Loan Review – July 2017

Monthly Commentary

August 07, 2017

In late June several investment banks called, canvassing the market. They wanted to see if there was still enough demand to syndicate lower Single-B rated deals. July quickly erased any concern, not only surrounding hung syndications but also that there would be sustained weakness in the loan market. Demand overwhelmed supply and the percentage of loans trading above par shot up from 56.1% at the end of June to 72.2% by the month end.

July loan returns were the strongest of the year, driven primarily by a lack of new issuance. In fact, less than $13 billion of loans allocated in the month, which marks a 17-month low. The market has averaged approximately $40 billion per month during the last six months.

Performance

In July 2017, the Credit Suisse Leveraged Loan Index (“CS LLI”) was up 0.78% and the S&P Leveraged Loan Index (“S&P/LSTA”) was up 0.69%.

  • Year-to-date ending July 31, 2017, the CS LLI was up 2.76% and the S&P/LSTA was up 2.62%.
  • For the twelve months ending July 31, 2017, the CS LLI was up 6.83% and the S&P/LSTA was up 6.64%.

Lower quality continued to outperform higher quality throughout the month with distressed loans netting a return close to 2.2% in July. Double B and Single B loans returned 0.71% and 0.82%, respectively. Larger, more liquid loans slightly outperformed smaller term loans during the month.

Sector Performance

Every sector posted a positive return in July, led by Energy (+2.51%), Food & Drug (+1.69%) and Utility (+1.27%).

WTI crude oil was up 8.4% in July and began to move higher on the heels of Saudi Arabia announcing that it would make deep cuts to exports in August. Energy loans caught a bid in the back half of the month and led all sectors.

News of Amazon entering the bricks and mortar retail grocery business with the acquisition of Whole Foods sent shock waves through the industry in June. However, investors thought the selloff was overdone and July saw Food & Drug move higher as several of these borrowers bounced back.

Finally, Utilities also moved higher despite natural gas dropping nearly 8%. Rumors of mergers & acquisitions surrounded many of the larger players in the industry. This combined with small acquisitions in the space, led to some optimism surrounding valuations.

Metals/Minerals, Consumer Non-Durables and Consumer Durables were the three worst performing sectors with total returns of 0.52%, 0.44% and 0.09%, respectively.

On a year-to-date basis, Energy, Metals/Minerals, and Services led all sectors with total returns of 4.51%, 4.14% and 3.77%, respectively.

On a year-to-date basis, Food & Drug, Utility and Retail were the worst performing sectors with returns of 1.70%, 1.29% and -1.67%, respectively. Retail was the only sector to have negative performance on a year-to-date basis as well as on a trailing 12 month basis.

Total Return by Sector

Source: Credit Suisse Leveraged Loan Index

The flow-name prices in the S&P Index (below) increased during the month before very slight weakness crept in during 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. By the end of July prices returned to the same levels found in May and early June.

Average Bid of the S&P/LSTALL Index

Source: CS, LLI, LCD, an offering of S&P Global Market Intelligence; S&P/LSTA Leveraged Loan Index

Technical Conditions

CLO new issue supply was $7.9 billion in July down 42% from June, which was the largest inflow in the last 12 months. While CLO issuance declined, it was evident that CLOs printed in June and July were actively ramping and pushing prices higher. Year-to-date, over $58 billion of CLOs have been issued, exceeding most estimates for 2017.

CLO New Issue Volume

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

Institutional new issue volumes decreased month-over-month by nearly 20% while pro rata new issuance declined over 80%. This, combined with approximately $25 billion in index loans repaying, left investors scrambling to invest growing levels of cash. For the first month since January, the amount of par outstanding loans shrank, in this case by $7.0 billion.

Leveraged Loan Volume

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

50% of institutional issuance was driven by opportunistic financings (dividends, refinancing/repricing) while 50% of the issuance was driven by M&A activity.

YTD Institutional Volume

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

Consistent demand has pushed over 70% of loan borrowers above par. With prices reaching recent highs, and coupons shrinking via re-pricings and refinancings, the trailing 12-month return has begun to decline..

Inflows and Rolling LTM Returns

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

Single B spreads in July widened from the prior month although remain 10.2% tighter than 12 months ago. It is important to note that mix plays a factor in the average spread and that a solid Single B loan, that is a repeat issuer, would price at a tighter level than the prior month. Double B spreads also reflected a slight widening based on asset mix. Double B loans remain nearly 7% tighter on a YTD basis and 21% tighter on a y-o-y basis.

New Issue Spread Changes

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

Average new issue yields widened month-over-month for Double Bs while Single Bs tightened slightly.

Average New-Issue Yields

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

There have been 22 defaults in the last twelve months with one in July: True Religion. The LTM default rate increased from 1.17% to 1.29%, based on a number of defaults while the default rate increased from 1.29% to 1.36% based on par amount outstanding. Regardless of measurement, default rates remain very low on a historical basis.

Lagging 12-Month Default Rates

GRAPHIC11

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

Retail and Restaurant loans provided seven defaults in the last 12 months while commodity driven loans provided five. This is the first reading in the last several years when commodity driven loans were not the leading default contributor. The shadow default activity remains low, suggesting that there will not be any broad-based increase in the next 12 months.

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 discount margin for the CS LLI is 417 basis points. At month end, the 3-year DM was tight to the historical average, at 423 basis points and 19 basis points tighter than the prior month.

The DM spread differential between double Bs and single Bs has widened from August 2016 to July 2017 by 13 basis points and is still 31 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 July 31, the S&P/LSTA Index imputed default rate was 1.64%, the lowest level since December 2007. While this is shocking, it also contrasts with the multi-year high in February 2016 of 7.3%.

Technical conditions remained as imbalanced as they have been since the first quarter 2017. Growing CLO demand and stagnant retail fund flows dwarfed an anemic new issuance calendar. The overwhelming demand is leading to higher leverage levels and tighter spreads. While the new issue calendar is expected to pick up, it will not likely occur until after Labor Day. In the interim, loans are likely to continue to grind higher, absent a larger credit risk event.

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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. © 2017 TCW