Loan Review – March 2016

Monthly Commentary

April 06, 2016

It always provides some comfort to look at historical data for future guidance. Does this cycle remind us of a previous cycle? Does this technical condition resemble a previous imbalance? Unfortunately, the longest running loan index only has 24 years of history. The two longest periods of monthly declines are in 2008 (6 months) and 2015/2016 (7 months). After 6 straight monthly declines to end 2008, the loan market rebounded with 16 straight months of positive returns producing a cumulative return in excess of 53% during that time. March 2016 produced the first positive return in 8 months. It was also the best return since October 2011. Therefore, the question is – is the loan index going to follow a similar path to 2008?

First, it is important to acknowledge that U.S. economic performance will most matter to the loan market. While many borrowers have global reach, the U.S. economy is overwhelmingly the biggest factor to performance.

In response to economic weakness in 2008 and 2009, the United States along with other countries embarked on a global monetary experiment whereby central banks began massive economic stimulus programs. As governments drove rates down, investors began reaching for greater returns/yield, which assisted the rebound in loan returns. This is perhaps the first such difference between 2008 and 2016. Given the current low-rate environment, there will be no such easy answer.

Obviously, the goal of quantitative easing was to stimulate a recovery in Gross Domestic Product (GDP) and the byproduct of such a program resulted in investors moving into the loan asset class (as well as other risk assets). The chart below highlights the GDP growth rates of the 10 largest economies since 2006. These 10 economies represent approximately 70% of the world’s gross domestic product.

Historical Global Growth and 2015 Forecast of the 10 Largest Countries by GDP1,2

1 World Bank Data and January 2016 Global Economic Prospects (A World Bank Group Flagship Report - January 2016). Annual percentage growth rate of GDP at market prices based on constant local currency.
2 2015 France, Germany, Italy and United Kingdom forecast is from European Economic Forecast, Winter 2015.

In 2008, the recession came primarily from financial centers (United States, United Kingdom and Japan). In 2015/2016, Brazil and Russia are expected to have demonstrably negative GDP growth rates as a result of the commodity crisis. In 2008, the United States, United Kingdom and Japan represented 31% of the world’s GDP. In 2015, Russia and Brazil represent less than 6% of the world’s GDP. Time will tell if the commodity crisis is a canary in the coal mine or if the commodity-driven countries are simply too small to overwhelm global growth.

Many have accepted the premise that commodity price declines have been driven lower primarily from oversupply. However, it is also evident that China, which has been one of the largest sources of demand for commodities, is slowing dramatically. China has grown from 3.8% of the world’s GDP in 2006 to 14.4% in 2014. Point being, China has been a large part of the world’s growth engine in the last decade and its visible deceleration has contributed to commodity weakness during the last 18 months. Consequently, the notion of weaker demand highlights the risk of slowing global GDP.

With that said, can the U.S. economy overcome these growth issues and continue its expansion? If the answer is yes, then the loan market will have a fundamental back drop that could allow the loans to continue producing positive returns. If the answer is no, then the loan market will likely see continued outflows from retail mutual funds, a lack of CLO issuance and a resumption of negative returns. While those questions are difficult to answer, it is clear that investors’ expectations of a near-term recession certainly changed from February to March as loan risk premiums shrunk considerably.

Many of the headwinds to global growth in 2008/2009 are still obstacles in 2016. In fact, monetary policy may have obfuscated these problems but they have not resolved them. Certainly, the Federal Reserve has fewer arrows in its quiver to assist the economy than it had in 2008. One could likely infer as a result of all these factors that the 2008/2009 experience for loans will not likely serve as a road map for 2016.

Ignoring fundamental growth concerns, the CLO market has unresolved structural issues. If the market continues to see a rally in risk then the market will likely see an increase in the formation of CLOs. However, without a change in regulation, CLO formation will likely continue to shrink. There are multiple facets to regulatory hurdles. First, there is risk retention, which in and of itself creates a hurdle for CLO creation. Second, in my opinion, there are simply not enough AAA/AA natural buyers of CLO paper to allow for an easy arbitrage. If one or both of these issues continue to persist then CLO issuance will likely continue to have a large hurdle to overcome.

Performance

The Credit Suisse Leverage Loan Index (“CS LLI”) produced its first positive return since July 2015 (+.09%). In March, the CS LLI was up 2.64% and the S&P Leveraged Loan Index (“S&P/LSTA”) was up 2.76%.

  • For the 12 months ending March 31, 2016, the CS LLI was down -1.11% and the S&P/LSTA was down -1.24%.

Sector Performance

All loan sectors provided positive returns for the month. The sectors that outperformed the most are the sectors that have performed the worst during the last 12 months. Energy, Metals, Retail and Utilities were the top performing sectors with returns of 9.29%, 8.92%, 3.47%, and 3.23%, respectively.

By Industry Total Return

Source: Credit Suisse Leveraged Loan Index

The worst performing sectors in March were some of the better performing sectors during the last 12 months. Food/Tobacco, Consumer Durables, Forest Products and Consumer Non-Durables with returns of 1.03%, 1.24%, 1.34%, and 1.60%, respectively.

The last 12-month returns for Energy, Metals and Utilities provided a few of the worst industry returns in the history of the loan index. The super cycle in commodities weighed heavily on these sectors. Retail has also produced a negative 12-month return; however, it seems to be driven more perhaps by a secular change in the way consumers buy their goods.

By Rating Total Return

Source: Credit Suisse Leveraged Loan Index

Risk rallied in the month as Split Bs and CCCs led returns with Split BBB lagging. As higher rated credits sold off less in the last year, there was less room for them to appreciate in March. Most loans are constrained by the price of par since they are pre-payable at par without penalty.

The largest loans, contained in the S&P/ LSTA Leveraged Loan 100, were even more resilient. Inflows into high yield funds led many high yield investors to buy loans as well. High yield investors tend to focus on the most liquid names in the loan market. As a result, the S&P/LTA Leveraged Loan 100 was up 3.15% in March.

Technicals Conditions

Technical conditions improved in conjunction with the rally in loans. CLO issuance picked up to $4.2 billion in March, from $2.07 billion in February and just $827 million in January. While that is down 74% from the prior year, it did create demand, which helped push prices higher.

Monthly CLO Volume ($B)

Source: S&P Leveraged Loan Index

As retail outflows turned to inflows, net flows between CLOs and Retail Funds turned quite positive. This demand coincided with higher loan prices, which can be seen below.

S&P/LTSA Leverage Loan Index Returns and Loan Inflows

Source: S&P Leveraged Loan Index

On the supply side of the equation, year-to-date issuance has been evenly split between institutional and pro rata deals. This has been driven by a shift in demand with regional banks growing exposure while institutional investors shrink. In March, this trend reversed as institutional issuance was nearly twice the pro rata portion. Issuance essentially follows demand. The increase in institutional demand resulted from three primary catalysts. First, March cash positions were high. Second, repayments from amortization and prepayments of loans due to mergers, acquisitions and refinancing have remained consistent. Simply put, loans keep getting paid down. Consequently, elevated cash levels have only grown from prepayments. Finally, CLO issuance and slight retail inflows have contributed to an overall demand increase.

Leveraged Loan Volume

Source: S&P Capital IQ LCD

The first quarter loan issuance is down roughly 8.5% from 2015. Institutional new issuance is down 27% in the first quarter. Mergers and Acquisitions continue to dominate the new issue calendar as year-to-date 75% of the issuance has been driven by M&A.

U.S. Use of Proceeds for New Issue

Source: S&P Capital IQ LCD

Fundamentals

Single B new issuance YTM tightened 76 basis points in March from February. Since no BB new issuance was closed in February it is difficult to compare. However, the average new issue yield-to-maturity in March was 5.42%, 116 basis points tighter than single Bs and 36 basis points wider than January BB new issue.

New-Issue First-Lien Yield to Maturity

Source: S&P Leveraged Loan Index

In March, there were four new defaults, including Southcross Holdings, Templar Energy, Foresight Energy and Aspect Software. This pushed the LTM default rate to 1.68% based on a par amount. The default rate based on unique issuers as opposed to par amount reached 1.92% in March.

Lagging 12-Month Default Rates

Fourteen of the 24 defaults are in the Energy/Metals 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.

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 & 2009) the 3-year discount margin for the CS LLI is 412 basis points. At month end, the 3-year DM was wide of the historical average, at 621 basis points. However, the 3-year DM has tightened 71 basis points since February. Only 9 times in the history of the index has the 3-year DM tightened more than 71 basis points.

The DM spread differential between BBs and single Bs has widened significantly from March 2015 to March 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

As of March 31, the S&P/LSTA Index was trading at a spread of L+581, suggesting an implied default rate of 5.6%. While this is down from February’s multiyear high of 7.4%, it remains materially wide of recent measures. More importantly, the implied default premium remains above the current default rate and the consensus forecast for the next 12 months.

Therefore, measuring loans by historical valuations and recognizing that the imputed default rates are higher than consensus estimates, both suggest that loans offer a compelling valuation. Certainly March’s rally suggests that the expectation of a nearterm recession was probably overstated and while April does not feel like the loan rally will end in the near-term, the upside does feel limited. With the percentage of loans trading above par at 11.3%, and the percentage of loans trading above $99 at 47.8%, one could assume there is less room for loans to run at these levels. As loans revert to par, the asset class becomes much more of an interest carrying investment. Therefore, taking more risk with higher price loans offer less ability to outperform than when they trade at a substantial discount.

Despite the fact that CLO issuance is proving resilient, it is the lowest issuance since Q1 2012. Issuance will not only be hampered by risk retention, but the rally in loans will make the arbitrage more difficult to achieve for Q2 prospective issuers. The question of whether or not the US economy will be dragged down by a slowing global market will continue until the global economy stabilizes without constant stimulus programs. Therefore, the upside for loans seems to be more limited in the near-term and many fundamental and technical issues need to be resolved before volatility lessens.

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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