Loan Review – November 2018

Monthly Commentary

December 12, 2018

In the beginning of November, several members of the TCW credit team made their way to New York to meet with 11 or 12 investment banks. The objective was to get the insight and opinions of traders, bankers and capital markets participants on what they thought would occur for the remainder of the year. The trading desks at these major investment banks were clearly split. A little more than one-half thought prices would grind higher in the absence of a large new issue calendar and a little less than half were concerned with large macro events influencing the loan market. For those in the latter camp, the focus was generally on crossover sellers and less focused on true weakness in loans.

What happened in the final two-thirds of the month was astonishing. Loan prices had their biggest monthly drop since December 2015. Lower prices often beget outflows and outflows beget lower prices. This was indeed a major dynamic in November as the market saw $4.0 billion of retail loan outflows. The CLO market also had a number of issuers defer the pricing of deals from year-end to the first quarter of 2019. At the end of the month, Opal held its annual CLO Summit, which allows investors, managers and bankers an opportunity to meet and discuss the direction of the CLO market. What did we learn? Several investment banks highlighted huge inventories of deals that they could potentially print in the first quarter of 2019. We also heard of investors pulling back on credit budgets and having a strong preference for shorter deals. With investors pulling back and bankers having large inventories of supply, liability prices have moved wider and are continuing wider.

With little earnings news likely to influence the market until April, prices are dropping on sentiment. Certainly participants are reacting to flows but the fear lingering at the back of the market’s collective mind is – is this the end of a very long credit cycle? That question can be solved in time and in other forums; however, the mere fact that that question is being readily bantered around suggests that loan levels are not poised to bounce higher in the near term.

Performance

In November 2018, the Credit Suisse Leveraged Loan Index (CS LLI) and the S&P Leveraged Loan Index (S&P/LSTA) were down -0.82% and down -0.90%, respectively.

  • Year-to-date, ending November 30, the CS LLI was up 3.49% and the S&P/LSTA was up 3.06%.
  • For the 12 months ending November 30, the CS LLI was up 3.91% and the S&P/LSTA was up 3.47%.

Triple Bs was the top performing category followed by Single Bs and then Double Bs. Lower quality underperformed with Split Single Bs, Triple Cs and Distressed loans all down roughly -1.3%.

Total Return by Rating

Source: Credit Suisse Leveraged Loan Index

Sector Performance

No sector was spared as all 20 sectors in the CS LLI provided negative returns for the month. The top performing sectors in November were Chemicals (-0.55%), Service (-0.56%) and Financial (-0.56%).

The worst performing sectors for the month were Forest Products/Containers (-1.08%), Retail (-1.72%) and Energy (-1.74%).

On a year-to-date basis, Retail (+6.31%), Energy (+5.34%) and Food & Drug (+5.08%) outperformed.

In the last 12 months, Energy, Food & Drug and Retail have led all sectors with total returns of 6.43%, 6.20% and 6.13%, respectively. In contrast, Aerospace, Forest Products/Containers and Consumer Durables were the worst performing sectors with returns of 3.10%, 2.75% and -0.77%, respectively.

Industry Returns

Source: Credit Suisse Leveraged Loan Index

CS LLI prices decreased -121 basis points in November while the average bid of the S&P LCD flow-name loan composite fell 124 basis points from 99.48 to 98.24.

Average Loan Flow-Name Bid

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

Technical Conditions

Leveraged loan funds reported outflows totaling -$1.32 billion for the holiday week ending November 28, and $1.74 billion in the week prior to Thanksgiving. These outflows were the largest since December 2015 and marked five consecutive weeks of outflows for actively managed funds after 34 consecutive months of inflows. Inflows for loan mutual funds total +$12.7 billion year-to-date, including -$594 million of outflows for the ETFs and +$13.3 billion of inflows to actively managed funds.

There were $13.1 billion of CLOs issued in November, which brings year-to-date issuance to $122 billion and just $2.0 billion shy of the all-time high annual issuance level.

CLO Volume

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

Institutional new issuance declined in November to $21.8 billion, the second lowest monthly level of 2018. On a year-to-date basis, institutional new issue is down -10.1% from the first 11 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, on a year-to-date basis repricings represented approximately 27% of total new issuance while acquisitions, mergers and LBOs represented 61%. In November, acquisitions, mergers and LBOs represented 65% of new issuance.

November Institutional Volume

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

Amid November retail outflows, we saw gross CLO and retail issuance decline to the third lowest level in 2018. The persistent outflows in October and November have led to the recent decline in trailing 12-month returns to roughly 3.5%.

Inflows and Rolling LTM Returns

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

November saw new issue spreads widen by 10%, month-over-month, while year-to-date spreads were wider by nearly 16%. It is important to note that there was very little double B issuance during the month and overall loan issuance in November was only higher than August. While November’s sample size was small, and focused only on new issuance, the overall loan index has only had an average spread wide of L+400 for six months since 1992 (8/2012-1/2013).

New Issue Spread Changes

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

In terms of new issue yields, double Bs widened -48 basis points while single Bs widened -31 basis points. On a year-to-date basis, double B yields and single Bs are 105 and 144 basis points wider, respectively. Most of this was driven by 3-Month LIBOR as it was up 104 basis points during the year.

Average New Issue Yields

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

There were two defaults in November and the default rate changed from 1.92% in October to 1.61% in November. David’s Bridal first lien loan traded in the high 60s/low 70s at the time of default while Full Beauty traded in the low 30s.

The last 12-month default tally for the S&P Leveraged Loan Index is 19. Retail jumped past Oil & Gas in defaults with two in November and leads all categories with seven while Oil & Gas is close behind with five.

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. The 3-year DM finished the month at 443 basis points, which is the highest it has been since March 2017.

The DM spread differential between double Bs and single Bs has widened from December 2017 to November 2018 by 5 basis points and is still 44 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

While loan weakness in October and November appears to be surprising investors, the market pullback has been in the making for some time. As we discussed in the October monthly, loan prices were actually down in July and August and the market felt poised to reset in September. And baring the huge inflows we had into SMA accounts in September, loans would have reset then.

Loan selling in October was largely driven by crossover investors experiencing outflows. Selling in November and early December has been driven by retail loan mutual funds. What we have not seen is CLO warehouse liquidations. CLOs still represent the largest buyer of loans and warehousing CLOs are being forced to delay the pricing and closing of deals due to market conditions. If warehouse liquidations begin, volatility will dramatically increase.

In early December weakness has continued if not accelerated. Although new loan issuance has been very low, we are seeing early signs of the primary market breaking down. Deals getting successfully syndicated often require a deep discount to par. If this persists, there will be broader capital market impacts and disruption to the pace at which LBOs, mergers and acquisitions can be completed.

 

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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