Loan & CLO Review – August 2019

Monthly Commentary

September 10, 2019

The month of August can be divided into two parts for the purpose of loan market activity. In the first half, the loan market was extremely active with both a large new issuance calendar as well as an avalanche of earnings results. In the second half, many loan participants went on vacation and it was as if the market pressed pause, waiting until after Labor Day to recommence.

While most of the earnings seemed to meet expectations, there were a handful of disappointing results. What has become clear in the loan market is that sponsorship of “storied” credits has faded. Companies that missed results were penalized. Companies that are rated low-single B borrowers or in less favored sectors also have had little support. In particular, loans in energy, retail, cyclicals, manufacturing or Chinese influenced end-markets all dropped dramatically.

Industry dispersion has increased as shown below. We have also seen an increase of price dispersion as nearly 9% of the index was trading below 90 at the beginning of September.

Energy, Retail and Healthcare Underperformed in August

Source: Credit Suisse

In contrast, higher-rated bank loans benefited from both a flight-to-quality and a technical characteristic whereby in inordinate amount of double-B bank loans were prepaid at the end of July – leaving CLOs as a forced buyer of high-quality loans.

The loan market seems to be operating in a manner that is extremely sensitive to other risk markets and global macro stories. When the U.S. and Chinese trade war headlines dominate the press, loans seem to follow the same pattern as equities and high yield. When equities open in the “green,” loan buyers emerge. Overall, any strength felt in July was erased in August and sentiment for most of the month was poor. Interestingly, the spread between the 3-year discount margin for double Bs and single Bs is at its widest since July 2016.

Performance - Loans

In August 2019, the Credit Suisse Leveraged Loan Index (CS LLI) and the S&P Leveraged Loan Index (S&P/LSTA) were up -0.28% and -0.27%, respectively.

  • Year to date, ending August 31, the CS LLI was up 5.94% and the S&P/LSTA was up 6.30%.
  • For the 12 months ending August 31, the CS LLI was up 3.38% and the S&P/LSTA was up 3.33%.

During the month, higher quality paper outperformed lower quality loans. Triple Bs and double Bs outperformed all other categories. Single Bs trailed triple Bs by 70 basis points (bps) while triple C and distressed loans were down roughly -97 and -87 bps, respectively.

On an LTM basis, triple Bs and double Bs outperformed single Bs. Triple Cs and the distressed categories have posted negative returns during this time period.

Total Return by Rating

Source: Credit Suisse Leveraged Loan Index

Sector Performance

Five of 20 sectors provided positive returns in the CS LLI for the month of August. The top performing sectors were Housing (0.22%), Gaming (0.21%) and Aerospace (0.13%).

The worst performing sectors for the month were Metals/Minerals (-2.85%), Energy (-2.22%) and Retail (-1.43%). There was a 308 bps difference between the top and bottom sectors in August, which was the second highest level of industry dispersion this year.

On a year-to-date basis, Food & Drug (8.91%), Housing (7.55%) and Gaming/Leisure (7.24%) were the top performing sectors.

In the last 12 months, Utility, Food & Drug and Gaming/Leisure have led all sectors with total returns of 4.91%, 4.82% and 4.81%, respectively. Metals/Minerals, Energy, and Retail provided the worst performing sectors with returns of -3.21%, -1.07% and 0.68%, respectively.

Industry Returns

Source: Credit Suisse Leveraged Loan Index

CS LLI prices (excluding defaults) decreased -70 bps in August while the average bid of the S&P LCD flow-name loan composite decreased -21 bps from 99.54 to 99.33. The average flow name bid is up 403 bps on a year-to-date basis.

Average Loan Flow-Name Bid

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

Performance - CLOs

CLO performance continued to be weak in August. CLOs returned 0.12% during the month with YTD returns at 4%. AAAs and AAs contributed to the positive monthly returns while single As, BBBs and BBs all had negative returns as spread return could not compensate for price declines this time around. Over the month, CLOs outperformed loans, but lagged HY and IG credit. YTD CLOs are underperforming all three corporate asset classes (Loans, HY and IG credit).

AAA spreads remained firm as there was high demand for senior paper. Short AAAs even tightened 1-5 bps, especially for discount dollar price bonds.

As rates rallied, 3 month LIBOR declined another 15 bps over the month. As a result, single As were another 10-15 bps wider with spreads now in the mid to high 200s dm. As mentioned previously, many single A investors are yield buyers and with lower LIBOR, single As are less attractive to this investor base.

BBB and BB rated tranches, which are more affected by loan prices, widened 25 and 50 bps respectively over the month. With the average price of the S&P LSTA index down 70 bps in August, MVOC coverage for BBBs and BBs declined in tandem. Higher MVOC BBBs traded in the mid to high 300s dm while lower MVOC BBBs traded wide of 400 dm. BBs traded in a similar fashion with higher MVOC BBs trading closer to 700 dm and lower MVOC BBs wide of 800 dm.

BWIC activity decreased during the month with only $1.8bn out for bid vs. $2.3bn in July. Weekly activity averaged $400-$500mm in volume for the first three weeks of the month, tapering down to less than $100mm in the last week of August as many market participants were out of the office. BB activity was unusually high with more BBs out for bid over the month than AAAs.

Secondary CLO 2.0 Total Returns

Source: JPM CLOIE Index

Secondary CLO 2.0 Spreads (DM)

Source: TCW

Technical Conditions- Demand

August’s retail fund outflow was -$3.2bn, the 11th consecutive monthly outflow for the asset class. The rate environment has weighed heavily on the retail loan sector with AUM for the loan mutual fund base down to $106bn from a high of $154bn in October. Loan retail funds now hold 8% of the outstanding loan universe versus a peak of 20% in 2013. Year-to-date outflows are roughly $27.6bn which compares to a $15.0bn inflow for the same period in 2018.

Primary issuance totaled $7.2bn across 16 deals, a 28% and 20% decline from June and July, respectively. AAA spreads were a few bps wider over the month, with Tier 1 AAAs going from 130 to 132 dm. In tandem with the secondary market, new issue mezz spreads widened with tier 1 BBs going from 690 dm to 700 dm. BB new issue spreads ranged from 690 to 760 dm during the month. The theme remained the same as last month in new issue with plenty of demand for AAAs but no appetite for mezz. Mezz has been and will most likely continue to be a headwind for CLO issuance in the coming weeks. Typically, when impediments to CLO issuance arise, arrangers and managers tend to get creative in order to get deals done. It will be interesting to see how the market adapts to the challenging mezz environment in September.

Also of note, a large number of mid-market deals priced over the month. Of the 16 new issue deals, five were mid-market totaling $2bn (28% of August new issuance). AAA spreads ranged from +170 to +185 dm.

In addition to 16 new issues, four refis and five resets priced over the month. The amount of refinancings decreased from 12 the month prior. As demand for short AAAs was high, the decline in supply is more likely due to the time of year and refis should pick up in September. During the month, AAA refis with 1-2 years left in the reinvestment period priced in the 113-115 dm range, similar to July.

CLO cost of debt was unchanged over the month at 191. Equity arb increased 6 bps to 181 dm with loan spreads wider over the month.

CLO New Issuance

Source: TCW

New Issue BSL AAA DM – August

Source: TCW

Tier 1 New Issue Spreads (5 yr reinv)

Source: TCW

Technical Conditions – Supply

August saw a spike in refinancing activity in the loan market, which was a clear departure from what has occurred in the last seven months. It is counter intuitive that companies would look to extend maturities and refinance existing deals when the secondary market is weak. The reality is that there is a large CLO warehouse investor base that can pick up new incremental exposure to term loans refinancing. M&A and LBO activity has accounted for roughly 60% of new issue year to date, while in August, M&A and LBO activity only accounted for 35% of new issuance.

Institutional New-Issue Volume by Purpose

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

Loan fund outflows have been offset by strong CLO production. This, combined with crossover high yield buyers, has created enough demand for loans to produce very strong YTD returns and modest 12 month returns. However, when headlines surrounding Brexit and U.S./Chinese trade agreements turn negative, we have seen crossover buyers leave the market. This combined with outflows from retail funds left CLOs as the sole true buyer of loans in August. As a result, the declining flows contributed to negative monthly returns.

Inflows and Rolling LTM Returns

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

New issue spreads widened 2.0% month-over-month in August and were -14.0% tighter on a year-to-date basis. New issuance spreads remain 3.0% wider than 12 months prior.

New Issue Spread Changes

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

Yields continued to decline for new issues, primarily as a result of a declining LIBOR rate.

Average New-Issue Yields

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

Fundamentals – Loans

There were no loan defaults in August. The default rate changed from 1.00% in July to 1.29% in August, based on par outstanding.

The last 12-month default tally for the S&P/LSTA is 23. Retail leads all categories with six defaults while Services & Leasing is just behind with four. Oil & Gas is the third leading category with three defaults.

Lagging 12-Month Default Rates

*Shadow default rates includes potential defaults, including those companies that have engaged bankruptcy advisors, performing loans with SD or D corporate rating and those paying default interest
Source: LCD, an offering of S&P Global Market Intelligence

Fundamentals – CLOs

CLO fundamentals remained steady over the month. Caa/CCC %, WARF and WAS levels were flat. Equity NAVs were down 7-10 pts as a result of lower loan prices. BB MVOCs also decreased ~80 bps.

Valuation

Since 1992, the average 3-year discount margin (DM) for the CS LLI is 460 bps. If the global financial crisis (2008 and 2009) is excluded, the 3-year discount margin for the CS LLI is 417 bps. The 3-year DM finished the month at 473 bps, 24 bps wider than July.

The DM spread differential between Double Bs and Single Bs is 78 bps wider from September 2018 to August 2019 and 35 bps wider than the historical spread differential since inception.

3-Year Discount Margin Differential Between BBs and Single Bs

Source: Credit Suisse Leveraged Loan Index

Summary and Looking Forward

As of August 31, the S&P/LSTA Index imputed default rate was 2.8%, up from 2.25% in the prior month.

As CLO market participants get back from summer holiday this month, we should see a pick up in new issuance volumes. With over 100 warehouses open and only a few months left to issue a deal this year, dealers will be teeing up their pipeline over the next couple of weeks. The big question mark remains in mezz. The lack of interest in BBB and BB tranches can potentially deter issuance or at least slow it down. Resets should also give way to refis as seasoned mezz could be even harder to sell if it is reset for another five years. We may also see more new issues with shorter reinvestment periods as we did earlier this year as arrangers tackle a way to sell mezz. All in all, with AAA demand high and equity placed in risk retention funds, deals will continue to get done in some way or another.

Loan market sentiment has been clearly driven by broader headline macro news. Crossover buyers flow in and out of loans as sentiment toward the broader risk markets changes. Retail loan funds continue to bleed assets as the outlook for rates remains negative or at least as the LIBOR curve is not upward sloping. The main buyer of the loan market continues to be CLOs. We have seen CLO debt buyers look to offset declining LIBOR rates with increasing spreads. This means CLOs have a higher hurdle rate, which will require lower prices to offset the negative impact to the arbitrage.

In September we have seen loan prices slowly grind higher again, which is counter intuitive to the fact that CLOs need lower prices to make the arbitrage work. Some of the disconnect derives from the fact that the existing CLO base does not become a natural seller because of worsening arbitrage as well as the fact that many CLO vehicles have permanently raised capital and need to print consistently to remain invested. These two factors, combined with significant activity from crossover investors, have offset retail outflows and provided enough demand at the outset of September to digest the growing new issue calendar. Looking forward to the fall, we expect to continue to see episodic volatility of loan collateral as headlines turn sentiment into a risk on/ risk off environment.

 

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