Loan Review – June 2017

Monthly Commentary

July 11, 2017

As we have reached the midway point in the year, it is necessary to take stock and see where we have been and where we are going. During the first six months, returns have lagged coupons. Retail fund outflows have picked up, particularly in the last month. In fact, the final week of the quarter registered the largest retail outflow in the last 12 months. The percentage of loans trading above par is slightly above the yearto- date low at 56.1%.

Despite uninspiring returns, prices backing up and retail outflows accelerating, opportunistic transactions persisted through the second quarter. While refinancing, re-pricing and dividend recaps have moderated from the first quarter, they still provided the second largest set of opportunistic transactions in the last two years.

Repricing Activity
(Q2/2015 – Q2/2017)

* Includes re-syndicated repricing
Source: LCD, an offering of S%P Global Market Intelligence

These opportunistic transactions have led to further spread compression despite softening demand. The opportunistic transactions have also led to leverage increasing in the quarter to its highest level since 2000.

Average Debt Multiples of Highly Leveraged Loans (2000 – Q2/2017)

Source: S&P Global Market Intelligence

The incongruity of weakening demand, increasing leverage and tighter spreads is difficult to reconcile and yet is a major theme in the bank loan market during the last three months. However, one bright spot in the second quarter was CLO demand. It provided stability in loans each time the market showed any weakness in June. Looking forward to the remainder of the summer, M&A activity will remain supressed. With several CLOs looking to price in July, technical conditions suggest the market will likely trade flat or even tighten from current levels.

Performance

In June 2017, the Credit Suisse Leveraged Loan Index (“CS LLI”) was down -0.06% and the S&P Leveraged Loan Index (“S&P/ LSTA”) was down -0.04%.

  • For Q2 2017, the CS LLI was up 0.75% and the S&P/LSTA was up 0.76%.
  • Year-to-date ending June 30, 2017, the CS LLI was up 1.96% and the S&P/LSTA was up 1.91%.
  • For the 12 months ending June 30, 2017, the CS LLI was up 7.49% and the S&P/LSTA was up 7.42%.

Sector Performance

All but four sectors had positive returns with the worst performing sectors being: Energy (-3.21%), Food & Drug (-1.48%) and Retail (-1.24%). WTI Crude Oil was down 5% in June and nearly 11% in the second quarter. As WTI dropped so did energy-driven borrowers.

News of Amazon entering the bricks and mortar retail grocery business with the acquisition of Whole Foods sent shock waves through the grocery business. This acquisition reverberated through the loan market as it pushed loan prices down for nearly every grocery loan in the Food & Drug segment. The retail sector also dropped, in sympathy with Food & Drug. In the absence of news, retail loans have been subject to constant concerns surrounding the viability of business models.

Utility, Metals/Minerals and Consumer Durables were the top performing sectors for June with returns of 0.42%, 0.35%, and 0.31% respectively. Utilities were bolstered by positive news and continued sponsor investment in the ERCOT region. Metals bounced back after being one of the three worst performing sectors in the prior month. Consumer durables moved higher for the second straight month as investors looked for higher beta discounted investments not in the sectors of retail, energy or metals.

On a quarter-to-date basis, the weakest performing segments shared similar themes to June. Energy, Food and Drug, and Retail were three of the five weakest segments on the quarter. Utility and Transportation also lagged the broader market.

On a quarter-to-date basis, Healthcare, Aerospace and Information Technology were the top performing sectors with returns of 1.34%, 1.24% and 1.23%, respectively.

Total Return by Sector

Source: Credit Suisse Leveraged Loan Index

The flow-name prices in the S&P Index (below) declined during most of the month before stabilizing in the final week.

Average Loan Flow-Name Bid

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

The average bid of the broader loan index is up materialy during the last year despite the weaker prices in the last six weeks.

LTM Averages CS LLI Index Price

Source: CS LLI

Technical Conditions

CLO new issue supply reached $13.7 billion in June for the largest inflow in the last 12 months. Q2 2017 demand more than doubled from Q1 2017 CLO inflows. Conversely, retail inflows declined to their lowest total since June 2016. Slowing retail inflows reflect a change in sentiment concerning the prospect of rising rates. Q2 2017 retail inflows were +$3.96 billion as compared to Q1 2017 inflow of +$16.0 billion.

CLO New Issue Volume

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

New issue volumes increased month-over-month by nearly 20%; however, Q2 2017 issuance dropped by approximately 24% from Q1 2017.

Leveraged Loan Volume

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

Excluding opportunistic financings, there is scarce real new issue supply. This lack of M&A activity has led to an environment that is permissive of spread compression.

Acquisitions, mergers and leveraged buyouts contributed to less than half of the institutional new issue volume on a year-to-date basis. The remaining portion was largely made up of borrowers’ extending maturities, re-pricing coupons and taking dividends.

YTD Institutional Volume

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

As total retail and CLO demand has moderated and begun to shrink, the trailing 12 month returns have also begun to decline.

Inflows and Rolling LTM Returns

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

Single B spreads widened in June from the prior month but still remained 4.5% tighter YTD. Double B spreads widened very slightly and remained nearly 10.3% tighter on a YTD basis.

Despite softening demand, second quarter spreads tightened for both Double B and Single B loans.

Spread Changes

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

Average New-Issue Yields

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

There have been 20 defaults in the last 12 months with one in June: Ignite Retail Food & Drug. The LTM default rate increased from 1.17% to 1.49%, based on a number of defaults while the default rate increased from 1.29% to 1.54% based on par amount outstanding. Regardless of measurement, default rates remain very low on a historical basis.

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

Commodity and retail loans contributed equally to the default rate, each with five defaults. This is the first reading in the last several years when commodity-driven loans were not the sole leading default contributor. Retail/Restaurants had hovered as the second largest default category for the last several months until finally equaling Metals/Minerals and Energy borrowers in June.

While shadow default activity remains low, suggesting that there will not be any broad-based increase in the next 12 months, it is worth noting that the number of distressed borrowers is increasing in the retail segment.

Valuation

Since 1992, the average 3-year discount margin (“DM”) for the CS LLI, is 463 basis points. If the global financial crisis (2008 & 2009) is excluded, the 3-year DM for the CS LLI is 417 basis points. At month end, the 3-year DM was tight to the historical average, at 442 basis points but 8 basis points wider than the prior month.

The DM spread differential between double Bs and single Bs has widened from July 2016 to June 2017 by 10 basis points and is still 30 basis points wide of the historical spread differential.

3-Year Discount Margin Differential Between BBs and Single Bs

Source: Credit Suisse Leveraged Loan Index

Summary

As of June 30, the S&P/LSTA Index imputed default rate was 1.81%, the second lowest level of 2017. It remains considerably below the multi-year high of 7.3% set in February 2016. While technical conditions softened in June, they still remained relatively strong. Growing CLO demand offset declining retail outflows. However, increasing M&A purchase price multiples have led to higher overall leverage multiples. The second quarter 2017 registered the highest leverage multiple in the last 17 years. Despite leverage ticking higher, spreads contracted during the quarter. The loan market has experienced episodic volatility during the last several years and while it felt like volatility may be creeping into the market in June, CLO demand quickly erased that notion. Heading into the summer months, M&A activity is not sufficient to satiate demand. Consequently, without a broader credit selloff, loan prices will likely push higher.

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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