Loan & CLO Review – April 2019

Monthly Commentary


Risk loving investors emerged in April. Against the backdrop of a strong equity market, loan prices jumped higher and produced comparable returns to high yield bonds during the month. By month end, nearly 30% of loans traded above par with approximately 39% of loans trading in the $99-$99.99 range. With little institutional new issue in the loan market and the strongest monthly CLO production (excluding refinancings and resets) in four years ($15.7 billion), the loan market had little opportunity to do anything but go higher. The relentless issuance of CLOs in April was counterintuitive to the arbitrage available to equity investors. However, the number of permanent equity capital vehicles raised (an unintended consequence of risk retention) continues to drive their creation.

Loan prices were up 1.15% during the month and actually increased in 20 of the 21 trading sessions. The first part of the month was strongest as nearly 80% of the gain was provided in the first 15 days.

The mismatch between supply and demand led to opportunistic loan issuance. Dividend recaps emerged with nearly 14% of the month’s institutional supply coming from equity holders taking money out of businesses while adding debt. We also saw a number of refinancings and amend-to-extend deals printed during the month.

U.S. Leveraged Loan Amend-to-Extend Volume

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

Performance - Loans

In April, the Credit Suisse Leveraged Loan Index (CS LLI) and the S&P Leveraged Loan Index (S&P/LSTA) were up 1.59% and 1.65%, respectively.

  • Year to date, ending April 30, the CS LLI was up 5.42% and the S&P/LSTA was up 5.71%.
  • For the 12 months ending April 30, the CS LLI was up 4.41% and the S&P/LSTA was up 4.24%.

The distressed segment of the loan market led all categories in April with a 3.82% return. This was followed by split single B and split double B. On a year-to-date basis, similar themes exist with the distressed category leading all segments (9.35%) followed by split single Bs (7.39%) and split double Bs (5.97%).

On an LTM basis, the exact opposite trend existed with higher quality loans outperforming the distressed segment of the market. For the LTM period, distressed loans were up 0.99% while split triple Bs, double Bs, split double Bs and single Bs were all up more than 4.0%.

Total Return by Rating

Source: Credit Suisse Leveraged Loan Index

Sector Performance

All 20 sectors provided positive returns in the CS LLI for the month. The top performing sectors were Retail (2.48%), Food & Drug (2.11%) and Housing (1.98%). The worst performing sectors were Metals/Minerals (0.95%), Consumer Durables (0.82%) and Energy (0.66%).

On a year-to-date basis, Food & Drug (7.75%), Retail (7.30%) and Metals/Minerals (6.51%) were the top performing sectors.

In the last 12 months, Retail, Food & Drug and Utility have led all sectors with total returns of 7.63%, 5.84% and 5.66%, respectively. Retail continues to lead all categories in defaults during the last 12 months as well as to lead in returns. In contrast, Food/Tobacco, Manufacturing and Consumer Durables were the worst performing sectors with returns of 3.54%, 3.49% and -0.12%, respectively.

Industry Returns

Source: Credit Suisse Leveraged Loan Index

CS LLI prices increased 115 basis points (bps) in April while the average bid of the S&P LCD flow-name loan composite increased 72 bps from 98.89 to 99.61. The average flow name bid is up 363 bps on a year-to-date basis.

Average Loan Flow-Name Bid

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

Performance - CLOs

Given strong loan performance, CLO mezzanine (mezz) tranches performed well over the month with single As and triple Bs tightening 10-15 bps and double Bs ~20 bps. Short triple As also tightened 5-10 bps during the month with spreads moving inside 100 bps discount margin (DM) for deals with less than two years left in reinvestment. Longer triple A spreads remained in the 125-140 DM range but caught a bid towards the end of the month with tier 1 triple As tightening 5 bps to 120 DM (15 bps basis to primary).

Secondary CLO 2.0 Total Returns

Source: JPM CLOIE

Secondary CLO 2.0 Spreads (DM)

Source: TCW

CLO equity performed well as NAVs increased 12 points, month-over-month, due to loan price appreciation. In addition, collateral WAS stabilized, improving Q1 2019 distributions by 20-30 bps vs. Q4 2018.

Technical Conditions- Demand

April retail loan outflows were approximately -$3.2 billion. The week ending May 1st represented the 24th consecutive withdrawal for the asset class, although, the last two weeks were slightly more modest. Outflows for floating rate loan funds now total -$34.5 billion since the beginning of the fourth quarter 2018. AUM for the loan mutual fund base is down to $120bn from as high as $154bn in October.

Countering retail outflows, CLO primary markets proved resilient with over $15 billion pricing in April, the second highest monthly issuance to date. YTD we have seen $44bn of new issue, up 5% y-o-y. Managers navigated the tight arbitrage by issuing shorter deals and offering a variety structural features to appeal to more buyers. About one-third of deals priced with the AAA tranche split into a Sr/Jr structure where the Sr. AAAs (40% CE) were preplaced at 133dm (5-year reinvestment). Toward the end of the month we saw a regular way AAA (36% CE) also price at 133dm. Short deals were in high demand as two static deals priced with the AAAs oversubscribed.

Refi and reset supply has been down considerably this year. Only eight refi/resets priced in April vs. 40 in April 2018, as high liability costs provided little-to-no savings for deals exiting their non-call period. The average cost saving from a refi/reset that priced in 2018 was 65 bps vs 35 bps for those priced in 2019.

CLO New Issuance

Source: TCW

New Issue Tier 1 Spreads (bps) - 5yr reinv

Source: TCW

April New Issue BSL AAA DM

Source: TCW

Technical Conditions- Supply

Contributing to the technical backdrop that allowed for strong loan performance during the month was the fact that institutional new issuance in April was $29.7 billion. This was the second lowest total of the year.

Leveraged Loan Volume

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

April acquisitions, mergers and LBOs represented 50% of primary issuance, which was well below the 67% mark set for the first quarter. As demand for loans increased, we saw an increase in more speculative, opportunistic deals, which included a significant increase in dividend recapitalizations. In addition to this, there was increase in amend-to-extend activity.

Institutional New Issue Volume in April

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

Loan fund outflows have been offset by strong CLO production. This combined with the crossover high yield buyers created strong demand for loans. In April, increased demand contributed to the LTM return.

Inflows and Rolling LTM Returns

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

New issue spreads in April tightened but remained -0.8% and -11.6% on a year-to-date basis. New issuance spreads remained 26.2% wider than 12 months prior.

New Issue Spread Changes

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

In terms of new issue yields, Double B yields tightened month-over-month by 39 bps while Single B yields were flat.

Average New-Issue Yields

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

Fundamentals - Loans

There were three defaults in April, Fusion Telecommunications (Telecom), Crossmark Holdings (Business Services) and Southcross Energy Partners (Oil & Gas). The default rate changed from 0.93% in March to 1.01% in April.

The last-12-month default tally for the S&P Leveraged Loan Index is 19. Retail leads all categories with four while Oil & Gas has declined to just two defaults.

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

Fundamentals – CLOs

The three loan defaults in April had minimal impact in CLOs with the average CLO default rate remaining below 1%. Managers improved WAS cushions by 5 bps, according to Fitch, with 60% of CLOs now having a WAS cushion greater than or equal to 10 bps (vs. 50% in Dec). CCC/ Caa buckets remained steady in the 3-3.5% range; however, WARF levels rose as B3/B- exposure continues to increase.

Valuation

Since 1992, the average 3-year discount margin (“DM”) for the CS LLI is 460 bps. If the global financial crisis (2008 & 2009) is excluded, the 3-year discount margin for the CS LLI is 417 bps. The 3-year DM finished the month at 429 bps, which tightened 38 bps from the prior month.

The DM spread differential between Double Bs and Single Bs is 30 bps wider from April 2018 to March 2019; however, it is still 8 bps tighter than the historical spread differential.

3-Year Discount Margin Differential Between BBs and Single Bs

Source: Credit Suisse Leveraged Loan Index

Summary & Looking Forward

As of April 30, the S&P/LSTA Index imputed default rate was 1.79%, down from 2.34% in the prior month. Despite a troubled natural arbitrage, CLO issuance boomed during the month of April. This factor, combined with moderating retail loan outflows and consistent crossover high yield buyers, led to significant loan price appreciation during the month. Higher risk outperformed higher quality loans as buyers looked to add discounted loans. However, it is important to remember that the winds of “risk on” or “risk off” have varied greatly during the last several years. Consequently, loans’ technical conditions have changed dramatically from month to month as loans have had episodic volatility. The April return of 1.59% and the year-to-date return of 5.42% are outsized returns for the loan asset class. We would expect this volatile “ebb and flow” pattern to persist through the year.

In terms of the CLO supply/demand outlook, if we follow the trend from the end of April, we are on a path of spread tightening in the secondary market which will most likely have a follow-on effect in the primary market. New issuance numbers are very similar to last year; however, when taking refi and reset activity into account, new issue supply is dramatically lower y-o-y. Given low loan supply and the challenging arbitrage, it is expected that CLO issuance will also be limited in the near future. With low supply expectations, robust levels of investor cash, coupled with the fact that CLO spreads have underperformed YTD, buyers are seeing the relative value in CLOs vis-à-vis other structured and corporate asset classes and thus spreads should remain well supported.

 

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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