Loan Review – June 2016

Monthly Commentary

July 11, 2016

Contradictions do not exist. Whenever you think you are facing a contradiction, check your premises. You will find that one of them is wrong.
- Ayn Rand

Brexit stole all headlines in June and its impact was felt immediately the world around. On June 23rd, as results began to be released from unfamiliar jurisdictions in Britain, the loan market was sitting on a reasonable month’s performance. Up 26 basis points with seven trading sessions remaining, the return was pacing slightly behind the index’s monthly coupon. With a lack of earnings set to be released for the remainder of the month and a dwindling new issue calendar, the loan market seemed to be ushering in the beginning of a quiet summer. Surely no one in Britain would be mad enough to voluntarily introduce a monsoon of uncertainty into their economy. Except, they did just that. The world’s equity markets immediately began to wobble, commodity markets roiled and credit markets began to weaken. And strangely, all this occurred as Nigel Farage strutted in front of the camera as if the fight was over, instead of just beginning.

The day following the UK referendum, loan monthly returns immediately turned negative. The following two days posted the weakest two-day result since December 14, 2015. Adding insult to injury, stories emerged that the most prevalent Google searches, in the UK, following the vote were “What does it mean to leave the EU?” Only after the vote, did the voters begin to try to understand what they were voting on.

However, despite all this uncertainty, despite the drumbeat of potential ramifications that will result from Brexit, the selling was very orderly. Overwhelming retail fund outflows never materialized and by Tuesday the following week, buyers began to emerge to take advantage of the mild discounts that had been created. Several newly syndicated CLOs helped to create stability within the market. The loan market reaction was not unique, the broader credit markets, the equity markets and even some commodity markets all seemed to shake off the blow. And that is where we sit today. Markets continue to perform generally well despite a growing list of economic concerns. Equity markets continue to set record highs while corporate earnings continue to grow sluggishly. The contradiction between the strength of the economy and the strength of financial markets has seemingly persisted now for years. The incongruity between an economy in need of financial stimulus to prevent sub-optimal growth and a resilient and robust financial market was astonishingly apparent in June.

Performance

In June 2016, the Credit Suisse Leverage Loan Index (“CS LLI”) was up 0.03% and the S&P Leveraged Loan Index (“S&P/LSTA”) was up 0.02%.

  • Year-to-date ending June 30, 2016, the CS LLI was up 4.23% and the S&P/LSTA was up 4.51%.
  • For the twelve months ending June 30, 2016, the CS LLI was up 0.93% and the S&P/LSTA was up 0.89%.

Sector Performance

In June, the top three performing sectors were Energy, Metals & Mining and Utilities, which posted returns of 3.27%, 2.85%, and 2.11%, respectively. The Energy and Metals & Mining sectors are significantly comprised of deeply discounted names tied to commodity prices. The rally that has taken place in higher beta, lower quality loans throughout the second quarter continued for the first three weeks of June. While Energy weakened the last week of the month, the sector still provided outsized gains.

Metals & Mining benefited from a $500 million par pay down of the term loan by Fortescue in June, which helped pushed the loan price higher. The company has made (including bond tenders) a total of approximately $2.9 billion debt repayment in fiscal year 2016. Fortescue is the largest borrower in the Metals industry and its rally has positively impacted the sector. Performance within the Utility sector has been driven by an improving outlook for natural gas as well as a hot start to the summer in many parts of the country. Record temperatures in the Southwest have led to higher spark spreads within the ERCOT region and helped push loan prices higher.

Total Return by Industry

Source: Credit Suisse Leveraged Loan Index

The worst performing sectors in June were Retail, Media/Telecom and Financials with returns of -0.59%, -0.50% and -0.42%, respectively. Many of the leading participants in the Retail sector posted disappointing first quarter earnings results. There has been little good news following Q1 2016 earnings and many retail loans have subsequently drifted lower. Media/Telecom also lagged the Index. The Media sector is a diverse group of borrowers, including print publishers, internet related media companies as well as more traditional media borrowers. A number of these off-the-run, unrelated borrowers have declined in price and weighed on the sector more broadly. Performance of Financials was also weak in June as several borrowers like Walter Investments, JG Wentworth and York Risk Services all declined between 4 and 14 points during the month.

The year-to-date returns for all sectors in the CS LLI are positive. Metals & Mining, Energy and Utilities are the top performing industries, with returns of 15.82%, 13.65% and 6.06%, respectively. While these commodity driven industries have performed very well year-to-date, Energy loans seem to have weakened post Brexit. Food and Drug, Forest Products and Financials have lagged the Index with returns of 2.86%, 2.86% and 2.29%, respectively.

Total Return By Rating

Source: Credit Suisse Leveraged Loan Index

CLOs and retail funds primarily invest in single B loans or higher. Most of the ratings classes targeted by CLO investors provided negative returns for the month. Split BBBs managed the only positive return for par loans. The distressed sectors, which are typically not targeted by CLO investors, provided positive returns for the month. However, it should be noted that the distressed returns were much higher during the first three weeks of the month and then weakened post Brexit.

Currently, the percentage of loans trading above par is approximately 19.0% and roughly 45.2% of loans now trade $99.50 or above.

Average Bid of theS&P/LSTA Index

Source: S&P Leveraged Loan Index

During May and the first three weeks of June, roughly 40% of the market was trading above par. Given the fact that few loans benefit from very substantial call protection, borrowers will often look to lower coupons on loans that trade at a persistent premium. Typically when 50% of the market trades above par, opportunistic financings (repricings and dividends) will occur in abundance. The short-lived weakness post Brexit stopped the opportunistic refinancing wave that had begun in May.

Repricing vs. Dividend

Source: S&P Leveraged Loan Index

It should be noted that in July, the asset class has already recouped ~70% of the loan price decline that occurred in response to the UK referendum.

Technical Conditions

June marked the first month of 2016 with CLO issuance over $6.0 billion. For the second quarter and year-to-date CLO issuance was $17.5 billion and $25.7 billion, respectively. For the first six months of 2016, CLO volumes are down 57% year-over-year. While year-to-date CLO volumes have outperformed our issuance expectations, they will more than likely slow in the second half of 2016 due to current collateral prices and current liability costs.

Monthly U.S. CLO Volume

Source: LCD, a division of S&P Global Market Intelligence

Retail funds posted a very small outflow in June (-$0.08 million).

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

Source: S&P Leveraged Loan Index

Elevated levels of loan volatility and significant repayments/prepayments have led investors to hold high levels of investable cash. Consequently, when Brexit occurred and loan prices declined, material balances of cash balances coupled with CLO inflows created almost immediate market stability. As can be seen above, as net inflows (CLO inflows plus mild retail fund outflows) turned positive, the trailing 12-month returns turned positive.

In May and June institutional issuance dramatically increased as compared to pro rata issuance. This was in part driven by the spike in opportunistic refinancings and dividend deals, which became a much larger portion of the primary calendar.

Leveraged Loan Volume

Source: S&P Leveraged Loan Index

Total year-to-date institutional loan issuance is down roughly 15% from 2015. Mergers and acquisitions, which dominated the calendar in the first quarter, dropped to approximately 57% of the issuance year-to-date. Repricing volume, which had been nonexistent for the prior six months ballooned in the second quarter.

2016 YTD Institutional Loan By Purpose

LoanStats Weekly – June 30, 2016

Fundamentals

Single-B new issue yield-to-maturity widened 17 basis points in June from May. BB new issuance widened 33 basis points in June. However, the average new issue yield-to-maturity in June was 5.35%, which was 113 basis points tighter than February 2016.

New-Issue First-Lien Yield to Maturity

Source: S&P Leveraged Loan Index

In June, there were no additional defaults. LTM default rate remained essentially flat at 1.97% based on a par amount outstanding. The default rate based on unique issuers also remained flat at 2.22% in June.

Lagging 12-Month Default Rates

Source: S&P Global Market Intelligence

* 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.

16 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. 2.5% of the CS LLI is made up by Energy borrowers trading below a price of 75. Excluding commodity driven sectors, the average bid of retailers has also been in decline following a number of revised earnings forecasts and disappointing results from a wide array of borrowers.

Valuation

Since 1992, the average 3-year discount margin (“DM”) for the CS LLI, is 463 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 581 basis points. The 3-year DM widened 21 basis points since May.

The DM spread differential between BBs and single Bs has widened from July 2015 to June 2016 by 34 basis points. It is also 53 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

The average bid price of the S&P/LSTA Index as of June 30 implied a spread of L+531, which suggests an imputed default rate of 4.63%. That is up from 4.49% at the end of May but considerably below the multi-year high in February of 7.3%. In either case it is nearly twice as high as the existing default rate and implies that the market will likely see an increase in default rates in the next 12 months.

Over 8.5% of the index trades below the price of 75. Approximately 30% of the distressed component of the index is found in Energy. While the Retail industry remains a potential battle ground for defaults, Energy will likely drive the default rate during the next 12 months.

Returns in June were driven by Brexit, however, the technical conditions in the market still provided for a strong rebound in prices. In fact, barring a macro-related event spilling into the loan market, it would seem that loans should remain well bid through the summer.

The new issue calendar remains light with only $25 billion of mergers and acquisitions related deals in the forward calendar. Secondary prices and the recent volatility in June suggest that July will be a difficult time for borrowers to bring opportunistic bank loan deals. As a result, there will be little new supply issued during the next several months. Cash positions remain high for many loan investors, which will mean secondary loan prices should likely grind higher. While the technical conditions remain supportive in the summer, there are storm clouds on the horizon. It is hard to not imagine the potential volatility that could result from emerging market weakness, realized consequences of the U.K. referendum, a sluggish US GDP and an increasing default rate.


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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