loans are either trading above par, or through the $101 soft call.

The average bid price for the S&P LSTA Leveraged Loan Index at month-end was 98.38, up from the price twelve months prior (March 2016) of 91.51.

Average Bid: S&P/LSTA

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 increased over 1.65% to above par by the end of the month.

Average Loan Flow – Name Bid

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

Technical Conditions

February ended with $26.5 billion in US CLO issuance, an all-time record month. However, 70% came from refinancings and $8.1 billion represented the actual new total inflows. Volume ticked up to the highest level since November 2016.

CLO Volume

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

Combined with the increase in CLO inflows were the continued inflows from retail funds as investors looked to get exposure in floating rate credit. Leveraged loan funds reported an inflow of +$4.7 billion in February as compared to $6.7 billion in January. Year-to-date inflows for loan funds are $11.4 billion compared to -$5.3 billion of outflows over the same period in 2016. AUM for the retail leveraged loan mutual fund base stands at $128.3 billion now compared to $92 billion in February last year. Mutual fund AUM peaked at $154 billion in 2013.

As can be seen below, returns have increased as inflows have continued to drive demand for loans.

Inflows vs. Returns ($ Billions)

Source: S&P Leveraged Loan Index

Institutional new issuance slowed to $35 billion after an enormous month of issuance in January.

Approximately 45% of issuance was related to LBO/M&A and acquisition financing. The remaining portion of issuance relates to opportunistic financing: dividends, repricing and recapitalizations.

Total Volume YTD

Source: LoanStats Weekly

Fundamentals

Single-B new issue yield-to-maturity widened 9 basis points from January while double-B new issue widened 29 basis points in the month. During the last 12 months Single-B new issue yield-to-maturity tightened 145 basis points and double-B new issue tightened 150 basis points.

Average New Issue to Maturity

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

HHGregg, Inc., a retailer, was the lone company to default in February. The LTM default rate continued to decrease to 1.57%, based on a par amount outstanding from 2.77%. The default rate based on unique issuers also declined to 1.41%.

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 continue to grind lower each month. Defaults for the last 2 years have been dominated by the commodity sectors. Twelve of 25 defaults that have occurred in the last twelve months are Energy and Metals related borrowers. Shadow default activity suggests the default rate will remain low in the near future. The number of retail borrowers now trading below 90 suggests we may begin to see some increased default activity in that sector as secular changes in purchase habits continue to put pressure on bricks-and-mortar businesses.

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 DM 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 157 basis points tighter than the prior month.

The DM spread differential between double Bs and single Bs has tightened from March 2016 to February 2017 by 136.2 basis points. It is also 30.1 basis points tight of the historical spread differential.

3-Year Discount Margin Differential Between BBs and Single Bs

Source: LCD Loan Stats

CS LLI Snapshot

Source: LCD Loan Stats

Summary

As of February 28, the S&P/LSTA Index imputed default rate was 2.43%, 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 remains very low from a historical perspective and has been 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 continued to dominate headlines in February. Loan repricing dramatically reduced overall spreads in the loan market and perhaps have created a risk of future volatility. Increasing LIBOR and the fear of the Federal Reserve increasing interest rates is pushing investors into the loan asset class. While demand has increased, supply remains anemic. However, because investors continue to want exposure to floating rate credit risk, and demand is outstripping supply, investors are accepting tighter loan spreads at a rate seen few times in loan market history.

 

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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. © 2018 TCW