While economic growth has hovered around 2% during the
past 12 months, the loan market has had significant volatility.
It was down for eight consecutive months and up for the
last three. The rolling 12-month return for the Credit Suisse
Leveraged Loan Index, excluding the global financial crisis,
has provided negative returns in only eight months since
1992. Six of those months were found in the last year. The
last 12 months also included the seventh largest 2-month
gain since inception of the index. Therefore, without a true
change in the underlying fundamental performance of most
borrowers, the drop and subsequent rally in loans has been
no-less-than astonishing. Obviously, commodity-driven loans
have had material changes in financial performance, but
broadly speaking, much of the volatility has been driven by
macroeconomic factors that perhaps in the past did not
impact the loan market to the same degree as they have in
more recent years. Since these risks/macroeconomic factors
are unresolved (loose global monetary policy, Brexit, OPEC,
a slowing Chinese economy), it is only logical to believe the
loan market will continue to have episodic volatility. Given
the fact that par loans can only really possess asymmetrical
volatility, it is difficult to reconcile the fact that at the end
of May 38.4% of loans traded above par. Secondary market
trading volumes have been depressed. Chasing prices
above par when assets are refinance-able at par is a difficult
proposition. As a result, the market is collectively in a waiting
place, waiting for the demand/supply imbalance to come
back into equilibrium.
Performance
In May 2016, the Credit Suisse Leverage Loan Index (“CS
LLI”) was up 0.91% and the S&P Leveraged Loan Index
(“S&P/LSTA”) was up 0.89%.
- Year-to-date ending May 31, 2016, the CS LLI was up
4.19% and the S&P/LSTA was up 4.49%.
- For the twelve months ending May 31, 2016, the CS LLI
was up 0.58% and the S&P/LSTA was up 0.49%.
Sector Performance
Energy and Metals continued to outperform other bank
loan sectors for the third consecutive month while Gaming
provided the third best sector return in May. The top three
performing industries posted returns of 5.03%, 2.86%, and
1.52%, respectively. The Energy and Metals sectors are
significantly comprised of deeply discounted names tied
to commodity prices. Given the surge in crude oil prices,
as well as many other commodity prices, these discounted
credits have rallied for three consecutive months. Gaming
is a sector populated primarily by par credits; however, there
are a handful of lower-rated gaming credits, which trade at a
discount and have helped to drive sector performance.
Total Return by Industry
Source: Credit Suisse Leveraged Loan Index
The worst performing sectors in May were Retail, Utilities and Food and Drug with returns of -0.53%, -0.20% and 0.23%, respectively. The retail sector has been beset with a host of problems, which included poor earnings from many of the leading participants in the first quarter of 2016 and the fourth quarter of 2015. Performance of Utilities deteriorated in May after a strong rebound the prior two months. Utilities could not extend the 2-month rally given the fact that natural gas remained depressed during the month and the fact the PJM regional transmission organization had a disappointing auction. Finally, Food and Drug has lagged the broader Index as many of the credits in the Index tend to be higher-rated, lower spread, already trading above par. These characteristics tend to underperform when risk rallies.
The year-to-date returns for all sectors in the CS LLI are positive. Metals and Mining, Energy and Gaming are the top performing industries, with returns of 12.60%, 10.05% and 5.58%, respectively. Food and Drug, Financials, and Forest Products have lagged with returns of 2.59%, 2.71% and 2.95%, respectively.
Total Return By Rating
Source: Credit Suisse Leveraged Loan Index
Returns for May have largely been driven by quality and lower quality has outperformed. Given the negative convexity of loans, returns become limited to coupon as prices revert to par. The percentage of loans trading above par has climbed to 38.4% and the percentage of loans trading above $99.5 has risen to 58.4%. Consequently, the closer the index gets to par, the more likely the returns will simply mirror coupon returns. Since the monthly coupon for the CS LLI equates to roughly 40 basis points, any return in excess of that implies price appreciation.
Technical Conditions
Technical conditions improved in March, April and May. May CLO issuance was $5.4 billion, down slightly from $5.9 billion in April. Year-over-year, May issuance was down 66% and year-to-date volumes are down 58% versus the same time period in 2015. While year-to-date CLO volumes have outperformed our issuance expectations, they will more than likely begin to slow as the second quarter grinds on, simply due to the rally in loan (collateral) prices.
Monthly U.S. CLO Volume
Source: S&P Leveraged Loan Index
Retail funds posted their first inflow (+$0.44 million) since July 2015. Demand seemed to be spurred by the rising odds of a summer Fed rate hike. However, as the odds of such a hike fade, the flows may again turn negative.
S&P/LSTA Leverage Loan Index Returns and Loan Inflows
Source: S&P Leveraged Loan Index
Persistent retail outflows, elevated levels of loan volatility and significant repayments/prepayments led to investors holding high levels of investable cash to begin the month. These factors helped create an environment conducive for a rally. Retail flows turning positive in May only further exacerbated the demand/supply imbalance. As can be seen above, as inflows become more positive, the trailing 12-month returns recover.
Prior to May, year-to-date institutional issuance and pro rata issuance was evenly split. However, in May, institutional issuance not only posted its strongest month of the year with $33.1 billion of loans syndicated but it also was nearly three times greater than the month’s pro rata new issue volume.
Leveraged Loan Volume
Source: S&P Capital IQ LCD
Total year-to-date loan issuance is down roughly 12% from 2015. Institutional new issuance is down 18% during the same period. Mergers and Acquisitions, which have dominated the calendar for most of the year dropped to ~64% of the issuance year-to-date. As a result of elevated secondary loan prices in May, we have begun to see a significant amount of opportunistic financings, which include dividend deals and repricings (which simply lower the coupon on an outstanding loan). Repricing volume, which had been non-existent for the prior six months, soared to $17.38 billion in May.
Institutional New-Issue Volume ($99.5B)
Source: S&P Leveraged Loan Index
The trend of repricing loan deals is accelerating in June. Over 55% of the deals currently in syndication are repricing their existing term loans and another 14% are dividend recapitalizations. Therefore, LBO and M&A driven deals, which drove issuance for most of the year now only represent roughly 22% of the new issue calendar.
These repricings will further make the generation of new CLOs difficult and if the trend is prolonged, it could pressure the interest cushions of the outstanding CLO universe.
Fundamentals
Single-B new issue yield-to-maturity tightened 7 basis points in May from April. BB new issuance widened 2 basis points in May. However, the average new issue yield-to-maturity in May was 5.49%, which was 99 basis points tighter than February 2016 and 49 basis points wide of the tightest level in 2015 (May 2015).
New-Issue First-Lien Yield to Maturity
Source: S&P Leveraged Loan Index
In May, there were five new defaults including Seventy Seven Energy, Dex Media, Breitburn Energy, Atlas Iron and Fairway Group. LTM default rate increased to 1.96% based on a par amount. The default rate based on unique issuers also increased to 2.23%
in May.
Lagging 12-Month Default Rates
* 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.
18 of the 28 defaults are in the Energy and 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.
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 414 basis points. At month end, the 3-year DM was wide of the historical average, at 560 basis points. The 3-year DM has tightened 17 basis points since April and is the tightest level since August 2015.
The DM spread differential between BBs and single Bs has widened from June 2015 to May 2016 by 32 basis points. It is also 49 basis points wide of the historical spread differential.
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 May 31, the S&P/LSTA Index was trading at a yield-to-maturity of 5.3%. This suggests an implied default rate of 4.5%. This is down from April’s imputed default rate of 4.9% and is the lowest measure since July 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.
Over 7% of the index trades below the price of 80. Approximately one-quarter of the distressed component of the index is found in Energy. West Texas Crude (“WTI”) now is currently trading above 50 for the first time since July 21, 2015. There is a portion of the loan Energy sector that becomes more viable if WTI trades consistently above 60. Consequently, if WTI continues higher, the loan market could also see a reduction in the shadow default rate and the market’s risk premium.
Returns in May were driven by a positive recovery in most capital markets combined with a technical environment that simply consists of more loan demand than supply. However, as prepayments of loans moderate and CLO issuance wanes, equilibrium between supply and demand should begin to occur. As opportunistic refinancings continue and average loan coupons are reduced, there is a risk that interest coverage tests for existing CLOs will come under more pressure. Increased loan prices, lower loan yields and shrinking coupons will also make new CLO generation more difficult.