August High Yield Credit Update

Monthly Commentary

September 14, 2018

July’s reprieve in international market volatility proved fleeting, as stress in a growing constituency of emerging sovereign and corporate credits regained momentum in August (and has extended into early September). Pan-Euro HY credit was down -0.11% after rallying +1.31% in July, and EM HY credit was off -2.45% with benchmark spreads +86bps wider, though even this understates the mounting strain in those economies leading the fall (Turkey, Argentina at the center thus far). Domestic markets looked right through the “noise” however, with fixed income instruments, U.S. High Yield included, seeing credit spreads hold relatively steady (and benefit from the quality flight driven rally in treasuries). U.S. IG Credit returned +0.51% and U.S. HY Credit returned +0.74%. U.S. Equities have been the most agnostic to prospective contagion risk with the S&P up over 3% for a second straight month and the Russell 2000 up +14.3% on the year! While observing the apparent decoupling between EM and U.S. risk, it is hard not to recall the thesis de jure just a few months back that U.S. credit is late-cycle while EM is mid-cycle. However, if the U.S. is late-cycle could EM really remain immune to the transmission of actions taken domestically (specifically those of the Fed) in a complex interdependent financial system? Conversely, are U.S. assets truly ring-fenced from the fundamental ails of economies abroad? As always, most important is what is priced into securities, and with high yield risk premiums affording scant margin for error, we continue to see reason for caution.

Market Performance

Market technicals reigned supreme amid non-threatening (as far as the HY marketplace is concerned) macro and micro information flow. With inflows into non-discerning ETFs and a seasonally light new issue calendar, a general upward trend in market prices took hold, with the Bloomberg Barclays U.S. HY Index earning a +0.72% total return for the month. Interest rates were also supportive of fixed income prices with 5yr and 10yr treasury yields both 11bps lower month-over-month.

Across the quality strata, we saw a deviation from trend in that CCC-rated debt underperformed higher quality BB credits. Indeed CCC-rated bonds returned +0.26% in August, while BBs earned +0.92%. Notwithstanding August, the higher beta cohort has outperformed meaningfully this year – CCCs outperformed BBs by +510bps through July, though now down to +449bps post the August reversal. Looming LBO (i.e. CCC-rated) supply in September was touted as a principal headwind for this cohort this month; however, we would argue that following significant basis compression this year (the CCC / BB basis was 76bps tighter year-to-date through July), and escalating macro (EM contagion) and micro (deteriorating credit metrics) risks, valuations warranted (and still warrant) decompression.

CCC-BB HY OAS Basis

Source: Bloomberg

Source: Bloomberg, Barclays

Save for modestly negative returns for the Retail and Oil Field Services sectors, each industry realized generally positive performance. Idiosyncratic catalysts in large capital structures drove the negative returns for those two sectors. For Retail, poor operating results from J.C. Penney drove bonds across the capital structure down 6-16pts. Notably, the 2nd Lien bonds, which were issued at par in March to much investor fanfare, traded as low as 68 cents on the dollar mid-month. Also, Rite-Aid bonds dove -10pts following the surprised dissolution of its merger agreement with Albertsons. The grocer terminated the deal after RAD investors voted down its take-over bid. Oil Field Services were dragged down principally by Weatherford, the bonds of which lost incremental sponsorship on liquidity concerns after the company failed to sufficiently extend its revolving credit facility (only 36% of its revolving credit commitments agreed to extend).

Source: Bloomberg, Barclays

Fund flows have seemingly stabilized for the high yield market, or at least this has been the case in recent months. July fund flow estimates were revised to a small net outflow, in of itself a break from the heavy exodus we had seen consistently during the first half of the year, and estimates for August are a net inflow of ~$1.5bn. Of note, ETFs accounted for over 100% of the inflow with actively managed mutual funds receiving redemptions (~$200mn in August) as the balance between passive vs. active management continues to tilt, not inconsistent with late-cycle retail investor behavior. Still, the U.S. HY market has seen -$23bn on balance leave the sector this year, all seemingly with little impact on risk sentiment / volatility in the marketplace.

Capital Flight Has Taken a Pause in Recent Months as Other Asset Classes (Specifically, Emerging Markets) Have Seen Large Outflows

Source: Credit Suisse, EPFR

While traditionally a lighter month in terms of new supply, compared to July, primary activity received a jolt in August, principally in the first half of the month. Compared to just $7.5bn of gross issuance in July (one of the lowest prints of this cycle), August saw ~$17bn in USD denominated volume, anchored by several benchmark deals. BMC Software and Verscend were first movers in what is slated to be a robust LBO/M&A financing pipeline over the coming month (Thomson Reuters, Akzo Nobel, Lifepoint to name a few). Also, Intelsat and HCA Healthcare were other bellwether issuers which tapped the market to refinance near-maturing debt. Despite the more normal pace of activity in August and inflated expectations for volumes in September (est. $30bn), year-to-date gross issuance is still down -29% year-over-year.

High Yield Net Supply ($MM)

Source: Barclays

Cumulative Issuance Year-to-Date Is The Lowest in the Last 5 Years

Source: Credit Suisse

Fundamental Trends

August extended the corporate default drought as no high yield bond issuers defaulted on their obligations this month. Notably, default activity has been limited over the past four months, with only two issuers defaulting on just $1.0bn of debt (the lows of this cycle). Issuers in the Energy and Retail sectors have accounted for near 50% of the default volumes this year, though as the restructuring wave beginning in late-2015/early-2016 in the former abates, and accommodative funding markets and still healthy consumer spending offer a lifeline to the latter, activity has significantly calmed for now. As such, excluding this year’s bankruptcy behemoth iHeart (with $16bn of debt), the trailing twelve month high yield default rate through August stands at just 1.3% (2% including iHeart).

U.S. HY Default Activity Has Been Virtually Non-Existent Over The Last 4 Months

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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