High Yield Bond & Leveraged Loan Month in Review

Posted on August 13, 2020

July 1 - July 31, 2020

Summary

  • In July, while leveraged loans produced a gain, they lagged the high yield bond market, which delivered its best monthly return of 2020.
  • The Bureau of Economic Analysis provided confirmation of Q2’s historic GDP decline.
  • The Fed announced an extension of its monetary support measures through year-end.
  • With BB-rated bonds producing positive returns year-to-date, inside we take a closer look at the spread compression of this Cohort in recent days.

 

At the end of July, the U.S. Bureau of Economic Analysis released its Q2 GDP estimate, which was pretty dramatic. It showed that the U.S. economy had shrunk by a record setting -32.9% annualized rate, which is more than three times the previous record of -10% set back in 1958.1 Although a decline of this magnitude was expected, and likely already priced into the market, it provides good context for the scale of the economic disruption caused by the COVID-19 pandemic. In addition, digging into the details of the release reveals that the vast majority of the decline came from a massive reduction in personal consumption. Given the trajectory of initial unemployment claims since the start of the pandemic, coupled with stay-at-home advisories and temporary business closures that kept many Americans from spending on non-essentials goods and services, this decline in consumption was all but inevitable. While we expect a recovery from the current depressed levels of economic activity, initial jobless claims, which had steadily declined for 15 consecutive weeks, have marginally increased over the past two weeks, perhaps signaling a slowing of the economic recovery.

 

With that in mind, we wonder what Congress’s next move will be in terms of fiscal stimulus. While the Fed has made its intentions clear given its recent dovish comments/actions, a more partisan Congress seems divided based on the difference in the two plans being mulled over by the House and the Senate. Perhaps the Fed’s decision to keep interest rate policy lower-for-longer and extend its emergency lending facilities through year-end will be enough to push lawmakers to agree on a stimulus package sooner rather than later. Furthermore, while the spread of the virus has been contained in certain sections of the country, it continues to spread virtually unchecked in others. This dynamic will likely continue to weigh on the economic recovery as consumers struggle to learn to live with the coronavirus as part of their “new normal” daily routine. Regardless, the passing of an anticipated fourth fiscal stimulus package, continued extraordinarily accommodative monetary policy, and falling consumer sentiment all point to what will likely be a protracted, rather than “V-shaped”, economic recovery.

 

Notwithstanding these recent developments, during the month of July, high yield bond and leveraged loan markets delivered returns of 4.78% and 1.88% as measured by the ICE BofA US High Yield Index and Credit Suisse Leveraged Loan Index, respectively. Furthermore, through the end of July, the high yield bond and leveraged loan markets have produced year-to-date returns of -0.23% and -2.97%, respectively. Also, during the period, BB-rated and B-rated bonds outperformed their CCC-rated peers, reversing the trend that had developed during the previous two months. In July, returns by ratings tier in the high yield bond market were 5.00%, 4.58% and 4.25%, respectively. In addition, after briefly turning positive on a year-to-date basis in mid-June, on July 13th, BB-rated bonds once again moved into positive territory for the year and have gained 3.55% year-to-date through the end of July (Chart 1). Conversely, B-rated bonds and CCC-rated bonds remain in negative territory year-to-date, with losses of -1.97% and -11.24%, respectively.

 

Chart 1 – ICE BofA US High Yield Index Evolution of
YTD Performance (%) by Quality

Chart 1 ICE BofA US High Yield Index Evolution of YTD Performance% by QualitySource: ICE

Meanwhile, within the leveraged loan market, B-rated loans were the top performers during the month, generating returns of 2.01%, compared to BB-rated and CCC-rated loans, which returned 1.67% and 1.74%, respectively. Unlike their high yield bond peers, no ratings segment of the leveraged loan market has crossed back into positive territory for the year-to-date period, and B-rated loans have modestly outperformed BB-rated loans, while both have significantly outperformed CCC-rated loans (Chart 2). Furthermore, first lien loans outperformed second lien loans during the month, with gains of 1.89% and 1.71%, respectively. On a year-to-date basis, first lien loans have outperformed second lien loans by 183 bps, with each producing a loss of -2.91% and -4.74%, respectively. In addition, after bottoming out at 76.71 on March 23rd, first lien loan prices have recovered to 91.49 as of July 31st. Alternatively, second lien loan prices have seen a more modest recovery from a low of 69.68 on April 3rd to a price of 78.52 at the end of July.

 

Chart 2 – Credit Suisse Leveraged Loan Index, July
and YTD Performance (%) by Quality

Chart 2 – Credit Suisse Leveraged Loan Index, July and YTD Performance (%) by QualitySource: Credit Suisse

Switching gears to sector performance, given the strength in the high yield bond market during the month, it should come as no big surprise that all sectors produced healthy gains. In July, the top performers were the Automotive, Energy and Capital Goods sectors, which delivered returns of 6.33%, 5.72% and 5.61%, respectively. On the other hand, the biggest laggards, the Real Estate and Transportation sector, were the only two sectors to produce a gain of less than 3%, coming in at 2.63% and 2.90%, respectively. Similarly, among leveraged loans, all but one sector produced a gain in July, with that sector being Aerospace, which generated a loss of -0.63%. Conversely, the top performing sectors in the leveraged loan market were Retail, Metals & Mining and Healthcare, which returned 3.66%, 2.92% and 2.46%, respectively. Additional information pertaining to year-to-date sector performance for both high yield bonds and leveraged loans can be found in the Appendix (specifically Charts 4 and 5).

 

Furthermore, performance by issue size reveals that in July, smaller deals in the high yield bond and leveraged loan markets lagged their larger peers (Tables 1 and 2). The underperformance of smaller deals in the high yield bond market during the month reversed the trend over the previous two months in which smaller deals were able to meaningfully outperform their larger counterparts. Consequently, year-to-date, there remains a large performance gap between larger and smaller deal sizes in the high yield bond market. Conversely, in the leveraged loan market, while smaller deals continue to lag their larger peers, the difference in performance is not as large as what we have observed in the high yield bond market. However, similar to what we saw in the high yield bond market in July, smaller-sized loans underperformed after earlier outperforming in June.

 

Table 1: ICE US High Yield Index Total Returns
and Issue Size Return Dispersion (%)

Table-1---ICE-US-High-Yield-Index-Total-Returns-and-Issue-Size-Return-Dispersion-(%)Source: ICE

Table 2: CS Leveraged Loan Index Total Returns
and Issue Size Return Dispersion (%)

Table-2---CS-Leveraged-Loan-Index-Total-Returns-and-Issue-Size-Return-Dispersion-(%)Source: Credit Suisse

Turning our attention to flows (Chart 3), based on weekly flow data from J.P. Morgan, high yield bond mutual funds tallied a meaningful $10.5bn of inflows in July, while loans experienced an outflow of -$966 million, marking 21 consecutive months of outflows. Also included in Chart 3 is a breakdown of how flow activity has progressed thus far in 2020. One can see that after a decent start to the year, both high yield bond and leveraged loan mutual funds experienced dramatic outflows during the depths of the markets’ initial response to the COVID-19 pandemic. However, since that time, while leveraged loan mutual funds have continued to see asset leakage, high yield bond mutual funds have experienced a flood of new money. Specifically, from the end of March through mid-June, high yield mutual funds saw twelve consecutive weekly inflows. In fact, aside from a brief two week respite at the end of June, which was likely the result of some rebalancing following Q2’s strong performance, high yield bond funds have netted significant inflows since the end of March. Furthermore, the influx of assets into such funds over the past month, which themselves tend to invest in larger, higher-rated high yield bonds, likely contributed to some of the performance dispersion that we highlighted in the preceding paragraphs (i.e., larger, higher-rated bonds outperforming their smaller, lower-rated peers in July).

 

Chart 3 – Fund Flows ($mn)

Chart 3 – Fund Flows ($mn)Sources: Lipper; J.P. Morgan

In addition, after bottoming out in March, formation of new CLOs rose sequentially through the end of June. However, new CLO formation declined in July, even if only modestly, thus breaking the trend over the prior three months. For the year-to-date period, CLO activity is trailing the total produced during the same period last year by more than 50%. Given the rate of decline in U.S. Treasury yields this year, which has led to a lack of supply in new leveraged loans, this level of activity in the CLO market is not surprising.

 

Focusing on the primary market, based on data from J.P. Morgan, a total of $26.7 billion of new high yield bond deals printed in July, which compares to a record setting $61.5 billion in June and an average of $48.5 billion during the previous three months. New issue activity historically slows during July given the seasonal slowdown associated with the summer months. That said, the $26.7 billion issued in July is larger than what is typical for the month; by way of comparison, average monthly issuance for high yield bonds in July since 2010 has been $21.1 billion. As has been the case for most of 2020, proceeds from high yield bond primary market activity continues to be used to refinance existing debt and remains concentrated among higher-rated credits. Alternatively, new issue activity for leveraged loans remains anything but robust. According to data from S&P LCD, a total of $11.6 billion of new first lien loans were priced during July, while second lien loan issuance was a mere $0.3 billion. As we discussed earlier, continued outflows from loan mutual funds, and more importantly the relatively low volume of CLO formation, have resulted in a lack of demand for leveraged loans.

 

Zeroing in on default activity shows that relative to the recent volume of defaults that accumulated in Q2 2020 (which was the second highest quarterly default volume on record), default activity in July was subdued. During the month, 13 issuers defaulted on $11.7 billion of high yield bonds and leveraged loans, which compares to June’s 15 companies for a total of $23.4 billon. Regardless, at the end of July, the trailing twelve month leveraged credit default rate had climbed to 5.33% from 5.13% at the end of the previous month.

 

Moreover, J.P. Morgan recently published some interesting data on the slowdown in rating agency downgrades since April. For context, within the high yield bond market, rating agencies downgraded 194 and 168 issuers in April and March, respectively. Similarly, during that time the ratings agencies also downgraded 190 and 187 leveraged loan issuers, respectively. In addition, according to J.P. Morgan, 540 loan issuers have been downgraded thus far in 2020, which exceeds the previous annual record of 335 set just last year. As Table 3 shows, since the end of April, there has been a significant decrease in the number of downgrades taken by the agencies. Downgrade and default waves can have a very distortive effect on the broad leveraged credit indices and the individual ratings cohorts. Furthermore, the current downgrade wave has also greatly contributed to the freezing of the CLO market. However, the slowdown in downgrades should provide some ballast to the market as well as CLOs specifically, assuming most credits have settled into the appropriate ratings cohort after a considerable shake-up earlier in the year in particular.

 

Table 3: Number of Downgrades between March and July - High Yield Bond and Leveraged Loan Issuers

 Table-3---Number-of-Downgrades-between-March-and-July---High-Yield-Bond-and-Leveraged-Loan-Issuers

Source: J.P. Morgan


BB-rated Spread Compression

As we noted earlier, BB-rated bonds have dug themselves out of a sizeable hole since March and are now the only ratings cohort in the high yield market providing a positive return for the year. This cohort has received the most direct support from the Fed’s explicit backstop of fallen angels, as well as its ETF purchase program, and given the segment’s historical tendency to avoid widespread defaults, it is not surprising that BB-rated bonds have recovered so quickly. Over the next several paragraphs, we take a closer look at how spreads have compressed since the spread on the BB Index reached its crisis apex.

 

On March 23rd, the option adjusted spread (“OAS”) of the ICE BofA BB U.S. High Yield Index peaked at 837 bps. As of July 31st, the OAS of such Index was 345 bps, a decline of 492 bps in a little over four months. Spread movements in the high yield bond market have been volatile during the current crisis, swinging wildly in a very short period of time. During the period outlined above, the number of bonds in the BB Index increased from 872 to 995. However, of the original 872, only 732 remain as of July 31st, meaning that 140 BB-rated bonds fell out of the BB Index since March 23rd while another 263 BB-rated bonds were added. Those 263 new bonds comprise fallen angels as well as new issues in connection with robust primary market activity that has occurred since April.

 

Table 4 below details what has happened to these groups of BB-rated bonds since March 23rd. The group names “Out”, “Remain” and “New” reflect each cohort of bonds described above. In our view, the most notable observations from the table are in the “Remain” group, which has seen its OAS decline by -487 bps since March 23rd, while at the same time its weight has declined from 84% of the index market value to just 69% at the end of July. In addition, as of the same date, the “New” group offers a much higher spread than the “Remain” group.

 

Table 4: BB Index Composition Changes
March 23rd through July 31st, 2020

Table-4---BB-Index-Composition-Changes-March-23rd-through-July-31st,-2020Source: ICE

We mentioned earlier when discussing defaults and downgrades that such activity can have a distortive effect on both the index as a whole as well as individual ratings cohorts. This distortion becomes clear when one examines Table 4 above. For example, as of March 23rd, the BB Index spread was 837 bps, but we know that a relatively small group of outliers, (i.e., the “Out” group) was skewing the BB Index OAS higher. Conversely, the “Remain” group, which accounted for 84% of the index market value as of such date, had an average OAS that was lower than that of the average for the entire BB Index. At the end of July, we see a similar situation where the “Remain” group once again has a lower spread than the BB Index average, with the “New” group responsible for pushing the spread higher.

 

With that in mind, we find ourselves asking whether the current OAS for the BB Index, 345 bps as of July 31st, appears too tight in light of the risks facing the high yield market as well as the economy more broadly. For context, back on January 20th, the BB Index registered an all-time low yield of 3.63% while the OAS was 202 bps. Were investors in the BB-rated segment of the high yield market being compensated appropriately then? At that time, the likelihood of a recession in the near-term seemed low, but was viewed as rising. Meanwhile, a novel coronavirus called COVID-19 was in the news but was not yet widely perceived as a significant risk to the U.S. economy in the minds of most market participants. Today, of course, COVID-19 is front and center in our lives, and the economy is in the midst of a significant recession. Accordingly, default risk is elevated even for BB-rated bonds, which admittedly almost never default.

 

However, a counter to these last points would be that the Fed has essentially agreed to support credit markets for the foreseeable future while Congress debates another round of fiscal stimulus, potentially offsetting both liquidity and default risk, especially for the highest-rated cohort of high yield bonds. With these factors in mind, perhaps spreads can grind tighter, leading to further attractive returns in the BB-rated space. Alternatively, perhaps the slowing momentum of the economic recovery will give investors pause and spreads will once again widen. Of course, we cannot see the future, but as recently as a month ago we did have a more constructive view on the attractiveness of BB-rated bonds. However, after tightening by 117 bps during July, or 25% of the OAS at the start of the month, in our view the relative value of this segment is looking less attractive compared with the other segments of the high yield market. This is not to say that prudent investment managers cannot uncover relative value on a case-by-case basis, but rather that the current environment calls for even more heightened diligence and conviction with respect to BB-rated bonds prior to making any decision to invest.

 

In summary, the economic impact of the pandemic has been severe. While the reopening of the economy has begun to heal some of the wounds created during the shutdown, the Fed’s dovish stance suggests the increasing likelihood of a more drawn out recovery. Nevertheless, as consumers learn to live with the virus, we anticipate a return to growth in the near-term from the severely depressed levels registered in Q2. That said, with the U.S. presidential election moving to the forefront in the coming months, markets will likely experience more bouts of volatility. However, continued technical tailwinds, such as the Fed’s unwavering support of credit markets, could provide further fuel to the current rebound in markets. Led by BB-rated bonds, the high yield market has produced strong gains in recent months. To that point, July was no exception. With the first half of summer officially in the books, we are settling in for what is typically the quietest month of the year in the leveraged credit market. However, this summer lull is likely akin to the eye of a hurricane, a brief reprieve before the resurgent back half of the storm.

 

Appendix I – Additional Charts as of July 31, 2020


Chart 4 – ICE BofA US High Yield Index
YTD Performance by Sector (%)

Chart 4 – ICE BofA US High Yield Index YTD Performance by Sector (%)Source: ICE


Chart 5 – Credit Suisse Leveraged Loan Index
YTD Performance (%) by Sector

Chart 5 – Credit Suisse Leveraged Loan Index YTD Performance (%) by SectorSource: Credit Suisse

Chart 6 – ICE BofA US High Yield Index Option-Adjusted Spread in Basis Points (bps) – December 31, 1997 through July 31, 2020.

Chart 6 – ICE BofA US High Yield Index Option-Adjusted Spread in Basis Points (bps) – December 31, 1997 through July 31, 2020.Source: ICE

Chart 7 – ICE BofA US High Yield Index Cumulative Performance (%) by Quality: January 1, 2019 to July 31, 2020

Chart 7 – ICE BofA US High Yield Index Cumulative Performance (%) by Quality January 1, 2019 to July 31, 2020Source: ICE

 


1 Based on Commerce Department data, which dates back to 1947.

The information and views expressed herein are provided for informational purposes only, and do not constitute investment advice, are not a guarantee of future performance, and are not intended as an offer or solicitation with respect to the purchase or sale of any security. The inclusion of particular investment(s) herein is not intended to represent, and should not be interpreted to imply, a past or current specific recommendation to purchase or sell an investment. Any projections, outlooks or estimates contained herein are forward-looking statements based upon specific assumptions and should not be construed as indicative of any actual events that have occurred or may occur. This material has been prepared using sources of information generally believed to be reliable; however, its accuracy is not guaranteed. Investing involves risk, including loss of principal. Investors should consider the investment objective, risks, charges and expenses carefully before investing with DDJ.
Past performance is no guarantee of future returns.

David Breazzano, DDJ’s President, CIO and Portfolio Manager, offers some perspective on the COVID-19 crisis.