November 1 - November 30, 2020
- Leveraged credit markets produced impressive gains in November.
- Lower-rated credits in the high yield bond and leveraged loan markets meaningfully outperformed higher-rated peers.
- Prospects of continued political gridlock in the U.S. and positive COVID-19 vaccine news drove performance, with COVID-sensitive sectors outperforming.
- Strong returns occurred while daily coronavirus infections, hospitalizations, and ICU patients all hit record highs during the month.
As many expected, the outcome of the U.S. presidential election and a number of Congressional races remained too close to call on election night, with the prospect at the time that it could take days or even weeks until all votes were counted. However, election night did not result in a “Blue Wave” as many had predicted, with a continued divided government appearing to be the most likely outcome. Despite the uncertainty with who would be the next president in the immediate aftermath of the election, risk markets, including leveraged credit markets, rallied on the prospects that more gridlock in Washington would decrease the likelihood of any significant legislative changes being implemented. Less than a week after the election, media channels began to announce Democrat Joe Biden as President-elect and that the Democrats had retained control of the House of Representatives, albeit by a diminished margin. In the Senate, Republicans will hold 50 seats to 48 for Democrats, with the remaining two outstanding Senate seats in Georgia headed to a runoff election on January 5th.
One item that has support from both political parties is the desire to pass additional fiscal stimulus given the continued economic dislocation wrought by the COVID-19 pandemic; however, the passage of such legislation will require compromise on key details, such as its scope and size, that have stalled negotiations thus far. Recent COVID-19 trends should add additional pressure on lawmakers to finally come to an agreement. Specifically, new coronavirus cases in the U.S. increased significantly in November, with double the number identified than in October. In addition, November also marked record highs with respect to the number of new cases identified in a single day and total current patients hospitalized as well as those being treated in the ICU; sadly, but not surprisingly, deaths resulting from the spread of COVID-19 also increased, though with a typical lag. The recent surge in new cases and hospitalizations has resulted in targeted mitigation efforts in some states, which may begin to threaten the sustainability of the economic recovery, particularly in the absence of additional fiscal stimulus.
On the vaccine front, investors had reasons to be optimistic over the intermediate term. In particular, on November 9th, Pfizer announced Phase 3 vaccine trial data which showed its vaccine to be 90% effective in preventing COVID-19 infection. Furthermore, the following week, Moderna reported Phase 3 results indicating that its vaccine was almost 95% effective in preventing symptomatic COVID-19 in adults. The fact that the positive results came from two independent vaccines makes the potential for widespread distribution by mid-2021 seem more achievable and helps explain the strong performance across equity and fixed income markets in November.
In this environment, during the month of November, high yield bonds generated impressive returns of 4.00%, as measured by the ICE BofA US High Yield Index. From a quality perspective, CCC-rated bonds returned 6.71% during the month, significantly outperforming both BB-rated and B-rated bonds, which returned 3.61% and 3.45%, respectively. This result marks a continuation of outperformance by CCC-rated bonds that occurred during the last two months of the third quarter but took somewhat of a pause in October, when all quality segments generated modestly positive returns that were essentially in-line with one another. In addition, during the month, the year-to-date performance of the B-rated segment of the high yield bond market joined its BB-rated peers by moving into positive territory for the first time since the onset of the crisis in March (Chart 1). Since mid-July, higher quality BB-rated bonds have generated positive returns on a year-to-date basis, while CCC-rated bond returns still remain negative as of November 30th, albeit by a more modest -1.20% after this month’s strong performance.
Chart 1– ICE BofA U.S. High Yield Index Evolution
of YTD Performance (%) by Quality
Meanwhile, during the month of November, the leveraged loan market, as measured by the Credit Suisse Leveraged Loan Index, gained 2.13%, underperforming high yield bonds for the second consecutive month. Within the leveraged loan market, similar to the high yield bond market, lower-rated loans outperformed their higher-rated peers in November. As Chart 2 details, during the month, CCC-rated loans gained 5.11% compared to BB-rated loans and B-rated loans, which produced gains of 1.43% and 1.87%, respectively. However, unlike high yield bonds, on a year-to-date basis, BB-rated loans are still generating negative returns of -0.53%, underperforming both B-rated and CCC-rated loans, which through November 30th have gained 1.56% and 1.13%, respectively. In addition, in November, Second Lien loans outperformed First Lien loans, producing gains of 2.57% and 2.12%, respectively, marking the sixth time in the past seven months that returns for Second Lien loans have exceeded those of their First Lien peers. Furthermore, year-to-date through November 30th, Second Lien loans have gained 5.47%, which compares favorably to the gain of 1.34% generated by First Lien loans over the same period.
Source: Credit Suisse
Referring now to sector performance, all eighteen sectors in the high yield bond market produced gains during the month. In November, the top performing sectors were the Energy, Transportation, and Leisure sectors, which gained a whopping 8.25%, 6.49% and 6.18%, respectively. Conversely, the biggest laggards during the month were the Technology & Electronics, Telecommunications, and Healthcare sectors, which generated positive returns of only 2.00%, 2.13% and 2.66%. As we pointed out earlier, positive vaccine news announced during the month was a primary driver of positive investor sentiment and market performance. This is particularly evident in the performance by sector, with the sectors hardest hit by the COVID-19 pandemic and mitigation efforts (i.e., Energy, Transportation, and Leisure) meaningfully outperforming on the prospects of an effective vaccine and a return to normalcy perhaps sooner than originally anticipated. As one can see from Table 1 below (left side), the COVID-sensitive sectors referenced above had produced material losses on a year-to-date basis as of October 31st. The right side of Table 1 lists the sector performance (and rank) for the month of November, as well as the year-to-date performance as of November 30th, 2020. After the strong performance in November, particularly amongst the sectors most sensitive to COVID-19, the Energy sector is the only sector in the high yield bond market that remains in negative territory on a year-to-date basis.
Similar to the high yield bond market, every sector within the leveraged loan market produced gains during the month. COVID-sensitive sectors in the leveraged loan market were also the top performers during the month. Specifically, the top three performing sectors during November were Gaming/Leisure, Aerospace, and Energy, which produced strong positive returns of 4.82%, 4.41% and 3.52%, respectively. Conversely, in November, the bottom performing sectors were the Financials, Chemicals, and Food & Drug sectors, which generated gains of 1.24%, 1.33% and 1.35%, respectively. In addition, despite the strong performance during the month, seven of the twenty sectors that comprise the leveraged loan index have produced negative returns on a year-to-date basis through November 30th, with the Energy sector the worst performer by a wide margin. 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).
Moreover, Tables 2 and 3 below detail performance by issue size for both high yield bonds and leveraged loans. To provide context for how fourth quarter 2020 performance is tracking thus far, the performance data in the tables is shown by quarter as well as for the last two months. From Table 2, one can see that in November, there was not much performance dispersion by issue size, though the largest issue size bucket, which represents less than 1% of the high yield index market value, did meaningfully underperform. Table 3 illustrates that smaller leveraged loans modestly underperformed in November; however, smaller loans had outperformed their larger counterparts during each of the previous three months. Furthermore, year-to-date, while larger-sized high yield bonds continue to outperform their smaller peers, the gap has shrunk more recently, and all issue size buckets are now producing positive returns over the period. By contrast, within the leveraged loan market, the smallest-sized deals are outperforming their larger peers on a year-to-date basis.
Source: Credit Suisse
Meanwhile, as shown below in Chart 3, which details weekly fund flows since the end of July, high yield bond mutual funds experienced net inflows in November, the seventh monthly inflow in the last eight months. However, such flows were volatile with relatively large weekly inflows and outflows occurring during the month. In addition, such flow activity was predominately into ETFs, which accounted for over 75% of inflows in November with the balance going into more traditional mutual funds. Conversely, leveraged loan funds continued to experience outflows with November marking the twenty-sixth consecutive month of outflows. With the Fed indicating that it will hold rates lower for longer, retail investor appetite for floating rate leveraged loan funds may remain depressed for the foreseeable future.
Chart 3 – Fund Flows ($mn)
Furthermore, CLO volume decreased in November to $7.1 billion from $16.0 billion in October and $12.1 billion in September, which represented the second and third highest monthly totals of this year, respectively. In addition, thus far in 2020, CLO activity has totaled $109.5 billion, which is 28% less than the volume accumulated during the same period last year. Although CLO activity has been muted for much of the year, the thaw experienced during recent months by this important source of demand in the leveraged loan market has provided support to secondary loan prices and primary market activity, particularly in the face of continued leveraged loan fund outflows.
Moving on to the primary market, in November, high yield bonds experienced a third consecutive month-over-month decline in new issue activity, as $32.2 billion was priced compared to new issuance in October and September of $37.3 billion and $50.9 billion, respectively. In addition, refinancing activity accounted for over 70% of new issuance in November and remains the dominant use of proceeds from newly-raised capital as issuers continue to take advantage of the low yield environment. According to data from J.P. Morgan, on a year-to-date basis, gross high yield issuance of $419.8 billion has already surpassed the previous calendar year record of $398.5 billion set in 2013. Furthermore, while 2020’s refinancing volume of $277.0 billion already exceeds the previous full-year record that was also set in 2013, this year’s net issuance total of $142.9 billion lags 2013’s record of $175.3 billion.
In addition, leveraged loan new issue activity also decreased month-over-month in November to $22.1 billion. This result follows $52.0 billion of leveraged loan primary market activity in October, which represented the third highest monthly new issuance total this year, and the highest monthly total since the crisis began earlier this year. Loan issuance in November was primarily used for acquisitions and dividend deals, which combined accounted for more than 80% of new issue activity. Leveraged loan total primary market activity thus far in 2020 is slightly ahead of the total through the first eleven months of 2019; however, net issuance year-to-date is modestly below the net issuance volume through last November.
Turning our attention to defaults, according to data published by J.P. Morgan, there were no defaults in November, the first month without a high yield bond or leveraged loan default since August 2018. In our monthly review last month, we dug a little deeper into defaults in 2020, which bears repeating this month, particularly in the context of zero defaults occurring in November. In October, eight companies defaulted on a total $11.4 billion of high yield bonds and leveraged loans, which compares to four companies and $2.9 billion of high yield bonds and leveraged loans in September and three companies for a total of $1.6 billion in August. For context, from March through July, an average of $22.8 billion of bonds and loans defaulted per month, peaking in April at $36.9 billion. Despite the summer slowdown in default activity, the trailing twelve-month default rates for high yield bonds and leveraged loans now sit at 6.15% and 3.79%, respectively. Last month, the trailing twelve-month default rates for high yield bonds and leveraged loans reached 6.33% and 3.99%, respectively, which represented highs since the financial crisis, but are still well below peak default rates experienced in previous cycles. For perspective, in 2009, high yield bonds and leveraged loans experienced peak default rates of 10.98% and 14.18%, respectively. Furthermore, during the cycle of the early 2000s, while leveraged loan default rates peaked at 7.5% in 2000, high yield bond default rates reached their apex at 10.24% in 2002.
Based on this data, absent a significant downturn in economic growth, there is reason for cautious optimism that the market has reached (or nearly reached) its peak in defaults this cycle. Such an outcome would be a testament to the speed and magnitude of the fiscal and monetary response initially implemented upon the onset of the crisis combined with the fact that the economy was relatively healthy before the pandemic began. Of course, the future is far from certain and any significant surge in coronavirus cases that resulted in a meaningful reinstatement of mitigation efforts could put the economy at risk of a double dip recession, especially in the absence of a substantial additional fiscal stimulus package passed by Congress in the coming weeks.
In summary, optimism stemming from promising COVID-19 vaccine news helped drive strong performance in November across high yield bond and leveraged loan markets. Such performance was led by lower-rated bonds and loans, particularly within those sectors that have been most impacted by the pandemic and therefore would benefit disproportionately from an effective vaccine. In addition, after a very contentious and expensive election cycle in the U.S., the market appears pleased with the outcome as it likely reduces the possibility of any sweeping legislation that would otherwise unsettle investors. The positive vaccine news is hopefully a sign that we are in the later stages of the pandemic with the light at the end of the tunnel slowly but surely growing brighter. However, the current situation is fragile, with record numbers of daily infections, hospitalizations, and ICU patients all recorded during the month, and with winter yet to officially begin, public health experts have cautioned that the pandemic may still get worse before it gets better. However, with the election in the rear-view mirror, at least there is some optimism that Congress will provide additional fiscal stimulus to address the deteriorating pandemic situation, which is beginning to pose a real threat to the economic recovery. In any event, at DDJ, we believe the market will remain volatile in the near-term leading up to the inauguration of a new president in January as investors closely monitor and react to the latest news regarding vaccine advancement and distribution, the ongoing pandemic, economic data, further stimulus measures, and political developments.
Appendix – Additional Charts as of November 30, 2020
Chart 4 – ICE BofA US High Yield Index YTD Performance by Sector (%)
Chart 5 – Credit Suisse Leveraged Loan Index YTD Performance (%) by Sector
Chart 6 – ICE BofA US High Yield Index Option-Adjusted Spread in Basis Points (bps) – December 31, 1997 through November 30, 2020.
Chart 7 – ICE BofA US High Yield Index Cumulative Performance (%) by Quality: January 1, 2019 to November 30, 2020
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.