Loan Review – April 2016

Monthly Commentary

May 07, 2016

The strong rally which began in late February continued through April. How dramatic of price move has there been? The 4.6% 2-month return in March/April is the strongest 2–month return since August and September 2009. The 2016 rebound in loan prices has coincided with an improvement in sentiment in the broader capital markets, strong appreciation in commodity markets and a slight increase in CLO demand/origination. This combined with limited new issue supply and low dealer inventories has led to a rapid bounce back in prices.

Interestingly, in August and September 2009, the 3-year discount margin was 7.8% while the current 3-year discount margin is 5.8%. The magnitude of return the last two months is astonishing at current valuation levels. Technical conditions seem to be exacerbating price movements, both up and down. 

The CLO market continues to have unresolved structural issues. While issuance was more positive in March and April and liabilities spreads have improved, liabilities are not tightening as rapidly as collateral levels. 47% of domestic institutional loans now trade $99.50 or above versus only 9% in February. This makes a natural arbitrage difficult to achieve. With risk retention weighing on CLO generation and roughly 20% of CLO reinvestment periods ending before 2018, CLO demand will likely remain tepid compared to the last few years.

While lower CLO issuance creates concern regarding future loan volatility, the more pressing issue managers have faced has been the ratings momentum in the current environment. Per Bloomberg, YTD, Moody’s downgraded 451 high yield companies (including Watch Status) versus 124 upgrades. The Up/Down ratio was the lowest ratio since 2008. The significance of the downgrades is material for CLO managers, who typically account for roughly 60% of the loan demand. As ratings move lower, CLO managers can be restricted from purchasing these loans. The consequence of these decisions is simple. When prices go down for performing companies, they become more attractive purchases. But when the agencies become overwhelmingly negative, often based on forward looking scenarios rather than backward looking results, they negatively impact the ability of managers to take advantage of such opportunities. Regardless of the global macroeconomic outlook, it is hard to envision loans maintaining the recent torrid pace of price appreciation. Roughly half of the Index already trades near par or better. The closer the Index price gets to par, the more the asset class becomes an interest-carry investment story.

Performance
In April, the Credit Suisse Leverage Loan Index (“CS LLI”) was up 1.90% and the S&P Leveraged Loan Index (“S&P/LSTA”)
was up 1.99%.
  • Year-to-date ending April 30, 2016, the CS LLI was up 3.25% and the S&P/LSTA was up 3.56%.
  • For the twelve months ending April 30, 2016, the CS LLI was down -0.1% and the S&P/LSTA was down -0.21%.
Sector Performance
All loan sectors provided positive returns for the month. The sectors that outperformed the most in April are the sectors that have performed the worst during the last 12 months. Energy, Metals and Utilities were the top performing sectors with returns of 11.67%, 10.57%, and 5.15%, respectively.

Total Return By Industry



Source: Credit Suisse Leveraged Loan Index

The worst performing sectors in April were some of the better performing sectors during the last 12 months. Food and Drug, Consumer Non-Durables and Consumer Durables provided the worst monthly returns of 0.89%, 1.04% and 1.07%, respectively.

The year-to-date returns for Metals and Mining, Energy and Retail are astounding as gains are: 9.47%, 4.78% and 4.43%, respectively. Returns for Metals have been overwhelmingly driven by Fortescue, which is one-third of the CS LLI Metals and Mining exposure. Fortescue returns have been driven by a better pricing environment for Iron Ore as well as balance sheet management as the Company has paid down over $1.0 billion of debt YTD.

Total Return By Rating



Source: Credit Suisse Leveraged Loan Index

As loan prices revert to par, as the rally continues, higher quality names are limited in potential returns. Most loans are pre-payable at par without penalty and therefore upside is limited in terms of price appreciation. Lower priced, lower quality names still have the ability to trade higher. This is evident in April returns as returns are more limited in Split BBBs, BBs and Split BBs. However, higher beta rating categories of Single B, Split B and CCC provide much more upside during the rally. Another way to think about it is that higher rated credits sold off less in the last year; therefore, there was less room for them to appreciate in April.

Further looking at price levels of the loan universe, 47% domestic institutional loans now trade $99.50. More specifically, 24% of loans now trade above par versus 23% between $99.50 and $99.99.

Technical Conditions
Technical conditions improved in conjunction with the rally in loans. CLO issuance picked up to $4.8 billion in April, up from $4.2 billion in March. While that is down 53% from the prior year and YTD volumes are down 71% from the prior year, the additional demand was quite positive for returns.

Monthly U.S. CLO Volume



Source: S&P Leveraged Loan Index

Retail outflows remained muted in April and net flows between CLOs and Retail Funds have been positive. This demand has pushed loan prices higher, which is evident in the graph below.

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



Source: S&P Leveraged Loan Index

Beyond natural loan demand generated by loan funds and CLOs are a few other factors. First, cash positions were high for institutions. This is in part a result of significant volatility and it is in part due to high levels of loan repayments/prepayments. Second, there have been over $17 billion of inflows for high yield funds since mid-February. As high yield has rallied, some of that demand has been allocated to loans, which has added additional demand.

On the supply side of the equation, year-to-date issuance has been evenly split between institutional and pro rata deals. Pro rata supply has been pretty consistent this year as a result of regional bank demand. Institutional issuance has been more volatile as March and April issuance was 44% higher than January and February. Issuance is simply following demand.

Leveraged Loan Volume



Source: S&P Capital IQ LCD

Total YTD loan issuance is down roughly 18% from 2015. Institutional new issuance is down 32% during the same period. Mergers and Acquisitions continue to dominate the new issue calendar as 75% of the issuance year-to-date has been driven by M&A. However, the M&A activity has not been enough to satiate demand and we have begun to see the emergence of some refinancing activity. The purpose of the institutional issuance in April can be seen below. 63% of the issuance was related to M&A activity. 32% of the activity was opportunistic as refinancing existing deals and financing dividends became part of April’s new issue activity.

Institutional New-Issue Volume ($21.0B)



Source: S&P Leveraged Loan Index

Fundamentals
Single B new issuance YTM tightened 62 basis points in April from March. BB new issuance was tightened 19 basis points in April. However, the average new issue yield-to-maturity in April was 5.88%, which is now actually tighter than December 2015 by 4 basis points. This highlights the magnitude of the rally year-to-date.

New-Issue First-Lien Yield to Maturity



Source: S&P Leveraged Loan Index

In April, there were four new defaults including Midstates Petroleum, Core Entertainment, Peabody Energy and Vertellius Specialties. LTM default rate actually dropped to 1.68% based on a par amount; however, $38.9 billion or 4.4% of companies in the S&P LLI are in default. The default rate based on unique issuers, as opposed to par amount, stayed flat at 1.92% in April.

Lagging 12-Month Default Rates



Source: S&P Capital IQ LCD
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.

 

Seventeen of the 25 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 462 basis points. If you exclude the global financial crisis (2008 & 2009) the 3-year discount margin for the CS LLI is 413 basis points. At month end, the 3-year DM was wide of the historical average, at 578 basis points. The 3-year DM has tightened 43 basis points since March and was the 8th most significant monthly tightening since January 2010.

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

3-Year Discount Margin Differential Between BBs and Single Bs



Source: Credit Suisse Leveraged Loan Index

CS LLI Snapshot



Summary

As of April 30, the S&P/LSTA Index was trading at a spread (based on yield) of L+588. This suggests an implied default rate of 4.9%. This is down from March’s imputed default rate of 5.6% and is the lowest measure since August 2015. However, the implied default premium remains above the current default rate and the consensus forecast for the next 12 months, which suggests investors are anticipating a more rapid rise in defaults.

Returns have been driven by a positive recovery in most capital markets combined with a technical environment that has created more loan demand than loan supply. While M&A activity is driving the new issue calendar, it has not generated sufficient deal flow to meet demand. High levels of prepayments coupled with high levels of cash and mild CLO issuance have overwhelmed supply. When pending repayments (about $31.6 billion as of April 27, as tallied by LCD) are subtracted from the $36 billion forward calendar, net forward supply is only $4.4 billion.

In light of the large price increase in the last two months, coupled with the fact that there will be low levels of CLO generation for the remainder of the year, loan returns should be closer to interest carry and not benefit as much from price appreciation.

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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