August High Yield Credit Update

Monthly Commentary

September 20, 2019

Elevated dispersion in the high yield marketplace remains a principal theme in 2019, and one we believe relevant to reemphasize in this month’s recap. This is observable at the industry level with the extreme underperformance of the Energy sector (Oil Field Services down -0.06% year-to-date; Independent E&P down -1.45% year-to-date) versus top performing sectors, including Financials and Wireless (each up over 15% year-to- date). Observable across credit quality with the performance of higher risk, CCC-rated bonds decoupling materially from that of higher quality credits. This bifurcation accelerated in August, bringing year-to-date underperformance by CCCs to nearly -700 basis points (bps) behind BBs.

Risk Averse Rally: BBs are Trouncing CCCs Year-to-Date Cumulative Total Return by Rating
YTD Through 8/31/19

Source: Bloomberg

Importantly, and underpinning this bifurcation in the aggregates, the dispersion is observable at the bond level, with credit-specific and “thematic” dislocations growing both in frequency and breadth, at a time when approximately 35% of high yield bonds trade at a yield-to-worst of less than 4%! “High yield” indeed! Dispersion is everywhere with landmines present in both low fundamental credit quality bonds (this week McDermott bonds collapsed to 16 cents on the dollar down from 95 cents less than two months ago) and fundamentally safer risks (it’s a simple fact, there are many ways to lose investing in 4% yielding junk bonds).

Market Performance

High yield bonds generated positive returns of +0.40% in August, but the components of that performance are worth deconstructing. Of note, the rally in interest rates (5yr and 10yr Treasury yields declined -45bps and -52bps, respectively, for the month) contributed +154bps to that +40bps of total return. As such, the excess return for high yield credit during the month was actually negative, -1.14% to be exact.

The negative excess return is consistent with the risk-off expression across broader equity and fixed income markets during the month: large cap stocks outperformed small cap stocks (S&P 500 -1.6% vs. Russell 2000 -4.9%), investment grade credit outperformed high yield credit (IG +3.13% vs. HY +0.4%) and Treasuries outperformed everything (GOVT ETF +3.4%). Within the high yield market, bifurcation in performance across credit quality was also pronounced. As highlighted above, higher quality credits outperformed lower quality by approximately 300bps, on average, accelerating the dislocation observed for the better part of the year. Indeed, by the end of August, BBs had outperformed CCCs by +668bps year-to-date. The bifurcation in August seemed to be driven by two factors: 1) empirical interest rate duration (that of BB-rated bonds being higher than that of CCCs) and 2) continued reallocation of capital WITHIN the marketplace away from risk and toward relative safety in the absence of wholesale capital flight.

Source: Bloomberg, Barclays

Investor attention was squarely on Energy this month with HY E&P and OFS credits drawing down aggressively during the first half of the month as investor sponsorship of the sector at large continued to crater. The decline in spot commodity prices in the first week of the month, concurrent with select earnings misses from benchmark E&P credits (as an aside, it was not a good time for an Energy company to miss on earnings), sent market prices down across the sector -10-20pts. Energy, E&P and OFS subsectors specifically, are the only industries that have generated negative returns on average year-to-date. While market stress is most acute in Energy, August saw further evidence of waning investor sentiment and aversion to risk with numerous uncorrelated collapses in prices. Exela Technologies, Mallinckrodt, GTT, TeamHealth, Envision Healthcare, Dean Foods and Frontier, to name a few, saw their liabilities re-price lower in excess of 10bps. Frontier is of note, partially due to its relevance (a benchmark high yield capital structure), but also because significant mark-to-market losses were realized in its nearest maturing bond as investors began to lose faith in the company’s near-term creditworthiness.

Source: Bloomberg, Barclays

Market Technicals

While the high yield marketplace effectively closed for the season during the last two weeks of the month, flaring macro and microeconomic concerns during the first week in August prompted the first pronounced exodus of capital from ETFs and mutual funds since the end of April. Funds faced $4bn of redemptions, though we suspect some double-counting in the data as it is well understood that (some) high yield fund managers have positions in the HYG ETF itself and tend to sell those investments first to fund their own outflows. Regardless of the true magnitude, and in spite of the directional outflow, bond prices were less impacted on a sustained basis (Monday, August 5th did see aggressive selling of bonds from ETF authorized participants, driving prices indiscriminately lower and providing an attractive discrete buying opportunity) than in prior instances of large outflows.

Approximately $4bn in Retail Outflows Didn’t Prove Disruptive to the Marketplace as A Whole

Source: Credit Suisse, EPFR

The primary market was effectively shuttered for the month as market volatility in the first two weeks dissuaded issuers/bankers from syndicating deals, while the back half was impacted by the reality of seasonally thin marketplace participation. Under $10bn in USD-denominated high yield rated debt was issued in August, the lightest monthly volume for the year. Just under half of the total was the benchmark refinancing deal from Tenet Healthcare, which was also the last deal syndicated before investors returned after Labor Day. The Tenet deal was notable as it would appear to confirm our view that current investor complacency is fragile, even when dealing with high quality credit risk. Despite a relentless bid for high quality credit driving valuations to cyclical tights, these Tenet senior secured (1st lien) bonds were issued amid broad market volatility and suddenly that supposed overwhelming liquidity evaporated. The bonds cleared the primary market with a coupon that was reasonably +50bps wide to where investors indicated interest just one day prior. It was a good buying opportunity for TCW no doubt, but also a microcosm of the speed at which the pendulum will swing from complacency to fear.

Source: Barclays

Fundamental Trends

Aggregate high yield corporate default rates continue to hold at cyclical lows with just two bankruptcy fi lings in August from Halcon Resources and Sanchez Energy. Not substantial in notional size (just shy of $3bn in par amount of high yield bonds outstanding between the two issuers), though relevant observations as these are just the latest issuers within the Energy sector to be left for dead by lenders. While trailing default rates remain low, the growing stress within the Energy sector (and idiosyncratic distress in other corners of the market – Frontier for example) may portend losses ahead.

Risk Premiums for Energy Credits Have Those for the Rest of the High Yield Market…

Source: Bloomberg

…Reminiscent of the Lead-up to the Decoupled From Those 2015/2016 Market Sell-Off

Source: Bloomberg

 

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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