Loan Review – July 2018

Monthly Commentary

August 14, 2018

Two pugilists eyed each other to start the month: One, the reigning champion, secondary loan prices and the other, new issue supply. Secondary loan prices had its knees buckle from a solid right cross from new issue supply delivered in June, however, the market regained its footing in July. Just like a boxer, the loan market started the month/round tentatively. Banks launched new issues with concessions to the secondary. But as the month wore on, it became apparent that demand from loan investors remained stable amid very low supply. By month end, the market demonstrated strength as investment banks began to flex deals tighter to levels inside of original price talk.

Performance

In July, the Credit Suisse Leveraged Loan Index (CS LLI) and the S&P Leveraged Loan Index (S&P/LSTA) were up 0.83% and 0.74%, respectively.

  • Year to date, ending July 31, the CS LLI was up 3.20% and the S&P/LSTA was up 2.91%.
  • For the 12 months ending July 31, the CS LLI was up 4.72% and the S&P/LSTA was up 4.42%.

Risk outperformed as Distressed and Triple Cs led all categories in July. Interestingly, Double B loans outperformed Single B loans but all categories outperformed the coupon of the index. On a year-to-date basis, lower quality has continued to outperform higher quality with distressed loans registering the best returns and Split Triple Bs registering the worst.

Total Return By Rating

Source: Credit Suisse Leveraged Loan Index

Sector Performance

All sectors in the CS LLI provided a positive return during the month. The top performing sectors in July were Retail (+1.22%), Transportation (+1.18%) and Food and Drug (+1.05%).

The worst performing sectors for the month were Aerospace (+0.53%), Consumer Non-Durable (+0.45%) and Consumer Durables (0.40%).

On a year-to-date basis, Retail (+6.61%), Metals/Minerals (+6.17%) and Energy (+5.28%) outperformed.

In the last 12 months, Metals, Energy and Utility have led all sectors with total returns of 8.28%, 6.71% and 6.69%, respectively. In contrast, Food/Tobacco, Consumer Non-Durables and Consumer Durables were the worst performing sectors with returns of 4.17%, 2.62% and -4.28%, respectively. Food/Tobacco’s underperformance relates primarily to relative value as most of the sector trades with very tight spreads relative to the broader index. The consumer driven sectors have been impacted largely based on concerns surrounding the fundamental change in the way consumers buy products. These concerns have weighed on both consumer sectors. Specifically, within the durable category, one borrower represents a substantial portion of the sector and that company’s underperformance has weighed on the entire sector returns.

Industry Returns

Source: Credit Suisse Leveraged Loan Index

Credit Suisse Leverage Loan prices increased 31 basis points in July while the average bid of the S&P LCD flow-name loan composite started the month at 99.23% and ended the month higher at 99.65.

Average Loan Flow-Name Bid

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

Technical Conditions

Leveraged loan funds reported an inflow totaling approximately $900 million during the month of July. Total assets under management for the dedicated loan mutual fund base ended July at $149 billion, which compares to an all-time high of $154 billion in April 2014. On a year-to-date basis, inflows for loan mutual funds total +$13.8 billion compared to a +$13.1 billion inflow in 2017.

JP Morgan reported gross CLO volume to be $25.7 billion in July. That included $11.7 billion ex-refi/reset/re-issue activity. Gross CLO volume totaled $175 billion on a year-to-date basis (+2% y/y) with net CLO volume +39% y/y to $81.4 billion. JPM forecasts $130 billion of new U.S. CLO supply in FY 2018 (or $245 billion total gross volume). CLO outstandings are now $571 billion versus $519 billion at YE 2017.

Institutional new issuance declined to $29 billion in July and is likely to remain light in August, which is typically the slowest month of the year. On a year-to-date basis, institutional new issue is down 6.1% from the first seven months of 2017.

Supply Eased in July

Source: Credit Suisse, S&P LCD

Repricings, which dominated the loan landscape for the past year and a half, have disappeared amid the price volatility that began at the end of May. There were no traditional loan repricings over the past month, however, BJ’s announced a proposed repricing on the last day of the month. On a YTD basis, Acquisitions, LBOs and merger volume represented 57% of actual new issuance.

YTD - Institutional Volume ($311.7B)

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

Amid strong inflows, the trailing 12-month returns continued to pace slightly below 4.5%. The bounce in prices did little to impact the LTM returns as July 2017 had also produced a large return.

Inflows and Rolling LTM Returns

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

July saw new issue spread widening month-over-month. However, as previously mentioned, it did feel like a lot of the issuance (at month-end) was flexing tighter. On a year-to-date basis, new issue spreads in July were 10.7% wider for double Bs and 2.0% wider for single Bs. Spreads are still tighter on a 12-month basis for both double Bs and single Bs. The spread for the CS LLI ended June at roughly L+344 basis points. This is the tightest spreads have been for the CS LLI since September 2010.

New Issue Spread Changes

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

In terms of new issue yields, double Bs were wider month-over-month while single Bs remained pretty close to flat. On a year-to-date basis, double B yields were 145 basis points wider while single B yields were 118 basis points wider. Most of this was driven by 3-Month LIBOR as it was up 65 basis points during the year.

Average New-Issue Yields

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

The default rate continued to fall in July as the S&P/LSTA Leveraged Loan Index increased by 2 basis points to 1.97% by principal amount. There were no defaults in July.

The last 12-month default tally is 19. Oil & Gas defaults lead all categories with six while Retail is close behind with four.

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.

Valuation

Since 1992, the average 3-year discount margin (DM) for the CS LLI is 461 basis points. If the global financial crisis (2008 & 2009) is excluded, the 3-year discount margin for the CS LLI is 416 basis points. At month end, the 3-year DM (388 basis points) hovers close to the same levels it has been for all of 2018, which is its tightest level since October 2007.

The DM spread differential between double Bs and single Bs widened by 7 basis points from August 2017 to July 2018 and is still 37 basis points wider than 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 & Looking Forward

As of July 31, the S&P/LSTA Index imputed default rate was 1.16% and, with the exception of April 2018, this was its tightest level since October 2007.

The loan market was driven by technical characteristics in July. As reduced M&A activity led to less new issue, the inflows to retail funds and CLO growth contributed to the imbalance that has dominated much of the past year and a half. Consequently, prices grinded higher and the loan market produced its second strongest monthly return since January 2018.

The new issue forward calendar signals an increase to levels closer to those of June but much of that new issuance will not be syndicated until after Labor Day. This, combined with the fact that some bankers estimate upwards of 100 CLO warehouses are currently outstanding, would suggest that we will need a constant supply of new issue or an increase in outflows from retail funds to remain technically balanced.

 

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