Loan Review – July 2016

Monthly Commentary

August 09, 2016

As fall camp begins for college football fans across the country, I cannot help think of Lee Corso’s famous words, which he utters every Saturday “not so fast my friend.”

In July, investors focused on second quarter earnings results with 86% of the companies in the S&P 500 having reported. Fifty-four percent have reported sales above the mean estimate and 69% have reported earnings above the mean estimate. However, Q2 2016 blended earnings declined -3.5%. If the index reports a decline in earnings for Q2, it will mark the first time the index has recorded five consecutive quarters of year-over-year declines in earnings since Q3 2008 through Q3 2009.

Leverage for the S&P Leveraged Loan Index in Q2 2016 was higher than leverage for loans in Q1 2016. Leverage in Q1 2016 was greater than 2015. Looking to the S&P 500, leverage (debt-to-EBITDA) is at the highest point this century.

Debt-to-EBITDA Ratios are at the Highest Point of this Century...

Source: Haver Analytics, Thomas Reuters, Barclays Research

Fears of a Brexit recession appear to be real and shared by officials in Britain as the Bank of England reduced interest rates to a new historic low of 0.25%. The playbook of rate cuts is well known and has been seen worldwide since the global financial crisis. While economic growth resulting from rate cuts may be debated, the immediate benefit to financial markets seems to be more certain.

Consequently, if one had said that July would bring declining earnings, increasing leverage and concerns of a recession in Britain; one would assume the market would be down. Well… not so fast my friend. Loans traded higher.

Performance

In July 2016, the Credit Suisse Leveraged Loan Index (“CS LLI”) was up 1.41% and the S&P Leveraged Loan Index (“S&P/LSTA”) was up 1.43%.

  • Year-to-date ending July 31, 2016, the CS LLI was up 5.69% and the S&P/LSTA was up 6.00%.
  • For the twelve months ending July 31, 2016, the CS LLI was up 2.26% and the S&P/LSTA was up 2.34%.

Sector Performance

The top three performing industries for the month were Metals & Mining, Retail and Media/Telecommunications, which posted returns of 3.30%, 1.90% and 1.62%, respectively. Commodity driven loans surged in the first half of the month and then as oil prices weakened, loan prices in energy segments also moderated.

However, commodity prices for many metals were up modestly on the month and iron ore was higher by 9%. Consequently, Metals loans traded higher. Many of the leading participants in the Retail sector posted disappointing first quarter earnings results. There has been little good news for retailers this year, however in July as risk rallied, Retail did as well. The segment offered a low priced, high beta investment, away from commodity driven industries. Discounted retail loans like Neiman Marcus traded up more than 3% on the month despite the fact that the company made no material announcements.

Total Return by Sector

Source: Credit Suisse Leveraged Loan Index

The worst performing sectors in July were Food/Tobacco, Consumer Non-Durables and Food & Drug with returns of 0.74%, 0.88% and 0.97%, respectively. Underperformance for both food related sectors was driven by the fact that these sectors trade closer to par and the average spread of both sectors is below the average spread for the Index. Consequently, a rally will be less pronounced in this business.

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 19.64%, 15.13% and 7.38%, respectively. While these commodity driven industries have performed very well year-to-date, they are still the poorest performing sectors during the last 12 months.

Total Return By Rating

Source: Credit Suisse Leveraged Loan Index

All ratings categories traded higher for the month. Performance by rating or quality followed a pattern. Lower-rated loans outperformed higher-rated loans with the exception of CCCs and the distressed segment. The distressed sectors, which are typically not targeted by CLO investors, provided positive returns for the month but those positive returns faded in the second half of July. As WTI Crude Futures dropped more than 16% on the month, Energy became the worst performing sector for the last 2 weeks of July. Because Energy is largely populated by CCCs loans, it heavily influences overall CCC performance. It can also provide a benchmark for the CCC and distressed sectors in general.

The rally in July increased the percentage of the loan index trading above par. In fact, the JP Morgan Loan Index finished with 39.98% of loans trading above par and 62.66% trading above $99.50.

Flow name bids traded close to $99.50 for much of the month before retreating at the end of the month.

Average Loan Flow-Name Bid

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

Despite some price weakness at the end of the month, the overall strength of the market allowed for repricing activity, which will continue into August. Most notably, Broadcom was able to reduce its institutional term loan spread by 50 basis points. Effecting a repricing on a $6.0 billion loan certainly signals that repricings are available to borrowers trading at or above par.

Technical Conditions

June marked the first month of 2016 with CLO issuance over $6.0 billion. July followed with $5.8 billion as the CLO market continues to surpass expectations for volumes. The CLO market remains robust and JPM CLO strategist Rishad Ahluwalia upwardly revised his FY16 US CLO forecast to a range of $55-65bn.

CLO Volume

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

Retail funds posted a very small inflow in July ($0.24 million). As both CLO and retail flows together contributed ~$6.0 billion of demand, loan repayments spiked to nearly $30 billion for July. This combined with institutional new issuance down over 30% in July led to a surge in returns. The pattern of technical conditions driving returns has been evident during the last 12 months as can be seen in the graph below.

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

Source: S&P Leveraged Loan Index

Three-month LIBOR was also notable in July as it broke through 75 basis points for the first time since mid-2009. This is obviously important for any issuers with 75-basis-point LIBOR floors. This event will impact floating rate fund investors differently than CLO investors. While CLO investors will lose the floor benefit, floating rate fund investors will benefit from higher all-in rates. Only time will tell exactly how rising LIBOR will impact the technical conditions of the market but historically it has led to fund inflows.

July institutional issuance waned as compared to the prior two months. Year-over-year, July total volumes (institutional and pro rata) were down approximately 40%. Low M&A volumes continue to drive lower loan volumes.

Leveraged Loan Volume

Source: S&P Leveraged Loan Index

Total year-to-date institutional loan issuance is down roughly 10% from 2015. Mergers and Acquisitions, which dominated the calendar in the first quarter, dropped to ~36% of the issuance in July. Opportunistic refinancing volume ballooned to 54% of issuance for the month.

July New Activity by Purpose

LoanStats Weekly – August 4, 2016

Fundamentals

Single-B new issue yield-to-maturity widened six basis points in July from June. BB new issuance widened one basis point in July. However, the average new issue yield-to-maturity in July 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

There were two additional defaults in July (Transtar and C&J Energy) that increased the LTM default rate to 2.17% based on a par amount outstanding. The default rate based on unique issuers also remained flat at 2.44%.

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.

Eighteen 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 463 basis points. If the global financial crisis (2008 & 2009) is excluded, then 3-year discount margin for the CS LLI is 415 basis points. At month end, the 3-year DM was wide of the historical average, at 537 basis points. The 3-year DM tightened 45 basis points since June.

The DM spread differential between BBs and single Bs has slightly widened from August 2015 to July 2016. It is also 37 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 4.07%. That is down from 4.63% at the end of June and considerably below the multi-year high in February of 7.3%. However, the imputed default rate is still above the existing rate and implies that the market will likely see an increase in defaults during the next 12 months.

Defaults have been driven by the Metals/Mining and Oil & Gas segments. The decline in the WTI Crude Futures in July certainly increases the likelihood that energy driven borrowers will continue dominate the defaults experienced for the remainder of the year.

While defaults seem to be ticking up, returns remain very strong. If 2016 performance ended today, it would have posted the strongest return since 2013. Gains in July were driven by technical conditions in the market. Demand is significantly greater than supply. The net forward calendar which represents all institutional loans in the pipeline minus any visible repayments associated with the pipeline of planned new deals grew to approximately $25.7 billion in early August. However, if the pipeline is adjusted for the $21.9 billion of anticipated repayments that are not associated with the forward calendar, the net amount declines to $3.8 billion. This is a paltry amount in light of the fact that the CLO market has produced nearly $6.0 billion of demand each month for the last several months.

August is beginning with high cash positions for many loan investors while M&A activity remains light. The calendar in August will be dominated by opportunistic financings, lowering coupons and increasing dividend activity. Tightening coupons combined with increasing LIBOR rates will eventually squeeze existing CLOs interest coverage tests. However, in the near term, I expect to see loans continue to grind 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