Loan Review – October 2016

Monthly Commentary

November 10, 2016

Who are Tyler, Harrison, Van Buren, Fillmore, Buchanan, Hays and Arthur? They are arguably the least distinguishable and least recognized presidents in U.S. history. Americans agonized about the impact of both candidates during this last election cycle and perhaps an unremarkable presidency would be a positive outcome during the next four years. Similar to these less distinguishable presidents, October loan market performance was not distinctly different from the last several months. The technical imbalance between demand and supply remained intact for most of the month as inflows from both retail funds and CLOs overwhelmed mergers-andacquisitions- driven new issuance.

However, at the tail end of the month, loans began to weaken following declines in broader markets and a softening of crude prices. While the weakness backed the loan market down off of its inter-monthly highs, October still printed a solid gain. In fact, the CS Leveraged Loan Index recorded its highest return year to date through October since 2009.

The 3-month LIBOR rate rose approximately three basis points in October. This incremental rise added further stress to CLOs interest coverage tests. Increasing LIBOR erodes the benefit of the existing LIBOR floors. At the same time, increasing LIBOR attracts new investors (seeking higher yields) into the asset class.

The overwhelming majority of new issuance in October was dedicated to refinancing existing bank debt on more favorable terms for borrowers. Resistance to the most egregious requests began to emerge at the end of the month while trading volumes dwindled as investors wanted clarity on the presidential election.

Performance

In October 2016, the Credit Suisse Leveraged Loan Index (“CS LLI”) was up 0.77% and the S&P Leveraged Loan Index (“S&P/LSTA”) was up 0.83%.

  • Year to date ending October 31, 2016, the CS LLI was up 8.28% and the S&P/ LSTA was up 8.61%.
  • For the 12 months ending October 31, 2016, the CS LLI was up 6.30% and the S&P/LSTA was up 6.53%.

Sector Performance

The top three performing industries for the month were Energy, Metals & Mining and Information Technology, which posted returns of 5.20%, 4.30% and 1.04%, respectively. Crude prices rose over 5% in the first three weeks of October on OPEC news and Energy loans surged in response. However, loans began fading in late October along with OPEC’s hopes of significantly cutting production. Metals & Mining continued higher on positive Chinese economic data. Finally, Information Technology led all other industries and produced the best returns for the month of any non-distressed market segment.

Total Return by Sector

Source: Credit Suisse Leveraged Loan Index

The worst performing sectors in October were Transportation, Retail and Healthcare with returns of 0.38%, 0.30% and 0.05%, respectively. Retail and Healthcare are notable as several weak earnings reports have weighed on both segments. Within retail, Gymboree provided disappointing results, leading investors to rethink brick and mortar stores, which had rallied during the last several months.. Within Healthcare, both rural hospitals and pharmaceuticals have provided many negative headlines, sending a number of loans lower on the month.

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 35.20%, 29.06% and 9.91%, respectively. Interestingly only four sectors provided returns in excess of the Index return. This includes the three sectors listed above as well as Consumer Durables. Sixteen of the 20 sectors in the CS Index have underperformed the Index, which demonstrates the impact of Energy and Metals’ returns on overall performance.

Risk continued to outperform as lower-rated categories outperformed higher-rated categories. Single-Bs returned +0.69% versus 0.18% for double Bs. Some higher-rated names trading above par retreated from recent highs on refinancing fears. Year to date, single-B loan returns now stand at +8.21% compared to +5.76% for double-Bs. Despite their underperformance, the 3-year discount margin for double-B loans remains close to post-global financial crisis lows set in September (313bps). 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 rally has increased the percentage of loans trading above par and has allowed the refinancing wave to be extended into October. At month end, the percentage of The JP Morgan Loan Index trading above par was at a 16-month high, 56.4%.

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

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

October loan prices were 29 bps higher than September and this also represented the fourth consecutive monthly price increase.

Technical Conditions

October was the highest issuance month for CLOs year to date with $8.4 billion in new-issue volume. It represented the second consecutive month of volumes in excess of $8.0 billion. Tightening liabilities, led by foreign investment, helped spur recent issuance levels. There was also a rush of deals seeking refinancing or resetting before risk-retention rules come into effect. In fact, twenty-one deals were refinanced or reset during the month, doubling the amount year to date.

CLO Volume ($ Billions)

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

While rising rates negatively impacted most asset classes in October, leveraged loans managed to provide a steady gain. Loans outperformed most asset classes during the month, including high-grade bonds (-0.88%), the 10-year Treasury (-1.11%), and S&P 500 (-1.82%). Technical characteristics of the market continued to drive prices higher. Historically, rising LIBOR has attracted retail fund flows and this has been true thus far in 2016. LIBOR has risen 27 bps points during the year and 3 bps in the month of October. As LIBOR has moved higher, demand has outpaced supply.

Retail funds had posted 14 consecutive weeks of positive inflows by the beginning of November, totaling over $2.0 billion for the second consecutive month. Outflows year to date for loan mutual funds remain negative at -$3.8 billion. 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

October new issue supply remained strong, driven by opportunistic refinancings and repricings. Volumes for the month were up 200% from October 2015 but down 22% from September 2016 as many investment banks moved up their forward calendars to be syndicated prior to U.S. elections. This was done for two reasons: first to take advantage of the strong demand and second to avoid the risk of a “Brexit” type event in the U.S. Presidential election. New net-volume (volumes less refinancings and repricings) continued to be inadequate in terms of satiating loan demand. Approximately 70% of the institutional loan issuance since May has been either re-pricing or refinancing.

Leveraged Loan Volume

Source: S&P Leveraged Loan Index

Mergers and Acquisitions, which dominated the calendar in the first quarter, dropped dramatically in the last two quarters. While nearly 60% of new issue, year to date, may be classified as LBO driven or acquisition related, much of that is not bringing actual new dollars to the loan market. For example, in October, Hoffmaster launched a new issue syndication whereby the company was being sold from one financial sponsor to another. This means the old term loan gets paid down and a new term loan syndicated. The net amount of incremental dollars is not significant. However, 100% of the newly syndicated term loan is picked up in the LBO new issue volume.

New-Issue Loan by Purpose – YTD 11/3/16 Total Volume

LoanStats Weekly

Fundamentals

Single-B new issue yield-to-maturity widened 5 bps in October from September while double-B new issue tightened 31 bps in the month. Yields on new issue double-B are at the tightest levels since August 2015.

New-Issue First-Lien Yield to Maturity

Source: S&P Leveraged Loan Index

One additional loan company defaulted in October, Tervita. It was another deal in the Oil & Gas sector. The LTM default rate decreased from 1.98%, based on a par amount outstanding, to 1.62%. The default rate based on unique issuers also declined to 2.00%.

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.

Eighteen of the 28 defaults that have occurred in the last 12 months are Energy and Metals related borrowers. Overall default rates remain low and are concentrated in commodity sectors. Shadow default activity suggests the commodity sector 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 a potential contributor to the default rate during the next year.

Valuation

Since 1992, the average 3-year discount margin (“DM”) for the CS LLI, is 463 bps. If the global financial crisis (2008 & 2009) is excluded, the 3-year discount margin for the CS LLI is 416 bps. At month end, the 3-year DM was wide of the historical average, at 494 bps but 14 bps tighter than the prior month.

The DM spread differential between double Bs and single Bs has tightened from November 2015 to October 2016 by 66 bps. It is also 3.9 bps 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

Source: Credit Suisse Leveraged Loan Index

Summary

As of October 31, the S&P/LSTA Index imputed default rate was 3.22%. That is down from 3.62% at the end of September 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 3.22% 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 to 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. © 2017 TCW