October 1 - October 31, 2020
- October was a volatile month for leveraged credit markets, which produced modest gains.
- Lower-rated credits in the high yield bond market lagged, while lower-rated leveraged loans outperformed.
- We provide a few thoughts on the upcoming U.S. elections.
In last month’s High Yield Bond & Leveraged Loan Review, we stated that we expected October to be a volatile month for markets, and it did not disappoint. At the beginning of the month, markets were faced with the news of President Trump’s COVID-19 diagnosis and subsequent hospitalization. Since that time, COVID-19 cases have steadily risen in the U.S. and across the globe. In particular, the spread across Europe has resulted in renewed lockdowns and further restrictions, albeit to a degree far less draconian to date than those of the spring. In the U.S., rising number of infections have brought the country’s total number of cases to more than 9 million, with hospitalizations similarly increasing. Nonetheless, continued progress on how best to treat patients with the virus has increased survival rates, in particular among those hospitalized.
In addition, during the month, markets also had to come to grips with the lack of additional fiscal stimulus provided by Congress prior to the election. For the millions of Americans that remain unemployed, especially among the hardest hit sectors of the economy, the relief from such stimulus cannot come soon enough. Moreover, while future economic growth will be affected by a multitude of factors, including additional fiscal stimulus as well as the availability of a viable, widely-distributed vaccine, the rising case count in the U.S. could give one cause for concern. The recent acceleration in infections raises the specter of state and local governments imposing additional restrictions, which would potentially place pressure on the burgeoning economic recovery.
Be that as it may, on October 29th, the U.S. Bureau of Economic Analysis released its Q3 GDP estimate, which showed the economy expanded at an annualized rate of 33.1% during such period. This increase in economic activity reflects a historic rebound in growth following the worst contraction in U.S. history with GDP declining at an annualized rate of -31.4% in Q2. In spite of this record breaking third quarter, GDP growth nonetheless remains down close to 3% year-over-year. Furthermore, as of this writing, the U.S. elections are just days away. As is typical at this time, the news cycle is filled with the opinions of pundits and pollsters, especially as it pertains to tight races in battleground states; however, it is unlikely that we will know the outcome of several races on election night, including the race for president. Regardless of the outcome, we look forward to the conclusion of what has been an unconventional and exhausting election cycle.
Focusing specifically on performance in the high yield bond and leveraged loan markets, October brought modest gains to both markets during the month. Moreover, the ICE BofA U.S. High Yield Index gained 0.47% and the Credit Suisse Leveraged Loan Index increased by 0.17%, with year-to-date performance as of October 31st of 0.17% and -0.66%, respectively. Additionally, as set forth in Chart 1 below, leveraged credit markets, after performing well for the first three weeks of the month, turned lower in conjunction with renewed concerns of surging COVID-19 infections and the potential economic ramifications thereof. Furthermore, among high yield bonds, BB-rated bonds outperformed both B-rated and CCC-rated bonds for the first time since July, with monthly gains of 0.50%, 0.48% and 0.27%, respectively. Year-to-date, BB-rated bonds have gained 3.24%, and outperformed B-rated bonds and CCC-rated bonds by 471 bps and 1131 bps, respectively (Chart 4 in the Appendix).
Chart 1 – October 2020 Index Returns:
ICE BofA U.S. High Yield Index (“HYBI”) and Credit Suisse Leveraged Loan Index (“CSLL”)
Conversely, as Chart 2 details, within the leveraged loan market, CCC-rated loans outperformed in October, and gained 0.66% compared to BB-rated loans and B-rated loans, which produced a loss of ‑0.12% and a gain of 0.17%, respectively. Furthermore, CCC-rated loans have now outperformed BB-rated loans for six straight months and B-rated loans in five of the past six months. However, on a year-to-date basis, B-rated loans are the top performers, producing a modest loss of -0.30%, compared to BB-rated and CCC-rated loans, which through October 31st have lost -1.93% and -3.78%, respectively. In addition, in October, Second Lien loans outperformed First Lien loans, producing gains of 1.76% and 0.13%, respectively, and marking the fifth time in the past six months that returns for Second Lien loans have exceeded those of their First Lien peers. Furthermore, year-to-date through October 31st, Second Lien loans have gained 2.82%, which compares favorably to the loss of -0.76% generated by First Lien loans over the same period.
Chart 2 – Credit Suisse Leveraged Loan Index,
October, and YTD Performance (%) by Quality
Referring now to sector performance, all but four sectors in the high yield bond market produced gains during the month. In October, the top performing sectors were the Automotive, Basic Industry and Healthcare sectors, which gained 1.64%, 1.17% and 1.04%, respectively. Conversely, the biggest laggards during the month were the Leisure, Energy and Media sectors, which produced losses of -0.80%, -0.23% and -0.12%. As we pointed out earlier, as of October 23rd, the high yield market was poised to provide another month of solid performance. However, from that date through the end of the month, performance suffered, especially among the sectors hardest hit by the COVID-induced economic contraction. As one can see from Table 1 below, the last week of the month significantly reduced the full month return across all sectors. Not surprisingly, this last point is especially true for the Energy, Transportation, and Leisure sectors.
Table 1: ICE US High Yield Index October Sector Returns
and Option Adjusted Spread Changes (“OAS”)
Similar to the high yield bond market, there were only four sectors within the leveraged loan market that were unable to produce gains during the month. Of those four, the three bottom performing sectors were Energy, Media/Telecommunications, and Forest Products/Containers, which produced losses of -0.32%, -0.24% and -0.15%, respectively. Conversely, in October, the top performing sectors were the Consumer Durables, Food & Drug, and Consumer Non-Durables sectors, which generated gains of 2.57%, 0.96% and 0.83%, respectively. In addition, while there was a great deal of dispersion in performance between the top and bottom performing sectors during the month, twelve of the twenty-one sectors that comprise the index produced returns between 0.21% and 0.48%, indicating far less dispersion at least between the majority of sectors during the month. 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 5 and 6).
Moreover, Tables 2 and 3 below detail performance by issue size for both high yield bonds and leveraged loans. The performance data in the tables is shown by quarter as well as for each of the last four months to provide context for the most recent month’s performance. From Table 2, one can see that in October, smaller high yield bonds outperformed their larger peers for a third consecutive month. Similarly, smaller leveraged loans have outperformed their larger counterparts during each of the last three months (Table 3). Furthermore, year-to-date, while larger-sized high yield bonds continue to outperform their smaller peers, the gap is shrinking. In addition, while not depicted in the Table below, although down from 260 bps at the end of April, bonds smaller than $750 million in size are still offering 130 bps of yield advantage relative to their larger peers. As investors continue to search for value in the high yield market during a period where absolute yields have significantly compressed, higher yielding, albeit potentially less liquid, smaller bond issues will likely continue to be bid-up. By contrast, within the leveraged loan market, the smallest-sized deals are generating modest gains on a year-to-date basis, as well as outperforming their larger peers.
Table 2: ICE US High Yield Index Total Returns and Issue Size Return Dispersion (%)
Table 3: CS Leveraged Loan Index Total Returns and Issue Size Return Dispersion (%)
Source: Credit Suisse
Meanwhile, as shown below in Chart 3, which details weekly fund flows since the end of July, high yield bond mutual funds experienced net inflows in October. However, such flows were volatile and very much skewed towards the beginning of the month. In addition, such flow activity was fairly evenly split between ETFs and more traditional mutual funds. Unlike high yield bond funds, which according to J.P. Morgan have received inflows thus far this year in an amount equal to 25% of their beginning of the year AUM, leveraged loan funds continue to leak assets and have only seen inflows in a mere 8 of the past 100 weeks. With the Fed indicating that it will hold rates lower for longer (i.e., the foreseeable future), it will likely be some time before retail investor appetite for floating rate leveraged loan funds increases.
Chart 3 – Fund Flows ($mn)
Furthermore, although loan funds experienced net outflows during the month, CLO activity in October reached $13.0 billion, the second busiest month this year. Having said that, thus far in 2020 CLO activity has totaled $98.9 billion, which is 29% less than during the same period last year. Although CLO activity has been muted for much of the year, the thaw experienced during the past several months by this important source of demand in the leveraged loan market has provided support to secondary loan prices and primary market activity.
Moving on to the primary market, in October, high yield bonds experienced a slowdown in new issue activity, as $37.3 billion was priced compared to the previous two months in which more than $50 billion of high yield bonds per month was priced. In addition, refinancing activity continues to dominate the use of proceeds from newly-raised capital as issuers continue to take advantage of the low yield environment. However, after accounting for 80% of new issue activity over the previous two months, including record refinancing volume in August, only two-thirds of October’s volume was used to refinance existing debt. According to data from J.P. Morgan, on a year-to-date basis, gross high yield issuance of $387.6 billion is within striking distance of the current record of $398.5 billion set in 2013. Furthermore, while 2020’s refinancing volume of $253.8 billion already exceeds the previous full-year record also set in 2013, this year’s net issuance total lags 2013’s record of $175.3 billion.
On top of that, leveraged loan new issue activity continues to increase. Following a solid month of capital market activity in September, the primary market priced $52.0 billion of leveraged loans in October, which was the third strongest month of 2020. Leveraged loan primary market activity thus far in 2020 has already exceeded that of last year, but it is front-loaded where more than 53% of the year’s activity occurred in the first two months. Notably, the activity posted in January and February was skewed towards repricing and refinancing activity, which has been the dominant use of proceeds year-to-date. However, since the beginning of Q2, of the $166.2 billion that has been issued, one-third has been used for refinancing while acquisitions and dividend deals account for more than two-thirds of activity. Year-to-date, leveraged loan gross issuance totals $365.2 billion, which as J.P. Morgan notes is up 22% over the same period last year.
Turning our attention to defaults, according to data published by J.P. Morgan and S&P/LCD, in October, nine companies defaulted on a total $11.5 billion of bonds and loans, which compares to four issuers 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 6.34% and 3.99%, respectively. While both of these rates represent highs since the financial crisis, they 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.
The final item that we would like to briefly discuss is the upcoming election. As of this writing, the U.S. presidential election is just days away. While the presidential election often takes center stage, equally as important is which party ultimately controls each of the two branches of Congress. Ultimately, the outcome of this election cycle, and the composition of the federal government, will have implications on a range of critical policies, tax, healthcare, and trade just to name a few. Prior to Americans heading to the polls, or as is the case this year, the mailbox, there are several items that both sides of the aisle agree need to be addressed, such as relations with China, rising healthcare costs, and prescription drug pricing. However, the devil is in the details, and at this time it is unclear exactly what those details are. Historically, when the U.S. government is unified under one party, that party is quick to act, and ratify its favored policies sooner rather than later. We saw this outcome with the enactment of the Affordable Care Act prior to the mid-term elections in President Obama’s first term and the tax policy refresh early in President’s Trump’s tenure.
Nevertheless, even in these periods of action, markets typically have time to digest the information and react accordingly. Be that as it may, the Energy sector, especially in the high yield market, comes to mind as one such sector in which investors will be keeping a close eye on election outcomes, as a Blue Wave could prove detrimental to many companies in the sector. In the case of a split government, where Democrats control both the White House and the House, but control of the Senate remains with Republicans, there will likely be resistance to the Democrats’ agenda, which will delay or impede the passage of new laws. Lastly, an election that essentially results in the status quo will likely result in more of what we have seen over the past several years, including continued pressure on China as well as a push for further deregulation.
Regardless of the outcome, additional fiscal stimulus in the face of the continued economic dislocation wrought by the COVID-19 pandemic will likely be a top priority, though the contours of any agreement on the size and scope of such an aid package will depend largely on the results of November 3rd. While we believe that it is more likely that we will know the make-up of Congress on November 4th, because of the substantial increase in mail-in ballots together with a number of extensions granted with respect to when votes can be received and counted, there is the risk that election night turns into election week.
Further, while it has been well telegraphed to markets and individuals that election results will likely not be finalized on election night, or even the day after, let us hope that we do not experience an election month or for that matter a contested election that further prolongs the uncertainty associated with its eventual outcome. Such a result would likely result in a spike in volatility and a risk-off sentiment. With that said, it is important to note that at DDJ, we generally do not prognosticate about the consequences of elections. As such, while we incorporate current and potential shifts in policy and regulatory regimes as part of our due diligence process, we have not and do not alter individual portfolio positioning based on the upcoming election or the results thereof.
In summary, optimism for a new round of stimulus pushed markets higher early in October. However, as hopes of additional fiscal stimulus prior to the election faded and COVID-19 cases surged, markets adopted more of a “risk-off” stance as election day in the U.S. approached. This renewed sense of caution resulted in a month-end pull-back in the leveraged credit markets, among others. However, the relative calm of the first several weeks of the month allowed issuers to tap capital markets for a total of more than $80 billion of high yield bonds and leveraged loans in October. In addition, although the default rate continues to tick higher, supportive credit markets and a rebound in economic activity have led to a reduction in default activity. As expected, October was full of tricks, and with the election and its aftermath looming, November may prove to be equally thorny.
Appendix – Additional Charts as of October 31, 2020
Chart 4 – ICE BofA U.S. High Yield Index Evolution
of YTD Performance (%) by Quality
Chart 5 – ICE BofA US High Yield Index
YTD Performance by Sector (%)
Chart 6 – Credit Suisse Leveraged Loan Index
YTD Performance (%) by Sector
Source: Credit Suisse
Chart 7 – ICE BofA US High Yield Index Option-Adjusted Spread in Basis Points (bps) – December 31, 1997 through October 31, 2020.
Chart 8 – ICE BofA US High Yield Index Cumulative Performance (%)
by Quality: January 1, 2019 to October 31, 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.
Past performance is no guarantee of future returns.