Loan Review – October 2017

Monthly Commentary

November 13, 2017

Mergers and acquisition activity slowed significantly in October from August and September while CLO demand remained steadfast. Relentless demand combined with scarce new issue, led to the second strongest month of loan performance in 2017. Rising prices pushed the percentage of the Index trading above par to 74.4%, exceeding the recent peak in August.

Typically, when 70% of the loan market trades above par, we see a re-pricing wave of loan-LIBOR spreads. October was no exception to this pattern. Approximately $200 billion of loans in the past 12 months were issued at spreads of less than 250 basis points. This means roughly one-fifth of the institutional loan market is now priced at or below L+250.

Loan spreads tightened 14 basis points for the month, briefly touching post-crisis lows. This trend will likely continue for the remainder of the year as the technical conditions of the market remain unchanged.

Repricings are being affected in both the syndication market as well as via amendment. Roughly 78% of repricings were completed by amendment, which means the existing lender base is more concerned about losing paper than they are about maintaining the current yield on the loan.

Leveraged Loan Repricing Volume

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

However, despite the strong monthly performance, the loan market still possessed a certain incongruity. Toward the end of October we began to see volatility increase. A number of loan borrowers missed earnings estimates and a number of industries began to see some duress. Therefore, while the new issue market is issuing deals at post financial crisis tights, we are also seeing a growing list of borrowers and industries that are falling out of favor.

Performance

In October, the Credit Suisse Leveraged Loan Index (“CS LLI”) was up 0.66% and the S&P Leveraged Loan Index (“S&P/LSTA”) was up 0.60%.

  • Year-to-date ending October 31, the CS LLI was up 3.72% and the S&P/LSTA was up 3.59%.
  • For the twelve months ending October 31, the CS LLI was up 5.25% and the S&P/LSTA was up 5.06%.

Split single B and triple Cs outperformed all categories while single B and split BB loans provided identical returns. On a year-to-date basis, lower quality loans nearly doubled returns for single Bs, Split BBs, double Bs and split BBB.

Source: Credit Suisse Leveraged Loan Index

Sector Performance

All sectors provided a positive return during the month led by energy (+1.14%), utility (+1.14%) and food & drug (+0.90%). Rising oil prices and improved supply-demand power dynamics (particularly within the ERCOT market) helped energy and utility outperform.

The worst performing sectors were Aerospace (+0.52%), Healthcare (0.50%) and Consumer non-durables (0.20%). Healthcare began to lag in October as concerns surrounding hospital admissions weighed on earnings estimates and loan prices alike. Consumer non-durables continue to lag as investors fear the impact of a changing retail landscape. Interestingly, when looking at the CS Liquid Leveraged Loan, Consumer (-0.6%) and Retail (-0.3%) were the worst performers in October due to continued weak fundamentals and very negative sentiment in the space.

Returns by Sector for CS Leveraged Liquid Loans

Source: Credit Suisse

On a year-to-date basis, Energy, Services and Metals led all sectors with total returns of 4.96%, 4.84% and 4.69%, respectively.

On a year-to-date basis, Consumer Durables, Food & Drug and Retail were the worst performing sectors with returns of 2.04%, 0.62% and -3.26%, respectively. All three sectors are being impacted to some degree by e-commerce.

Total Return by Sector

Source: Credit Suisse Leveraged Loan Index

Flow-name prices moved higher in October, peaking midmonth and then declining during the last two weeks of the month.

October loan prices benefited from a dearth of supply, helping to push loans close to their highest levels in the last 12 months.

Average Loan Flow-Name Bid

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

Average Price of the CS LLI (LTM)

Source: CS LLI

Technical Conditions

CLO new issue supply was $12.8 billion in October, up 44% from September. Year-to-date, over $94.5 billion of CLOs have been issued, far exceeding estimates for 2017. With the constant drumbeat of CLO issuance, loan prices continue to grind higher and spreads continue to tighten.

CLO Volume

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

Institutional new issue volumes decreased 36%month-over-month while pro rata new issuance declined by 66%. The loan market issued approximately $40 billion of loans in October (the second lowest month of the year) and almost half of that was simply repricing or refinancing existing deals. Therefore, the real supply to the market was closer to $20 billion, further contributing to the technical imbalance.

Leveraged Loan Volume

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

In October, the repayment rate dropped to its lowest level of the last 12 months. The repayment rate for the lagging three months was below 6.0%, down from the average lagging three-month repayment rate in 2017 of approximately 10.0%.

Lagging Three-Month Repayment Rate

Source: LCD, an offering of S&P Global Market Intelligence: S&P/LSTA Leveraged Loan Index

Within prime-rate funds, the loan asset class has now endured mild outflows in 11 of the past 14 weeks. The monthly reporting base had outflows of -$145 million in October. AUM for the leveraged loan retail base of $143 billion is now comparable to the peak in 2014 of $154 billion.

M&A-driven new issuance dwindled and nearly 50% of the primary consisted of repricings and refinancing activity. The combination of lower repayments, muted retail outflows and little new issuance in the market, left the growing CLO market needing more paper.

October Institutional Volume

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

The percentage of the index trading above par stands at 74.4%, exceeding the high reached in early August and near the 76.0% year-to-date high in mid-March. Given the fact that most loans trade near par and the fact that the average LIBOR spreads have declined as a result of repricings, the trailing 12-month return has declined amid heavy CLO inflows.

Inflows and Rolling LTM Returns

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

As can be seen below, new issue spreads in October were relatively unchanged for BBs and slightly wider for single B issuance. However, this is more a product of new issue mix than actually being representative of the spread trends.

The Index spread for the CS LLI ended October at roughly L+361 bps. The last time the CS LLI average LIBOR spread was close to this level was in April 2011. It is also 27 bps tighter than in January 2017 and demonstrates the spread compression which has taken place year-to-date.

New Issue Spread Changes

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

Average new issue yields contracted month-over-month for Single Bs (-0.01%) and Double Bs (-0.02%).

Average New-Issue Yields

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

While there had been 22 defaults in the last 12 months, there was only one in October. The LTM default rate remained stable based on number of defaults (1.41%) and declined slightly based on par amount outstanding (1.51%). Regardless of measurement, default rates remain very low on a historical basis.

Lagging 12-Month Default Rates

Source: LCD Loan Stats
* 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

Retail, Oil & Gas and Healthcare provided the most defaults in the last 12 months with the sectors tallying 7, 3 and 3, respectively. Given the secular changes in purchase patterns of consumers, it is likely that we will see Retail defaults increase. The shadow default activity remains low, suggesting that there will not be any broad-based increase in the next 12 months.

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, the 3-year discount margin for the CS LLI is 417 basis points. At month end, the 3-year DM (417 basis points) was tight to the historical average and 15 basis points tighter than the prior month.

The DM spread differential between double Bs and single Bs has widened from November 2016 to October 2017 by 8 basis points and is still 33 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

Source: Credit Suisse Leveraged Loan Index

Summary

As of October 31, the S&P/LSTA Index imputed default rate was 1.64%, one of the lowest levels since December 2007.

Buyers outpaced sellers by a good margin in October. The reduced supply of M&A-driven transactions from prior months led to a material technical imbalance between supply and demand. Secondary levels pushed higher and repricing of existing spreads accelerated. With nearly $95 billion of CLOs issued year-to-date, 2017 looks to be one of the strongest CLO issuance years in history.

Looking forward, with institutional cash balances at relatively high levels and a number of ramping CLOs looking to price before year-end, demand will likely remain intact for November and December. For the demand picture to change, it would require large retail outflows and strong selling of loan assets from high yield accounts.

 

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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