Air Pockets

High Yield Credit Update

November 22, 2019

Market Performance

October high yield bond performance was effectively a microcosm for the back half of this year: modest accretion to aggregate total return as high quality bonds outperformed while Energy and CCC-rated credits exhibited acute stress – effectively sums up the bifurcation in the marketplace since April. Absent, however, were positive tailwinds from falling interest rates which have been highly accretive to credit returns this year. High yield bonds on average returned +0.28% in October, bringing the year-to-date total return for the asset class to +11.71%. Sponsorship for fundamentally weak credits is virtually non-existent. More frequently are we observing bonds hit “air pockets” whereby investors go to sell their positions only to find the marginal clearing price is 20 pts+ lower. Party City is just one of the latest casualties. After the retailer disclosed poor operating trends, investors moved to divest their positions only to find no bids in sight. The capital structure re-priced by nearly 40 pts over a few short days, further evidence that credit is simply no longer being extended to challenged borrowers.

Latest Casualty: November “Air Pocket” in Party City Bonds

Source: Bloomberg

Meaningful dispersion continues to manifest as these idiosyncratic collapses in the bonds of lower quality borrowers begin to add up, while borrowers deemed creditworthy are met with excessive demand for the relative “safety” of their debt, no matter the price (yield). Indeed, the price for “safety” has inflated meaningfully in this market. As a byproduct, the returns on high quality (BBrated) bonds have outperformed those of lower quality (CCC-rated) bonds this year by over 900 basis points (bps) through mid- November – unprecedented for a period during which high yield bonds in the aggregate have produced double digit returns.

Source: Bloomberg, Barclays

Credit quality remains the principal vector by which investors are segmenting the market, though this past month we continued to observe the wholesale disenfranchisement of oil and gas producers and the companies that service them. With the high yield market in general returning near 12% year-to-date, and several sectors producing upwards of 20% gains, the now deeply negative returns earned on Energy bonds stands out. Prices of bonds in the sector fell incrementally by -15 to -20 pts across numerous capital structures during the month – Extraction Oil & Gas, Hi-Crush and Oasis Petroleum, just to name a few. Of note, the mounting stress among the producers and service providers is just now beginning to transmit to the midstream (pipeline) operators, which have thus far preserved their access to the capital markets despite ultimately being inextricably linked to the fundamentals of their shippers.

Source: Bloomberg, Barclays

Market Technicals

Supportive technicals continue to serve as ballast to a marketplace that is undoubtedly averse to taking risk. Capital continued to flow into the high yield marketplace in October on the order of $3 bn, presumably seeking the relatively “high” yields which still exist in U.S. credit (and possibly underappreciating the principal being put at risk to try and earn these “high” nominal yields). ETFs have been the principal beneficiary of the influx of capital, particularly since June, which may represent an area of vulnerability given the propensity for “renters” to abruptly reverse course and call their capital (i.e. the funds may be less sticky). Regardless, the high yield market has been the beneficiary of $22.7 bn of capital inflows this year and this has resulted in price inflation of those bonds which continue to have investor sponsorship (though has done little to dissuade the rationing of credit).

Favorable Demand Technicals Have Inflated High Quality Bond Prices, Though Have Done Little to Dissuade the Rationing of Credit

Source: Credit Suisse, EPFR

The race to the bottom in all-in yield for those credits deemed by the marketplace to be “high quality” remained in full effect in October as an incremental 30 deals cleared the primary market with 14 of them carrying a sub-5% coupon. Interestingly, we observed a dynamic at play in the new issue market whereby the ultra-low cost of capital afforded to borrowers in the European high yield bond market began to indirectly impact clearing prices domestically. In a series of cross-border financing deals where issuers marketed bonds denominated in both USD and EUR (Merlin, EG Group, Ziggo), the ultra-low market clearing yield in the European market compelled issuers to put U.S. high yield bond managers to a decision – accept a lower coupon on the USD tranche or we will simply finance the entire deal in euros. The U.S. high yield managers acquiesced. Over $18 bn in USDdenominated bonds were issued in October, following the robust >$30 bn calendar in September and it would appear we are off to the races once again in November.

Source: Bloomberg, Barclays

Fundamental Trends

Default rates remain low (~2% trailing) as just an incremental two issuers – Murray Energy and EP Energy – defaulted on their obligations during the month. More attention, however, is starting to be paid to the increasing level of distress in the marketplace, traditionally a good leading indicator of future defaults given 1) it serves as a gauge of creditworthiness and 2) the reflexive behavior of the capital markets (stress begets more stress). The analysis below was done by Credit Suisse, though we would take it one step further and marry the elevation in the distress ratio with the extreme dispersion being expressed in the marketplace. What we are observing is emerging distress concurrent with extreme segmentation as more and more segments of the market are being cut off while capital clamors into fewer and fewer cohorts. At a minimum, we believe this dynamic signals a heightened vulnerability to the entire system.

Rising Idiosyncratic Distress Portends Future Defaults

Source: Credit Suisse

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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