July High Yield Credit Update

Monthly Commentary

August 21, 2019

Beginning with a few summary statistics – 1) High yield bonds have returned, on average, +10.6% during the first seven months of this year, impressive; 2) interest rates have contributed positively to returns, though credit spreads have also tightened -155 basis points (bps) since the start of this year (as of 7/31); 3) our marketplace has been the beneficiary of over $17bn in capital inflows year-to-date, standing in contrast to the -$47bn of outflows in 2018; 4) trailing default rates remain at cyclical lows (<2%).

These statistics are now in the history books. They are in-fact what has happened, and empirically embed very little information about what will happen next. What will happen next? We don’t have a crystal ball. Though helping to educate our viewpoint – a product of our in-depth underwriting of the micro (corporate fundamentals) married with our respect for the macro (the credit cycle) – has been our observation of a wavering in investor risk-seeking behavior concurrent with examples of significant collapses across several high yield capital structures. Some refer to these as market internals. We focus on what they might portend for future distress, defaults, and risk-premiums.

Beneath the surface, evidence of these stresses (via appreciable idiosyncratic and thematic weakness) is apparent , with signals beginning to show through in the aggregates. One such aggregate indicator, to which we would like to draw attention, is the level of dispersion currently in the high yield marketplace. We calculate dispersion as the percentage of high yield bonds that trade with an option-adjusted spread (OAS) of +/-100(bps) of the market average. Historically, the level of dispersion in the marketplace has correlated positively with the absolute level of risk-premiums. One explanation is: as credit fundamentals deteriorate among one cohort of borrowers and permanent loss of principal is realized, credit conditions begin to tighten (and capital begins to exit the marketplace entirely). This, in turn, introduces funding stress for levered capital structures broadly, hence transmitting initially acute weakness throughout the marketplace. Below is a chart comparing the level of dispersion in the high yield market to the average high yield OAS. We note two takeaways: 1) the level of dispersion today is above what we saw in Q4’18 (despite the asset class remediating near-11% thus far this year) and is trending toward the peaks observed during prior recessions/crises; and 2) the decoupling between the level of dispersion in the market and the prevailing risk-premiums demanded by investors.

The inconsistency in the latter takeaway is apparent and helps inform our cautious disposition toward current valuations.

Market Internals (Dispersion / Credit-Specific Stress) are Signaling Risk of Contagion

* Dispersion = % of HY bonds trading at an OAS of +/-100bps from the mean
Source: BAML

Market Performance

July saw mixed results within the high yield market, pairing the momentum experienced in June with early signs of the unwinding we have observed thus far in August. Returns for the month were positive on average, +0.56% to be exact, though gains were more modest than other positive performing months this year. Notably, beneath the headline results, dispersion in single-name and sector performance has begun to magnify.

More on sector and credit-specific dislocations below. First, we must draw attention to the bifurcation in returns this year between credit quality – arguably the most prominent theme of 2019 (a byproduct of the growing list of idiosyncratic collapses we have observed in fundamentally challenged credits). By the end of July, the performance of BB and CCC rated bonds had diverged by 340bps. As of this past week, the outperformance of BBs over CCCs has grown to near 700bps! To be certain, in the last 30 years, we have not observed a single year where high yield bonds returned in excess of 10% on average and BBs outperformed CCCs. Above average returns have historically been earned during periods of exuberance concurrent with risk-seeking behavior. Unique to this year has been the advance in spite of an appreciable aversion to taking risk. The move in Treasuries has helped. Indeed, the impressive rally in interest rates can explain near half of the total return for the high yield market this year (and specifically for BB rated bonds, given their high empirical interest rate durations). However, interest rates cannot explain all of the outperformance. The complete withdrawal of sponsorship from an expanding universe of over-levered, typically CCC rated capital structures, is playing a role as well.

Source: Bloomberg, Barclays

Underpinning the dispersion in performance across credit quality are both thematic and idiosyncratic stresses. We shined light on the now over 120 capital structures which have seen prices of their bonds decline by more than 10pts over the past year (with several experiencing -20-80pt haircuts). While many of these credits are pressured by idiosyncratic drivers, several face correlated, or said another way, thematic headwinds. Of these observable themes, notable are: 1) the natural gas focused E&P dislocation (Energy), 2) bipartisan “surprise billing” legislation initiative (Healthcare), 3) opioid litigation (Pharmaceuticals). Uncorrelated? Seemingly. Prominent? More so day by day. Disjointed? Not in the sense that each feeds a growing aversion to take risk, itself capable of transmitting broader contagion. As seen in the table below, these themes resulted in the underperformance this past month of their respective sectors. We should note the decoupling of Energy, now the worst performing sector this year (with the downward momentum reminiscent of the 2015/2016 crisis), has begun to accelerate. To the upside, the Wireless sector generated strong results, underpinned by the rally in Sprint bonds after the Department of Justice blessed the merger between T-Mobile and Sprint.

Source: Bloomberg, Barclays

Market Technicals

Despite choppy macro and micro fundamentals, market technicals have, for the moment, helped buttress valuations – at least valuations of higher quality capital structures. To be certain, even a favorable technical backdrop has done little to support those credits which are fundamentally broken. What we observed in July (and this is a trend that has accelerated in August) can be characterized as a flight to quality, rather than a flight to safety. What do we mean by this? Effectively, we are seeing demand shift WITHIN the high yield marketplace, as capital is being diverted away from highly levered, cyclical credits in favor of lower levered, more durable balance sheets. As opposed to a flight to safety, with capital flowing OUT of the high yield market altogether. The latter was observed in Q4’18, though has yet to manifest this year. Indeed, in July, high yield bond funds (including ETFs) saw $4.2bn of net inflows, bringing the year-to-date total net inflow for the high yield mark $17.2bn.

Observed Market Technicals Can Be Characterized as a “Flight to Quality” as Opposed to a “Flight to Safety”

Source: Credit Suisse, EPFR

The primary calendar remained active in July with another $24bn in USD-denominated high yield bond issuance. Trends in the primary market such as, bifurcation / dispersion, flight to quality and risk aversion, parallel those we are observing in secondary trading. This is made apparent in what appears to be an open and accommodative new issue market for some, while concurrently far less accessible for others. The “haves” receive overwhelming demand for their bonds, with coupons clearing 25-50bps inside of where the underwriter initially markets the deals. These deals also saw robust follow-on demand in secondary trading (for example, Trivium Packaging saw the market price of their newly issued unsecured bond trade up +6pts within a week and a half of its primary syndication). Simultaneous to these deals seeing robust demand, others struggled to gather sponsorship, even while offering double-digit coupons.

Source: Barclays

Fundamental Trends

Trailing default activity remained very light in July (Stearns Lending filed Chapter 11, affecting just $183mn of high yield bonds) and the trailing 12-month default rate remained sub-2%, though as consistent readers of this memo will note, this backward-looking indicator is not our current focus. Rather, we believe our tracking sheet of the number of capital structures that have experienced bond price drops of 10pts or more over the trailing year is a better barometer of the current fundamental paradigm (as well as a leading indicator of where credit stress / distress will trend). That list continues to grow, month-over-month, and is now in excess of 120 borrowers. The conclusion of our observations thus far is that risk aversion and the concurrent credit stress is now far-reaching. What was a very acute dislocation in the Energy sector (yet again) has expanded in breadth (as well as scale and frequency). We are asked frequently by market participants what we believe the catalyst will be to transmit this idiosyncratic / thematic stress more broadly. While we do not opine with certainty, historical precedence points to several channels by which contagion spreads. Our position remains that evidence of late cycle fundamental deterioration is building, which warrants a cautious approach to credit investing.

Credit (Di)Stress Becoming Less Acute. What do the Below Have in Common?

 

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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. © 2019 TCW