The Carry Trade

High Yield Credit Update

December 18, 2019

The high yield asset class earned double digit returns for investors this year through November (and as we write today, it would seem those gains are set to advance further in December to close out 2019). While aggregate returns topped 12% over the past eleven months, the cadence at which these returns were earned merits further examination. Specifically, returns for the first half of the year totaled +9.9%. Said another way, over 82% of year-to-date performance for high yield bonds was earned in the first six months of the year. The subsequent five months have amounted to roughly a carry trade (slightly less even):

2H’19 Total Return Amounting to Less Than a Carry Trade Following Reflation in 1H’19

Source: Bloomberg, Barclays

Though it reasons that credit selection has been an important differentiator given the high degree of dispersion in the marketplace over the trailing year, the reality is investors, generally speaking, were bailed out by the magnitude of the overarching reflation (most acute during the first half of the year). However, on a go-forward basis, as has been the case during the back half of 2019, the limited scope for further reflation should allow alpha generation and performance differentiation through security selection to shine through.

Market Performance

High yield bonds returned an incremental +0.33% in November. The past five months have seen returns for high yield bonds steadily advance, amounting to what can effectively be characterized as a carry trade (plus or minus), contrasting with the rather volatile month-by-month performance during the second quarter. While idiosyncratic missteps remain a principal theme in the marketplace (we highlight the most recent credit-specific collapses below), they have yet to overwhelm returns in the aggregate to a significant degree this year. Year-to-date, high yield bonds returned, on average, +12.08% through November.

Performance dispersion between BB and CCC-rated debt set fresh wides in November after the former cohort outperformed the latter by 163 basis points during the month. This brought the total return divergence between the ratings buckets to just shy of 10% for the year, a standout result over a period when corporate credit has earned double digit returns in the aggregate. The reason, as is now well understood in the marketplace, is risk-seeking behavior was not the principal demand driver for levered credit this year. Rather, a global hunt for perceived “safe yield” crowded capital into the deemed higher quality, or safer, parts of the high yield (and leveraged loan) market, while doing its best to avoid any hint of secular risk.

Source: Bloomberg, Barclays

Cyclicals broadly remediated in November as optimism around trade negotiations improved. Aerospace, Automotive and Metals & Mining sectors benefited from this general rising tide in investor sentiment. This was counterbalanced by standout idiosyncratic movers which were, once again, to the downside. We introduced two new capital structures to our tracking sheet of credit-specific collapses (i.e., those issuers which have seen the price of their bonds drop by 10pts or more over the trailing year): Party City and Intelsat. Within Retailers, Party City bonds hit an air pocket, dropping by near-40 points to $60, after the company reported underwhelming quarterly results, weak Halloween sales trends and ongoing headwinds from a shortage of helium. The degree to which the market re-priced Party City credit risk is emblematic of the complete lack of investor appetite for underwriting secular risk currently. While the Party City meltdown was of note, the principal outlier during the month was Intelsat. Prices of securities in the bellwether high yield capital structure (the equity included) reset lower by a meaningful margin as the FCC opted to pursue a public auction process to transfer C-Band spectrum assets from satellite operators to wireless operators, rejecting Intelsat’s preferred private sale approach. Increased uncertainty over both the timing and sharing of C-Band auction proceeds drove up hurdle rates for the process risk, with intra-week volatility in Intelsat securities exacerbated by discrete technical factors – Intelsat bonds and stock were very crowded hedge fund longs and the abrupt unwind of the private sale thesis incited a scramble for the exits.

Source: Bloomberg, Barclays

Market Technicals

Fund flows were balanced in November, representing a lull in an otherwise very supportive technical backdrop to the high yield market this year. Net fund flows were -$115mn in November, though this is in the context of approximately $22bn in net inflows year-to-date. The stability (and incremental growth) of the capital base in our marketplace is a foundational characteristic of the trend experienced thus far this year. As we all now know, that capital base was diverted, rather aggressively, towards deemed safer credits, seemingly irrespective of yield, while access was restricted to more and more marginal borrowers. The point being, while the rationing of capital resulted in a high degree of dispersion in risk pricing this year (credit fundamentals), the stock of capital was the foundational element driving the overarching reflation (market technicals).

Another month, another 19 newly minted “high yield” bonds introduced into the market with coupons inside of 5%. No longer the exception, dealers syndicating high quality Single-B and BB rated debt with an initial marketed rate between 4-5% has become the rule. Not surprisingly, borrowers appear to be clamoring for the opportunity to capture their share of this capital, with ~$30bn in gross USD-denominated issuance in November. Opportunistic refinancings of currently callable debt was a prominent use of proceeds as those call options previously sold to borrowers are now broadly in the money at these low all-in rates. We also observed instances (for example, Centene’s acquisition financing deal) where future borrowing needs were pulled forward and placed into escrow as management teams feared missing out on these historically favorable financing terms.

Source: Bloomberg, Barclays

Fundamental Trends

The two high yield bond issuer defaults in November are worth reviewing for a number of reasons, though principal among them are the extremely poor recoveries implied by the current trading levels of the debt. McDermott International (MDR) and Dean Foods (DF) are prominent distressed capital structures in the marketplace. McDermott’s notoriety grew after the price of its debt cratered in a matter of days as it became clear the future earnings power of the enterprise is likely to be well below prior estimates due to its large backlog of mispriced construction contracts. The price of its unsecured debt fell from $95 to $10 over the course of five months as the business approached its inevitable restructuring. Dean Foods was a slower moving car crash, as secular headwinds from plant-based substitutes to dairy have been mounting for a couple years now. However, when the market determined its assets were no longer financeable, liquidity was pulled near instantaneously. Indeed, the unsecured bonds of Dean Foods traded down from $95 to $50 between October 2018 and October 2019 before dropping to $15 during the subsequent weeks. The current depressed trading prices of the MDR and DF unsecured bonds seemingly implies recovery values well below the historical average of approximately 40 cents on the dollar for high yield bonds. Though potential anomalies, this does appear consistent with the below average recoveries of many of the restructured capital structures this year. Whether these are the result of potential shortcomings unique to this cycle due to the significant erosion in creditor protections in bond indentures, or simply a reality that the first movers in any cyclical downturn are generally the weakest fundamental credits in the market (as opposed to the “good business, bad balance sheet” opportunities that emerge through a full default cycle), only time will tell. However, we think it prudent to appreciate the risk for structurally lower recoveries this cycle when underwriting stressed and distressed opportunities.

Ultra-Low Implied Recoveries of Recently Defaulted High Yield Bonds 

McDermott International Senior Unsecured Bonds – MDR 10.625 24

Source: Bloomberg

Dean Foods Senior Unsecured Bonds – DF 6.5 23

Source: Bloomberg

 

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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