Loan Review – October 2018

Monthly Commentary

November 14, 2018

“Taking stock.” What does that mean? Occasionally, we have to step back, look at our lives, our jobs or our markets and think about bigger questions. What does it all mean? Well, let’s just focus on the loan market for now and take stock of what has transpired in the last four months. Does it portend anything for the remainder of 2018 or even 2019?

In July, loan new issuance was 91 basis points wider than May. That seems to be a big data point. In August, a very light month for primary activity, new issuance only tightened 6 basis points from July. In fact, August new issue spreads required the second widest levels since November 2016 in order to get deals syndicated. As discussed in last month’s monthly commentary, this set the stage nicely for September’s mega-issuance month to struggle. But it did not struggle and what we have heard through the grapevine is that one Japanese bank may have contributed nearly $30 billion to a group of loan managers. Loan separate accounts do not have monthly reporting like mutual funds, so details are always vague. However, several investment banks have provided some confirmation of this massive investment. Separate account dollars are generally invested quickly at the market levels as opposed to the way a CLO is ramped over several months. Obviously, without that massive contribution, the loan market had been poised for more weakness.

That leads us to October and just as soon as a threat of a repricing wave materialized, it vanished. Broader global market weakness led to retail fund outflows and crossover selling of loans from high yield accounts. Loan prices sagged… again. That is a staggering thought. First that a single bank invested $30 billion in September and second, that one month post such a massive contribution prices sagged. One last data point: only three months in 2018 have actually provided loan price appreciation.

October also brought an earnings season of mixed results. Volatility increased and companies that underperformed expectations were severely penalized. Loans with high yield bonds in the capital structure, loans in more cyclical businesses and higher beta loans all traded materially lower.

During the last few years, loan spreads have generally tightened when primary issuance was low. The remainder of 2018 has very little loan issuance planned, and most investment banks are more focused on their first quarter of 2019. While loans have performed quite well versus other fixed income products, there has been an undeniable tone of weakness underlying the back half of 2018. While we suspect you could see prices slightly higher by the end of the year, it feels like this broader market volatility will prevent loans from bouncing too much.

Performance

In October, the Credit Suisse Leveraged Loan Index (CSI LLI) and the S&P Leveraged Loan Index (S&P/LSTA) were up 0.01% and down -0.03%, respectively.

  • Year-to-date, ending October 31, the CS LLI was up 4.33% and the S&P/LSTA was up 4.00%
  • For the 12 months ending October 31, the CS LLI was up 4.89% and the S&P/LSTA was up 4.54%

Lower quality loans underperformed as Triple Cs and Split Single Bs provided the worst performance during the month while Split Triple Bs and Single Bs led all categories.

Total Return by Rating

Source: Credit Suisse Leveraged Loan Index

Sector Performance

Thirteen of the 20 sectors in the CS LLI provided a positive return during the month. Top performing sectors in October were Transportation (+0.31%), Forest Products/Containers (+0.21%) and Service (+0.20%).

The worst performing sectors for the month were Housing (-0.22%), Retail (-0.72%) and Metals/Minerals (-1.35%).

On a year-to-date basis, Retail (+8.15%), Energy (+7.18%) and Food & Drug (+5.70%) outperformed.

In the last 12 months, Retail, Energy and Food & Drug have led all sectors with total returns of 8.22%, 8.19% and 7.47%, respectively. In contrast, Food/Tobacco, Consumer Non-Durables and Consumer Durables were the worst performing sectors with returns of 3.88%, 3.50% and -0.88%, respectively.

Industry Returns

Source: Credit Suisse Leveraged Loan Index

Credit Suisse Leveraged Loan prices decreased -48 basis points in October while the average bid of the S&P LCD flow-name loan composite drifted 10 basis points from 99.58 to 99.48.

Average Loan Flow-Name Bid

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

Technical Conditions

Leveraged loan funds reported an outflow of -$680 million for the four-week period ending October 31. While assets under management remain close to record high levels, three of the four weeks in October registered outflows. For context, the loan asset class has reported inflows in 37 of the past 41 weeks. Inflows for loan mutual funds total +$15.2 billion on a YTD basis.

There were $9.12 billion of CLOs issued in October, which brings year-to-date issuance to an astounding $110 billion.

CLO Volume

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

Institutional new issuance increased in October to $50.8 billion, the third largest monthly volume of 2018. On a year-to-date basis, institutional new issue is down -4.1% from the first 10 months of 2017.

Leveraged Loan Volume

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

Repricings have declined in significance since the end of May. In fact, repricings represented approximately 22% of total new issuance since then, while acquisitions, mergers and LBOs represented 67%. On a YTD basis, acquisitions, mergers and LBOs represented 61% of new issuance.

October New Issue by Purpose

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

Amid October retail outflows, we saw gross CLO and retail issuance decline to the lowest level since January 2018. The lower issuance contributed to the decline in the trailing 12-month returns of roughly 4.5%.

Inflows and Rolling LTM Returns

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

October saw new issue spreads tighten month-over-month. On a year-to-date basis, new issue spreads in October were 3.1% wider for double Bs and -6.0% tighter for single Bs. Spreads during the last 12 months were -1.3% tighter for double Bs and -5.2% tighter for single Bs. While average spreads have been in this range since April, these levels are the tightest spreads have been for the CS LLI since October 2010.

New Issue Spread Changes

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

In terms of new issue yields, double Bs tightened -12 basis points while single Bs widened 1 basis point. On a year-to-date basis, double B yields and single Bs are 57 and 112 basis points wider, respectively. Most of this was driven by 3-Month LIBOR as it was up 86 basis points during the year.

Average New Issue Yields

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

There were three defaults in October and the default rate changed from 1.81% in September to 1.92% in October.

The last 12-month default tally for the S&P/LSTA is 20. Oil & Gas defaults lead all categories with six while Retail is close behind with four.

Lagging 12-Month Default Rate

Source: LCD Loan Stats
* Shadow default rate includes potential defaults, including those companies that have engaged

Valuation

Since 1992, the average 3-year discount margin (“DM”) for the CS LLI is 460 basis points. If the global financial crisis (2008 & 2009) is excluded, the 3-year discount margin for the CS LLI is 416 basis points. At month end, the 3-year DM of398 basis points, while close to the same levels it has been at for all of 2018, is actually at its highest for 2018.

The DM spread differential between double Bs and single Bs has widened from November 2017 to October 2018 by 7 basis points and is still 43 basis points wider than the historical spread differential.

3-Year Discount Margin Differential Between BBs and Single Bs

Source: Credit Suisse Leveraged Loan Index

Summary & Looking Forward

As of October 31, the S&P/LSTA imputed default rate was 1.34%, up from 1.13% in the prior month. While this is a lower imputed rate for the loan market than existed from November 2007 through December 2017, it is the highest rate in 2018. Broader credit concerns regarding cyclical business have certainly emerged.

The massive investment into the loan market in September hurt the CLO arbitrage and while prices backed up in October, it did not relieve all arbitrage issues. October also witnessed a spike in LIBOR. While increasing LIBOR is generally positive for loans, the widening 1-month, 3-month LIBOR gap poses a near-term drag to CLO equity.

Looking forward, loans seem poised to have a slight improvement in prices for the remainder of the year simply because the new issue calendar is very light. However, earnings results have been mixed thus far for loans, and borrowers that have missed have been severely penalized. We have seen bifurcation in issuers as high beta borrowers and cyclical borrowers have not seen any bounce in price in the beginning days of November. Any potential spread tightening the market experiences during the last two months of the year, may be quickly readdressed as new issuance recommences in the first quarter 2019.

 

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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