Loan Review – November 2016

Monthly Commentary

December 13, 2016

Sell the rumor, buy the news? As the lead of Hillary Clinton eroded in the beginning of November and concerns that Donald Trump would be elected emerged, the markets wobbled. Concerns that the rejection of the status quo candidate would lead to a policy of protectionism, shook capital markets and the loan market was no exception.

Loans prices declined for the first half of the month, however, seeds of growth were being planted. These seeds, in the form of rising rates, would foster retail fund inflows in the back half of the month and in the beginning of December.

Bank Loan coupons are composed of a spread plus LIBOR. While the 10-year Treasury is not correlated to LIBOR movements, many retail loan investors use both LIBOR and treasury rates as a proxy for rising bank loan yields. Consequently, retail demand tends to increase for loans when LIBOR moves higher and/or when the 10-year Treasury goes higher.

LIBOR rates pushed up five basis points to 0.93% at the end of November and the 10-year Treasury yield increased 55 basis points to 2.38%. These rising rates generated significant demand from retail funds and helped push the average bid price in the CS Leveraged Loan Index up 50 basis points post-Thanksgiving. The rally that began post-election has been unwavering and while the technical dynamics of the market have been overwhelming for most of 2016, they had reached a fevered pitch by the end of November.

Performance

In November 2016, the Credit Suisse Leveraged Loan Index (“CS LLI”) was up 0.32% and the S&P Leveraged Loan Index (“S&P/LSTA”) was up 0.26%.

  • Year-to-date ending November 30, 2016, the CS LLI was up 8.63% and the S&P/ LSTA was up 9.04%.
  • For the 12 months ending November 30, 2016, the CS LLI was up 7.60% and the S&P/LSTA was up 7.89%.

Sector Performance

The top three performing industries for the month were Metals & Mining, Energy and Consumer Products, which posted returns of 1.28%, 0.82% and 0.67%, respectively. China, the world’s biggest consumer of metal, imported its third largest monthly volume of iron ore, to continue to grow their steel industry. Demand for raw materials beyond iron ore was also significant, which helped to push loans in the sector higher for the 9th consecutive month.

Crude prices rose over 5% in November on OPEC news and Energy loans surged in response. As predictions of a colder-thanexpected winter emerged, natural gas prices also increased over 10% on the month, further aiding a recovery in Energy loan prices. Finally, consumer products also rallied late in the month as investor demand began to pick up.

Total Return by Sector

Source: Credit Suisse Leveraged Loan Index

The worst performing sectors in November were Retail, Food/Tobacco and Food and Drug with returns of -0.48%, -0.07% and- 0.04%, respectively. Retail was notable as several weak earnings reports have weighed on segments and even as most segments rallied, a number of distressed retailers faltered. Both Food-related sectors lagged as average coupons in this space are typically smaller and any back-up in price can overwhelm the monthly coupon.

The year-to-date returns for all sectors in the CSLLI are positive. Metals & Mining, Energy and Gaming are the top performing industries, with returns of 36.93%, 30.11% and 9.91%, respectively. Interestingly, only five sectors provided returns in excess of the Index return. This includes the three sectors listed above as well as Information Technology and Consumer Durables. Fifteen of the 20 sectors in the CS Index have underperformed the Index, which demonstrates the impact of Energy and Metals’ returns on overall performance.

CCCs outperformed in November, gaining +1.1% this month and an impressive +21.0% on the year. BBs outperformed single- Bs in November (+0.3% versus 0.2%) for the second consecutive month. Single Bs (+8.4%) still outperformed BBs on the year (+6.1%) despite underperformance in November.

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 November. At month end, the percentage of The JP Morgan Loan Index trading above Par was 57.3%.

The average bid price for the S&P LSTA Leveraged Loan Index at month-end was 96.48; however, the average flow name bid was 99.15%. While flow name prices showed some weakness in October and the beginning of the month, they did rebound by the end of the month. However, the broader Index price has increased five consecutive months, or since Brexit concerns.

Average Loan Flow-Name Bid

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

Technical Conditions

November, October and September have been the highest CLO issuance months of the year. The increase in demand for loans from CLOs has been driven by tightening liabilities. Foreign investment has continued to drive these liabilities tighter, which in turn added to incremental demand, which has allowed the underlying collateral borrowers to reduce spreads.

CLO Volume ($ Billions)

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

While rising rates negatively impacted most asset classes in November, leveraged loans managed to provide a steady gain. Loans outperformed most fixed income products, including: the JPM high-grade bond index (-0.44%), JPM Investment Grade (-2.30%), and JPM EMBIG(Emerging Markets) (-4.10%). LIBOR has risen 32 basis points during the year and as LIBOR has moved higher, demand for loans has increased.

Leveraged loan funds reported an inflow of $339 million for the shortened week ending November 30, following the prior week’s largest inflow since September 2013 ($1.12 billion). The loan asset class has attracted $6.8 billion of inflows in the second half of 2016. Inflows year-to-date for loan mutual funds of +$444 million compared to outflows in 2015 and 2014 totaling $21.7 billion and $23.8 billion. These inflows have driven returns throughout 2016.

S&P/LSTA Leverage Loan Index Returns and Loan Inflows

Source: S&P Leveraged Loan Index

At the same time that demand reached its highest levels of 2016, new issue supply began to decline. There was less than $40 billion of institutional and pro rata issuance in November, representing a month-over-month decline in supply of over 29%. Many investment banks had accelerated the primary calendar to October, essentially leaving less to be syndicated in November. This was primarily done due to fears of what a Trump presidency would bring. In a similar fashion to Brexit, the market has surged ahead post-election, largely ignoring protectionist concerns that were on display in the early days of November. With little new issue expected for the remainder of the year, demand remains overwhelming.

Leveraged Loan Volume

Source: S&P Leveraged Loan Index

Mergers and Acquisitions, which dominated the calendar in the first quarter, dropped dramatically in the second, third and fourth quarters. Year-to-date, 44% of new issue may be classified as LBO or acquisition related. Much of the issuance is not bringing actual new dollars to the loan market. For example, in the late November the forward calendar stood at roughly $30.7 billion, yet the net new issuance was $6.7 billion. The net new issue represents the actual new dollars available to investors post visible repayments.

New-Issue Loan by Purpose – YTD 12/1/16

LoanStats Weekly

Fundamentals

While demand for loans has reached its high for the year, underlying performance is less robust. In fact, EBITDA growth has been anemic.

Following weak Q2 2016 earnings, year-over-year EBITDA growth among S&P/LSTA Leveraged Loan Index issuers that publicly file financial results declined again in the third quarter. This represented a new post-recession low of 4.3%, versus 5.8% in 2Q16 and 6.2% in 3Q15.

Quarterly EBITDA Growth

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

Single B new issue yield-to-maturity tightened two basis points in November from October while double B new issue tightened 17 basis points in the month.

New-Issue First-Lien Yield to Maturity

Source: S&P Leveraged Loan Index

Two companies defaulted in November, Erickson Air Crane and Bauer Performance Sports. The LTM default rate continued to decreased to 1.66%, based on a par amount outstanding from 1.98%. The default rate based on unique issuers also declined to 2.11%.

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.

Seventeen of 27 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. However, the rally in crude may change the recovery profile for many of these borrowers.

Valuation

Since 1992, the average three-year discount margin (“DM”) for the CS LLI, is 463 basis points. If the global financial crisis (2008 & 2009) is excluded, the three-year discount margin for the CS LLI is 416 basis points. At month end, the three-year DM was wide of the historical average, at 488 basis points but eight basis points tighter than the prior month.

The DM spread differential between double Bs and single Bs has tightened from December 2015 to November 2016 by 111 basis points. It is also 3.6 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 November 30, the S&P/LSTA Index imputed default rate was 3.22%, flat from the prior month. It remained 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. Certainly this latest rally is spelling a much more bullish outlook for loans. Default activity over the past year has been concentrated within sectors tied to commodities and many of those underlying commodities have been in a multi-month rally. Therefore, the market is ascribing a lower probability of a material default rate.

The same persistent themes that have dominated most of 2016 remained intact in November. Technical characteristics have driven returns. Increasing LIBOR and the fear of the Federal Reserve increasing interest rates is pushing investors into the loan asset class. While demand has increased, supply is anemic. Merger and acquisition driven supply has declined. Declining EBITDA levels, increased leverage and competitive bidding have made the generation of new deals tough, especially given leveraged-lending guidelines. With 57% of the Index trading above par, repricing activity has been very active. Lower spreads are offsetting any benefit from increasing LIBOR and without some disruption of capital markets, technical conditions will remain very supportive of loan prices.

 

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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