November High Yield Credit Update

Monthly Commentary

December 14, 2018

The pain trade for risk assets extended in November with equity volatility elevated (though stocks did end the month on a high note), and the average spreads of investment grade and high yield debt wider by an incremental +17 basis points (bps) and +47 bps, respectively. The re-pricing of risk broadly, and in high yield bonds specifically, has been swift no doubt. One need not look further than the price charts for say Weatherford International, Hexion, or Sanchez Energy debt (to name only a few) to diagnose a shift in investor behavior (and portfolio strategy) from complacency to fear (and yield capture to principal preservation) is underway. However, heightened risk and uncertainty, whether it be created by central bank tightening, the cycle maturation, or China (both trade and growth), should demand elevated risk premiums. While not losing sight of the forest through the trees (the re-pricing and developing stress is only two months old and starting from a very compressed basis), the re-emergence of volatility has started and should continue to present opportunity for value investors.

Market Performance

High yield bonds extended losses in November with the spread of the benchmark (Bloomberg / Barclays HY Index) gapping to two-year wides and closing the month at 418 bps over Treasuries (+47 bps month-over-month). Our asset class returned -0.86% for the month, buttressed in part by the rally in Treasuries, implying an excess return of -1.55%.

“Buy the Dip” not Rewarded in November

Source: Bloomberg

Risk premium decoupling across industries (more on this below) and decompression across credit quality remained a prominent feature of November trading activity. The rotation up in credit quality, and from cyclical to non-cyclical credits, that emerged in October was accentuated in November. This pressured prices of CCC-rated risk lower while BB credits experienced general support. Interest rates offered ballast to higher quality credits as well. As such, CCCs lost, in aggregate, -2.84%, whereas BBs and Bs lost just -0.25% and -0.75%, respectively. As of early December, the CCC-rated cohort is flat on a year-to-date basis, compared to having returned ~6% through September, erasing roughly 400 bps of outperformance relative to higher quality BB bonds.

Source: Bloomberg, Barclays

The prevailing risk-off trade has truly laid waste to a number of over-levered capital structures, notably in the Energy complex, though macro-sensitive sectors (Chemicals, Autos, Homebuilders) in general have underperformed less cyclical cohorts (Cable, Pharmaceuticals, Healthcare) as well. High risk E&P and Oil Field Services credits have been caught in the crossfire of the precipitous decline in spot oil prices, the price of the front month WTI contract is down -32% from $75/bbl to $51/bbl, and broadbased de-risking, with drawdowns in several capital structures reminiscent of 2015/2016 fallout. Indeed, of the 10 issuers that have experienced the greatest absolute declines in the prices of their bonds since the October 3rd highs, eight are from the Energy block.

Source: Bloomberg, Barclays

Market technicals proved unexpectedly supportive this past month despite the uptick in volatility. Sure, broken capital structures, particularly in the Energy sector, have received very little sponsorship these past two months; however, performing credit, particularly high quality, non-cyclical risk, has remained better bid by coined “real money” investors at these wider spreads. Moreover, the selling pressure in October (and early November) from hedge funds and dealers subsided as the month progressed and inventories depleted. Just under $2bn was redeemed from high yield bond funds (mutual funds and ETFs) during the month. While directionally negative, the absolute figure is fairly tame compared to other periods of elevated market volatility this year – February (-$12 bn) and October (-$9 bn).

Capital Flight Persisted in November, Though the Market Remains Better Bid at Lower Levels

Source: Credit Suisse, EPFR

Resurgent volatility closed the primary market early this year as bankers sidelined opportunistic financings, presumably hoping for calmer waters in the new year. Just $6bn in new USD-denominated debt was syndicated during the month, the lowest volume since December 2015 when shuttered capital markets cleared just under $5bn bonds amid the Energy collapse. M&A related deals dominated the calendar. Indeed, only debtors that had to issue (i.e. were less price sensitive) launched deals this month. Apollo’s CCC-rated LifePoint Health LBO financing was the largest of such syndications. With no new issuance expected for the remainder of the year, 2018 will conclude with gross high yield bond issuance of just $171mn, down -38% year-over-year and the lowest annual volume since 2009!

The Year of the New Issue Drought

Source: Barclays

Fundamental Trends

The high yield bond issuer default count in November was de minimis with just two small debtors defaulting on a cumulative $500mn bonds (Spanish-language television and radio broadcaster LBI Media and consumer finance company Community Choice Financial). Though trailing distressed activity has been benign for a year plus (save for the bankruptcy filing of iHeart), more interesting is the forward outlook with credit stress beginning to amass these past two months. Indeed, we have experienced an uptick in the number of credits priced below $70 and/or wide of 1,000 bps over Treasuries, an intuitively reliable leading indicator of future credit defaults. Much of the pain, as discussed above, has been concentrated in the Energy sector, though discrete pockets of distress are emerging across the marketplace.

Still Early Days, Though Signs of Future Distress are Emerging…

Source: JPMorgan

…With Current Pain Points Largely Confined to Energy Capital Structures

Source: JPMorgan

 

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