Loan Review – September 2016

Monthly Commentary

October 07, 2016

Do you know when you picture a town in the Old West, how the building fronts are high and impressive? But when you turn the corner, you immediately see it is all a façade. That is similar to what the impact of rising LIBOR has been on bank loan yields.

LIBOR is moving higher and with it, it is bringing new investors to mutual funds and separately managed accounts. Demand for loans is also being driven by significant interest in Collateralized Loan Obligations (CLOs), particularly from overseas investors.

The lure of increasing yields in loans, as a result of rising LIBOR, is quickly being offset by a repricing wave which is lowering LIBOR spreads. However, actual yields are being negatively impacted not only by LIBOR spread reductions but also the elimination of LIBOR floors.

LIBOR floors provide a minimum amount that investors will receive, regardless of how low LIBOR goes. In the last few years, most companies have had to provide a LIBOR floor in order to syndicate their loans. A typical double-B rated company has a 75 basis point floor. Most investors watch 3-month LIBOR as companies will typically peg their debt to that measure (most bank loans pay quarterly interest).

Removing LIBOR floors seems relatively harmless when the floor provides a minimum of 75 basis points and 3-month LIBOR is actually at 86 basis points. However, the front end of the LIBOR curve remains very steep. 1-month LIBOR is roughly 0.53% and 3-month LIBOR is 0.86%. With the removal of floors, most companies have the ability to toggle between different LIBOR rates: 1-month LIBOR, 3-month LIBOR and 6-month LIBOR. Therefore, when floors are removed, investors could actually experience a 30+ basis point reduction in yield from the loss of the LIBOR floor and a 25 to 50 basis point reduction in LIBOR spread.

Despite the repricing wave, the percentage of the JPMorgan Leveraged Loan index trading above Par has climbed to a 16-month high 58.49% and 71.1% of loans are also trading above $99.50. With loan prices this elevated, one would expect a continued pattern of companies repricing their debt at lower yields.

Performance

In September 2016, the Credit Suisse Leveraged Loan Index (“CS LLI”) was up 0.87% and the S&P Leveraged Loan Index (“S&P/LSTA”) was up 0.86%.

  • For the 3 months ending September 30, 2016, the CS LLI was up 3.10% and the S&P/LSTA was up 3.08%.
  • Year-to-date ending September 30, 2016, the CS LLI was up 7.46% and the S&P/LSTA was up 7.72%.
  • For the twelve months ending August 31, 2016, the CS LLI was up 5.35% and the S&P/LSTA was up 5.46%.

Sector Performance

The top 3 performing industries for the month were Metals & Mining, Energy and Gaming, which posted returns of 5.09%, 3.16% and 1.20%, respectively. Most base metals and precious metals moved higher in the month of September and the bank loans related to these industries outperformed. WTI crude prices increased over 10% in September, which helped to push Energy loans higher across the board. Gaming benefited from Caesars (CEOC) entering into restructuring agreements with all major creditor groups. This resolve led to all loans remotely connected with the Caesars complex to rebound significantly.

Total Return by Sector

Source: Credit Suisse Leveraged Loan Index

The worst performing sectors in September were Utility, Consumer Non-Durable and Housing with returns of -0.66%, 0.52% and 0.57%, respectively. In the Utility segment, the $19.5 billion Texas Competitive Electric Utilities term loan, which had entered into bankruptcy in April 2014, remains in the index. This Company has been restructured and there were some technical dynamics pushing the loan down as the debt was converted to equity. Therefore, while most of the Utility segment was up, this one loan, which represents a significant percentage of the sector, was down over 6% for the month. The remainder of the sector outperformed the index. Underperformance for Housing was driven by the fact that it trades closer to par and the average spread for the sector is below the average spread for the index. Consequently, the market rally had a less pronounced effect.

The year-to-date returns for all sectors in the CS LLI are positive. Metals & Mining, Energy and Gaming are the top performing industries, with returns of 29.63%, 22.68% and 9.13%, respectively. While Energy-driven industries have performed very well year to date, it was the second poorest performing sector during the last 12 months, proceeded by Utility.

Risk continued to outperform as lower-rated categories outperformed higher-rated categories. Single-Bs returned +0.86% vs. 0.58% for double-Bs. Year-to-date, single-B loan returns now stand at +7.48% compared to +5.56% for double-Bs. Despite their underperformance, the 3-year discount margin for double-B loans tightened to new post-global financial crisis lows in September (313bp). The average 3-year discount margin for double-B loans since 1992 is 330 bps. Single-Bs are at the 24-year average of 523bps.

Total Return By Rating

The CCC and distressed portion of the loan market also had strong months, posting returns of +2.09% and +2.68%, respectively. Year to date CCC and distressed returns are 16.13% and 18.84%.

The rally, which continued throughout September, increased the percentage of the loan index trading above par. In fact, the JP Morgan Loan Index registered 58.49%, a one-year high, trading above par.

The average bid price for the S&P/LSTA Leveraged Loan Index at month-end was 95.12, which is the highest level since September 15, 2015.

S&P/LSTA Leveraged Loan Index Average Bid

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

Loan prices continued to grind higher each of the last three months and the average bid increased 68 basis points from the prior month.

The graph above highlights the average bid of the S&P/LSTA Index, which includes over 900 issuers.

Technical Conditions

The CLO market continued to post significant issuance in the month of September with 16 U.S. CLOs priced for a 15-month high $8.4 billion. The continued strong bid for triple-A paper from Asia is driving the demand for CLO creation. Year to date volume significantly lags last year’s pace; 103 U.S. CLOs have priced year-to-date totaling $46.1 billion, which is down 41% versus $78.87 billion over the same period a year ago.

Monthly U.S. CLO Volume ($ Billions)

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

Three-month LIBOR remains notable as it broke through 86 basis points for the first time since May 2009. As LIBOR rises beyond the embedded value of the LIBOR floors, the overall yield on loans increases. In a world where yield is difficult to find, increasing yield and low duration is driving new investment in the loan space. However, rising yields seem to be offset with refinancing activity that lowers the spread of the loan.

Retail funds posted nine consecutive weeks of positive inflows by the end of September totaling $2.0 billion for the month. Outflows year-to-date for loan mutual funds remain negative at -$6.2 billion compared to -$9.9 billion in the same period in 2015. The combined demand for CLO and retail funds has coincided with increasing loan returns, as can be seen below.

S&P/LSTA Leverage Loan Index Returns and Loan Inflows

Source: S&P Leveraged Loan Index

September supply increased dramatically with opportunistic refinancings and institutional issuance reaching its highest level since February 2013. Total year-to-date institutional loan issuance is up 13% from same period in 2015.

Leveraged Loan Volume

Source: S&P Leveraged Loan Index

Mergers and Acquisitions, which dominated the calendar in the first quarter, dropped dramatically in September. The majority of September’s loan volume was used for repricing ($10.6bn) or refinancing ($24.2bn), whereas net new volume of $20.4 billion was manageable.

The percentage of loans trading above par has allowed issuers to refinance, reprice and aggressively pursue opportunistic transactions.

September Institutional New Issue Volume

LoanStats Weekly

Fundamentals

Single-B new issue yield-to-maturity tightened 36 basis points in September from August while double-B new issue tightened 38 basis points in the month. While yields on new issue double-Bs are at the tightest levels since August 2015, prices remain persistently high, which suggest the repricing wave will continue in October.

New-Issue First-Lien Yield to Maturity

Source: S&P Leveraged Loan Index

There were no defaults in September and the LTM default rate decreased slightly to 1.95% based on a par amount outstanding. The default rate based on unique issuers also remained essentially flat at 2.23%.

Lagging 12-Month Default Rates

Source: S&P Global Market Intelligence * 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.

Seventeen of the 27 defaults over the last 12 months are in the Energy and Metals sectors. While defaults generally remain low, they have increased and commodity sectors will continue to drive the default rate during the next 12-18 months. Retail contributed the third largest number of sector defaults in the last 12 months and also factors as being a contributor over the next year.

Valuation

Since 1992, the average 3-year discount margin (“DM”) for the CS LLI, is 463 basis points. If the global financial crisis (2008 & 2009) is excluded, then 3-year discount margin for the CS LLI is 415 basis points. At month end, the 3-year DM was wide of the historical average, at 505 basis points but 14 basis points tighter than the prior month.

The DM spread differential between double Bs and single Bs has tightened from October 2015 to September 2016 by 39 basis points. It is also 17 basis points wide of the historical spread differential.

3-Year Discount Margin Differential Between BBs and Single Bs

Source: Credit Suisse Leveraged Loan Index

CS LLI Snapshot

Summary

As of September 30, the S&P/LSTA Index imputed default rate was 3.62%. That is down from 3.88% at the end of August and considerably below the multi-year high in February of 7.3%. While the imputed rate implies that the market will likely see an increase in defaults, it is not implying a very high overall default rate. Moreover, default activity over the past year has been concentrated within sectors tied to commodities. Therefore, the 3.62% imputed rate likely implies that commodity driven sectors will continue to dominate defaults but the market will not likely experience a spike in defaults from other sectors.

Technical characteristics of the market have been driving the returns for most of the year. Increasing LIBOR and the fear of the Federal Reserve increasing interest rates is pushing investors into the loan asset class. Demand is outstripping supply and moving prices higher and yields lower. Despite less attractive valuations, the outlook for the near term remains the same. There is not enough new paper from true merger and acquisition activity to offset demand. Without a fundamental macroeconomic event or broad-based weakness spilling in from high yield and other capital markets, the technical dynamics for loans will continue keep loans well bid.

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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. © 2018 TCW