February High Yield Credit Update

Monthly Commentary

March 15, 2019

Just two and a half months in the books for 2019 and high yield bonds have already generated returns acceptable for a full calendar year. Indeed, piecing together an approximate 7% return in the wake of seeing 2018 gains eviscerated in the last three months of the year would be considered a fine outcome by many. Although, the early win is both a blessing and curse when considered through a behavioral economics lens as the returns booked give way to a more powerful aversion to avoid their loss. That loss (risk) aversion, is palpable in the marketplace today despite still supportive technical undercurrents and absolute valuations once again approaching cyclical tights. One need not look further than the still elevated risk premiums of CCC-rated bonds compared to BB-rated bonds (more on this below), as well as the growing list of fundamentally challenged credits losing sponsorship (notably in the Energy patch), to appreciate the tentative tone of the recent rebound. Taken together with valuations which we believe currently fail to appropriately discount weakening credit fundamentals and future uncertainties, our informed position is not to wait to top-tick the market, but rather take profits, de-risk portfolios, and once again preserve liquidity should worsening fundamentals catalyze that loss aversion into a scramble for the exits.

Market Performance

January’s head turning rally extended into February as high yield spreads tightened another -44 basis points (bps) during the month. The option-adjusted spread of the Bloomberg/Barclays High Yield Index stood at 379 bps at the end of February, -158 bps inside the January 3 wides. High yield bonds earned a total return of +1.66% during the month, despite a modest headwind from higher interest rates, bringing the total return for the year to an impressive 6.26%!

Source: Bloomberg, Barclays

The composition of the recovery year to date remains a focus point, as higher quality bonds have largely kept pace with (and by many risk-adjusted measures, outperformed) higher beta / riskier credits. Indeed, this has resulted in a decompression in risk premiums across credit quality more characteristic of risk-averse rather than risk-seeking behavior – i.e. a risk averse rally. BB-rated bonds generated a total return of +1.6% in February, equivalent to that of CCC-rated risk. On a year-to-date basis, the average price appreciation of BB bonds is only slightly behind that of CCC bonds (see table below). Finally, the spread basis between BB and CCC-rated risk has only marginally compressed off the recent wides whereas BB and market spreads overall have recovered 83% and 68%, respectively, of the Q4’18 widening.

CCC Bond Prices Have Appreciated Just +0.8pts More Than Those of BBs Amid the “Risk Rally”

Source: Bloomberg, Barclays

The OAS Basis Between CCC and BB-Rated Risk Remains Well Wide of the Pre Sell-Off Tights (CCC Index OAS – BB Index OAS)

Source: Bloomberg

Looking at relative performance across sectors, Energy credits have led the charge higher after losing the most last year, though the general rising tide has led to robust performance from effectively every sector year-to-date. Outside of Energy, which admittedly is only a marginal standout thus far in 2019, there has been de minimis decoupling between cyclical and non-cyclical sectors / risk – more of an indiscriminate recovery from the lows.

Source: Bloomberg, Barclays

Market technicals remained a tailwind for credit prices in February (excluding leverage loans), with U.S. high yield bonds a beneficiary of now over $10bn of capital flows into the marketplace year to date ($5.4bn in January and $4.8bn in February). Though only partially reversing the -$47bn outflow from the sector in 2018, the dollars are entering the marketplace at a time when the supply of paper remains very low (dealer inventories are near 12- month lows and primary issuance, while picking up, remains tempered overall). The result, an inflationary force on prices which in recent days has been quite “gappy” as buyers (principally ETFs) aggressively put cash to work.

High Yield Fund Flows

Source: Credit Suisse, EPFR

Capital markets were decidedly open for business in February following the resurgence in activity in the last few weeks of January. Just under $21bn in USD-denominated debt was syndicated during the month including a mix of benchmark M&A and opportunistic refinancings as well as smaller, off-the-run deals from issuers that saw an opening to raise needed financing and took their shot. Attractive discounts available among the January cohort of deals, were largely priced away during the February syndications as demand for paper overwhelmed supply.

Source: Barclays

With the January risk rally extending through February, broad based credit stress remains elusive. Indeed, only 1.8% of the high yield market currently trades at a price below $70, suggesting default volumes, at least for the time being, are expected to be low (i.e. the voting machine has cast its vote). Only one high yield borrower defaulted on its obligations this month and filed for bankruptcy, though the situation was quite idiosyncratic. Simply put, a district court ruled in favor of Aurelius, a litigious hedge fund, in its lawsuit against wireline operator Windstream over whether the company violated the terms of its bond indenture when it spun-out it’s wireline infrastructure assets into an independent REIT back in 2015. The ruling resulted in certain of the company’s debts (and unpaid interest) becoming immediately due and payable, forcing the company to file a “free fall” bankruptcy to restructure its balance sheet.

 

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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