March High Yield Credit Update

Monthly Commentary

April 18, 2019

We are officially back! Maybe not to the absolute tights of this cycle set on October 3rd just before the Q4’18 sell-off, but definitely to the general valuation regime which existed for most of 2018. Indeed, at +205 basis points (bps), current BB-rate credit spreads are actually inside the +222bps average valuation during the first three months of last year. Single-B spreads are within basis points of that period’s average. CCC valuations, as we highlighted previously, have lagged amid this recovery.

Current Valuations are Back In-Line with Pre-Q4’18 Levels (Save for CCCs)

Current Index OAS as of 4/14/19
Source: Bloomberg

These aggregates, however, in many cases understate the true extent of the rebound, particularly as it relates to high quality, non-cyclical credit risk. Using the benchmark bond for high yield bellwether Charter Communications as a general barometer (the CHTR 5 28), relative to October 3rd, the price of the bond is +5pts higher, spreads are -25bps tighter and all-in yields (given the move in interest rates) are -0.75% lower! So, as stated previously, in many respects…we are back. Corporate earnings and management guidance will be the next test to the market’s fundamental assumptions as seemingly a lot of optimism is now priced into securities.

Market Performance

High yield bond prices furthered their advance in March, though this month the tailwinds stemmed principally from the move lower in interest rates, rather than an incremental compression in credit spreads (though to be certain, credit risk remained well bid during the month). The high yield market returned +0.94%, bringing the total return for the year to +7.26%, the best first quarter performance for high yield bonds in over two decades!

With interest rate duration a positive in March, more rate sensitive BB bonds extended the outperformance we have observed this rally and have now earned greater absolute as well as risk-adjusted returns relative to CCC-rated debt through the first quarter. Indeed, BB-rated credit has returned +7.21% year-to-date while CCCs have returned +7.15%. While rate sensitivity explains part of the total return story, the fact remains that higher quality credit spreads have experienced a far more pronounced recovery from the December wides than that of lower quality risk. An intriguing composition to the rally (which we previously branded a riskaverse rally), seemingly signaling investor skepticism in the prevailing fundamentals remains elevated.

Source: Bloomberg, Barclays

The general reflationary environment has lifted nearly all boats, save for those that have sprung a leak. Feels like an appropriate analogy considering the drag a growing number of capital structures have had on the Independent E&P sector. In March, it was Halcon Resources (challenged well results) and EP Energy (liquidity concern sparking fear of a possible restructuring), though these credits are just the recent additions to an expanding cohort of Energy credits that have completely lost sponsorship in recent months (discussed further at the end of this memo). Notably, the credit stress (seemingly isolated for now) has emerged despite the broader market reflation, including a ~45% recovery in spot oil prices (again, the risk-averse rally).

Source: Bloomberg, Barclays

Market Technicals

The technicals have yet to waver this year, creating (once again) the impression the market can continue along this path unfettered for the foreseeable future. Nothing lulls the market into complacency like supportive technicals. March welcomed incremental capital into the high yield marketplace. We have now amassed over $12bn of net inflows year-to-date (recall this follows a -$47bn exodus from the sector in 2018). This, along with coupon payments and low net primary issuance, has been supportive of the recent upward momentum in high yield bond prices.

Fixed-Rate Credit Has Seen Robust Retail Demand in a Rotation Away from Loans and Equities

Source: Credit Suisse, EPFR

February’s pace of issuance was sustained in March as an incremental $21bn of USD-denominated debt cleared the primary market during the month. This cohort of syndicated bonds has generally fared well in secondary trading (several deals have appreciated +2-5pts in just a few weeks), similar to the January and February batches. This has naturally had a positive feedback (from the issuers’ perspective) to April’s deals, resulting in recent issues clearing at seemingly aggressive valuations and subsequently realizing lackluster secondary performance. Still, with demand firm and all-in yields trending back to cyclical lows, we would expect opportunistic financing volumes to ramp as borrowers look to take advantage of accommodative funding conditions.

Source: Barclays

Fundamental Trends

In the context of a marketplace that has seen de minimis corporate defaults over the past several quarters, volumes in March seemed rather elevated. Five debtors defaulted on their obligations (including both high yield bonds and leveraged loans) during the month, affecting $2.5bn of debt. Prominent among the defaulted companies were those involved in oil and gas exploration and production (as well as certain service providers), including Jones Energy, Vanguard Natural Resources (both Independent E&Ps) and PHI, Inc. (operates a fleet of helicopters that provides transportation services to offshore producers). As mentioned above, amid the broader recovery, a growing list of Energy-related capital structures are beginning to lose sponsorship and be forced to consider restructuring. Bristow is another helicopter operator that is seemingly nearing bankruptcy, while Alta Mesa and EP Energy have hired advisors to explore restructuring options. At present, these appear to represent discrete issues, though the trend is notable and worth ongoing monitoring.

Source: Bloomberg



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