July High Yield Credit Update

Monthly Commentary

August 14, 2017

The third quarter kicked off with a broad-based melt-up in high yield bond prices consistent with risk assets broadly. While the “melt-up” characterization is fair when considering the -12bps of spread compression and +$0.60 of price appreciation in the Barclays High Yield Index, the truth is the month was not that linear. In fact, sitting here in early August and feeling the uneasiness that is currently permeating investor psychology, one can’t help but draw parallels to market conditions in early July. Stock prices were fading, oil was inflecting downward after an almost two week rally, outflows were ramping (though not yet disruptive), interest rates were rising and geopolitical and policy risks were starting to build. Ultimately, the dip in bond prices proved shallow and short-lived, as fundamental signals stabilized (oil rebounded nicely, earnings were decent) and highly supportive technicals took hold. While the verdict is still out on August, the ease at which the market can be jarred from its state of complacency is telling about investor conviction at current valuations.

HYG Traded Heavy in the First Week of July Before Grinding to All-Time Highs by Month End

Source: Bloomberg

MARKET PERFORMANCE

High yield bonds generated solid returns in July, shaking off a rather weak start to the month as rising commodity prices (specifically spot WTI) and excess cash (see discussion on technicals below) lifted bond prices across the risk spectrum. Indeed, the rebound in oil off local lows settled investor nerves and encouraged incremental risk taking, while cash build from balanced fund flows, seasonally low issuance, and cash inflows from coupon payments, tenders and calls drove demand for low beta, “cash substitute” paper. In aggregate, high yield bonds generated a total return of +1.1% for the month, or a >14% annualized return (now that would be a good year!).

Rates and Risk Rallied in July

Source: Barclays

Consistent with a risk-on market psychology, CCCs took back the reins in July, outperforming fundamentally higher credit quality bonds. While high beta did lead the rally, returns across the ratings cohorts were robust. Notably, despite entering the month with spreads at post-crisis tights, BBs still managed to earn a +1% total return!

CCCs Led, Though Higher Quality Credits Outperformed Their Beta

Source: Barclays

Both exogenous and idiosyncratic drivers reinforced the “rising tide” momentum during the month that benefited all sectors, except Supermarkets. Amazon’s encroachment on the grocery industry, through the planned acquisition of Whole Foods, has put the market on edge as investors struggle to handicap risk under the new business reality. Set against this uneasy backdrop, Albertsons bonds re-priced meaningfully after the company’s private equity sponsor concurrently shelved plans for an anticipated IPO (a creditor-friendly liquidity event) and announced it would take a large cash dividend out of the business (a bad signal for creditors). At the other end of the spectrum, commodity-levered credits outperformed, principally in the Energy patch. Weekly inventory data turned bullish for most of the month, driving oil prices higher. As a result, Oil Field Services and high beta E&P bonds retraced some of the June selloff while higher quality E&Ps and Midstream credits traded above pre-selloff levels. Adding fuel to the flames, Halcon announced the sale of its Bakken acreage at a valuation well above what had been expected by the market. Halcon unsecured bonds rallied +12pts on the news, with other Single-B Bakken-levered credits trading higher in concert (on short covering!).

Source: Barclays

MARKET TECHNICALS

Market techncials were exceedingly accommodative during the month as demand, simply put, decidedly overwhelmed supply (both secondary and primary, more on the new issue calendar below). Outflows in the beginning of the month quickly subsided and did little to incite much in the way of forced selling as low primary issuance and cashflows from coupons and principal paydowns offset the flow drag. A large $2bn+ inflow into HY ETFs in the middle of the month put upward pressure on bond prices. The ensuing OWICs from authorized participants became the marginal price setter in the marketplace as these accounts (ETF arbitragers) indiscriminately bought paper to satiate demand.

HY Funds Had Net Inflows of +$478mn in July that Drove a Steady Grind Higher in Bond Prices

Source: Lipper, J.P. Morgan

The new issue calendar, or lack thereof, was even more culpable for the squeeze higher in secondary bond prices than the demand-side technicals. New issue volumes were very light in July (even seasonally adjusted) with the primary market only clearing $11bn in USD-denominated bonds (the first deal didn’t price until two weeks into the month). Without any large benchmark deals in the market, small, infrequent issuers found themselves cast into the spotlight, with deals garnering seemingly insatiable interest from investors looking to diversify in a marketplace otherwise void of opportunity. Asymmetric supply / demand for these new issues was apparent in early trading with freshly minted bonds trading up +2-3pts even after pricing through the tight end of our assessment of fair value as investors clamored to add size.

Regardless of Valuation, Overwhelming Demand Seemed to Carry New Issues in Early Trading

Source: Bloomberg, TCW

High Yield Net Supply ($mn)

Source: Barclays

FUNDAMENTAL TRENDS

Symbolic of the general calm in the marketplace in July was the total absence of high yield issuer defaults during the month. Indeed, only a single loan-only issuer filed for Chapter 11, and one high yield issuer effected a distressed exchange (though this did trigger a technical default per ratings agency standards). The companies were both apparel / retail brands, True Religion Apparel and J Crew, respectively. As a result, trailing default rates have declined significantly from the early-2016 peak, reinforcing investor forecasts for benign default volumes over the near-to-medium term. We believe market prices imply sub-2% forward defaults, in-line with the low end of strategist projections, though at apparent odds with what has historically transpired at the end of a credit cycle.

LTM HY Default Rates Per JPM Fell to a Meager 1.3% in July (Including Distressed Exchanges)

Notes: Excludes the record setting defaults of Energy Futures’ $36bn default in April 2014 and Caesar’s $18bn default in December 2014.
Source: J.P. Morgan

 

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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