September 1 - September 30, 2020
- In September, leveraged loans produced a gain and outperformed high yield bonds, which experienced a loss for the first time since March.
- CCC-rated bonds and loans generated positive performance and outperformed their higher rated peers.
- We conduct a deeper dive into spread changes in the CCC-rated segment of the high yield market.
In general, various indicators continue to show improvement in overall economic activity as the U.S. economy resumes its reopening. Unfortunately, such renewal in activity has coincided with a surge in COVID-19 cases. However, and thankfully, the most recent surge or “second wave” in the U.S., and abroad, has yet to result in an alarming increase in hospitalizations or mortality rates. That said, the recent announcement that President Trump has tested positive for COVID-19 will create further uncertainty and likely inject volatility into the markets. In addition, the markets are regularly digesting news related to COVID-19 vaccines and therapeutics, which while providing a potential light at the end of the tunnel, more often than not has created noise and increased market volatility in the short run. Although it has been more than six months since the pandemic-induced lockdowns began in the U.S., federal, state and local governments, companies and individuals continue to adjust and learn to live with the virus and work to protect those most vulnerable, all in a manner intended to provide for the safest acceleration of economic activity.
That notwithstanding, given the level of unemployment in the U.S., especially among the hardest hit sectors of the economy, additional fiscal stimulus seems likely. In our view, markets have for some time now assumed that Congress would enact legislation providing for additional stimulus. However, with the passage of more time, we expect that contentiousness in Washington will continue to increase as the election draws near, likely leading to greater concern among market participants that such stimulus may be left by the wayside. Our view remains that a new stimulus package will be passed; nevertheless, the timing of such a deal remains unclear. That said, recent negotiations among Congressional leadership on a new stimulus package have been more constructive. Furthermore, with each successive negotiation, the prevailing Senate and House plans have moved closer to one another in terms of size and scope. Be that as it may, until such time that a deal is reached, we anticipate continued market volatility.
Turning our attention to performance, in September, after five consecutive months of gains, high yield bonds as measured by the ICE BofA U.S. High Yield Index produced a loss of -1.04%. Conversely, leveraged loans represented by the Credit Suisse Leveraged Loan Index gained 0.69%. Moreover, year-to-date returns as of September 30th were -0.30% and -0.83% for the high yield bond and leveraged loan markets, respectively. Within the high yield bond market, CCC-rated bonds produced a modest gain during the month of 0.43% and outperformed both BB-rated and B-rated bonds, which generated losses of -1.42% and -0.90%, respectively. However, notwithstanding their relatively weak performance in September, BB- rated bonds continue to be the top performers year-to-date and maintain a significant edge over their B- rated and CCC-rated peers, as Chart 1 below shows. That said, CCC-rated bonds have outperformed BB- rated and B-rated bonds in four of the past five months, during which time CCC-rated bonds topped their BB-rated and B-rated peers by 835 basis points (“bps”) and 708 bps, respectively.
Chart 1 – ICE BofA U.S. High Yield Index Evolution
of YTD Performance (%) by Quality
Alternatively, within the leveraged loan market, all ratings categories generated gains during the month with Distressed loans the top performers, returning 2.21%; however, this loan cohort remains significantly stressed with returns of -34% year-to-date (Chart 2). In addition, CCC-rated loans, which gained 2.14% during the month, outperformed B-rated and BB-rated loans, which generated more moderate returns of 0.57% and 0.13%, respectively. Furthermore, CCC-rated loans have now outperformed B-rated and BB- rated loans during each of the last five months. During this period, CCC-rated loans unsurprisingly have gained considerable ground on their higher rated peers. For context, as of April 30th, CCC-rated loans had produced a year-to-date return of -19.30%, lagging their B-rated and BB-rated peers by 1,323 bps and 987 bps, respectively. However, although still lagging their higher rated peers year-to-date, as of September 30th, CCC-rated loans are now underperforming their B-rated and BB-rated peers by only 395 bps and 260 bps, respectively. Similarly, Second Lien loans have outperformed First Lien loans in four of the last five months, including September, when Second Lien loans generated a gain of 3.19% compared to 0.61% for First Lien loans. Nonetheless, what distinguishes Second Lien loans is that although this cohort underperformed their First Lien peers through the first four months of 2020 by 460 bps, year-to-date through September 30th, Second Lien loans are now outperforming First Lien loans by 193 bps.
Chart 2 – Credit Suisse Leveraged Loan Index, September and YTD Performance (%) by Quality
Source: Credit Suisse
Focusing on sector performance shows that the weakness experienced by the broader high yield bond market during the month was widespread, as all but two sectors generated losses. In September, the biggest laggards were the Energy, Media, and Real Estate sectors, which produced losses of -4.30%, -1.11% and -0.98%. The Energy sector in particular suffered from a wild month of price swings in the oil market, which saw the commodity’s price decline by more than 10% through mid-September before rallying to finish down closer to 3% at month end. Conversely, the top performing sectors were the Transportation and Capital Goods sectors, which delivered modest gains of 0.42% and 0.03%, respectively. On the other hand, among leveraged loans, every sector generated positive performance in September. The top performing sectors for the month were the Retail, Consumer Durables and Consumer Non-Durables sectors, which generated gains of 2.28%, 1.98% and 1.88%, respectively. Conversely, the bottom performing sectors in the leveraged loan market were Media/Telecommunications, Utility and Healthcare, which returned a more modest 0.03%, 0.23% and 0.32%, 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).
At the same time, performance by issue size reveals that in September, smaller deals in the high yield bond and leveraged loan markets outperformed their larger counterparts for the second consecutive month (Tables 1 and 2). In any case, on a year-to-date basis, high yield bonds with larger deal sizes continue to outperform their smaller peers by a considerable margin; however, the relationship is improving. For context, although not shown, the year-to-date performance gap between bond deals smaller than $750 million and bond deals $750 million or larger was -697 bps at the end of March. Nevertheless, during the two quarters that followed, these smaller deals performed well on a relative basis and have erased about half of the performance gap that opened up in Q1. More specifically, as of September 30th, on year-to date basis, these smaller deals are now lagging their larger peers by -368 bps. By contrast, within the leveraged loan market, the smallest sized deals are now outperforming their larger peers on a year-to-date basis.
Table 2: CS Leveraged Loan Index Total Returns
and Issue Size Return Dispersion (%)
Source: Credit Suisse
In addition, as detailed below in Chart 3, according to data from J.P. Morgan, September dealt high yield bond mutual funds their largest outflows since March. Similar to what was experienced at the end of Q2, high yield bond mutual funds suffered significant outflows during the last three weeks of the month, which is likely the result of increased market volatility in September, as well as some rebalancing by investors given the performance of the high yield market during Q3. While high yield bond mutual fund flows have been positive, albeit volatile, thus far in 2020, leveraged loan funds have been negative and unidirectional. Leveraged loan funds continue to be plagued by outflows as -$1.0 billion exited these funds in September. Additionally, so far in 2020, leveraged loan funds have experienced outflows in 33 of 39 weeks, with an average outflow of -$619 million, compared to an average inflow of $157 million during this year’s six weeks of inflows. Given the interest rate environment today, and the expectation that rates will remain low for the foreseeable future, investor appetite for floating rate leveraged loans will likely remain muted.
Sources: Lipper; J.P. Morgan
Furthermore, CLO activity has regained momentum following a seasonal slowdown in August. For the month of September, J.P. Morgan data notes that close to $12 billion of new CLO formation occurred, which compares favorably to $5.3 billion in August. Year-to-date, total CLO activity, at $85.9 billion, amounts to just under two-thirds of the total produced during the same period last year. As mentioned in previous versions of this commentary, the low yield environment has resulted in a lack of supply in new leveraged loans; therefore, this level of activity in the CLO market is not surprising. However, the thawing of the CLO market has helped provide at least some support to secondary loan prices and primary market activity.
Shifting attention to the primary market, September was another month of strong new issue activity in the high yield market. According to data from J.P. Morgan, September historically has been the most active month in terms of average monthly new issue activity with $36 billion per month since 2010. During the month, $50.9 billion of new high yield bonds priced; however, such activity was somewhat lumpy as considerable activity in the middle of the month was book-ended by a slow start following Labor Day and a weak finish prompted by increased market volatility. In addition, consistent with the theme for 2020, the vast majority of proceeds from primary market activity during the month was used to refinance existing obligations. Year-to-date, high yield primary market activity stands at $350 billion, which is 68% ahead of the same period last year and is within striking distance of the current record of $398 billion set in 2013. Conversely, leveraged loan new issue activity remains more modest. That said, September, which has the second lowest average monthly new issue total dating back to 2010, had its strongest month since February, as $33.7 billion of new loans priced during the month. Leveraged loan primary market activity thus far in 2020 has already exceeded that of last year, but it is front-loaded where two-thirds 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 dominates use of proceeds year-to-date. However, in September, and during Q3, new issue activity was tilted toward acquisitions and dividend deals.
Drawing attention to default activity, although up month-over-month, default activity remained subdued. According to data published by J.P. Morgan and S&P/LCD, during the month, four issuers defaulted on $2.9 billion of high yield bonds and leveraged loans, which compares to three companies in August for a total of $1.6 billon. Nonetheless, at the end of September, the trailing twelve month leveraged credit default rate stood at 5.07%, up modestly from 5.00% at the end of the previous month.
Spread Changes in the CCC-rated Segment of the High Yield Market
Recently, an article published by Barclays provides an interesting analysis of the lower-rated segment of the high yield market1. Specifically, the analysis focused on the drivers of spread compression among the market’s CCC-rated cohort2. As of September 24th, the authors noted that the spread of the CCC-rated segment of the Bloomberg U.S. Corporate High Yield Index had fallen below 1,000 bps for the first time since February. Additionally, the ratio between the spread of CCC-rated bonds and that of the broader index had fallen from 2.8x at the start of the year to 1.9x at the time of the writing.
Nonetheless, as the authors suggest, further analysis is required to better understand the true drivers of such compression. In the report, the authors note that while the face value of bonds outstanding in the CCC-rated segment has increased only modestly since the start of the year, from $194 billion to $204 billion, there has been an elevated amount of turnover within the segment largely as a result of downgrades and defaults. In addition, the authors note that since the end of May, when CCC-rated bonds began to rally, through September 24th the spread for CCC-rated bonds declined by 423 bps. However, only about 56%, or 237 bps, of the decline can be attributed to those issuers that were in the CCC-rated segment throughout the entire period. Furthermore, bonds that exited the index as a result of default account for approximately one-third, or 138 bps, of the total decline in such spreads since the end of May. The remaining balance is the result of several factors, the largest of which was bonds that were called or matured during the period and accordingly dropped out of the index (-112 bps).
Lastly, the authors highlight that although a significant portion of the recent spread compression is attributable to defaults, since July, CCC-rated bonds have performed well relative to both the broader high yield market and their higher-rated peers. However, the authors remind readers that although performance for the CCC-rated cohort has improved more recently, lower-rated bonds continue to lag their higher-rated counterparts by double digits year-to-date. Nevertheless, given lower yields among new issues and higher-rated bonds, the authors suggest that more recent strength in the CCC-rated segment of the market may signal a willingness from investors to seek out higher yielding opportunities in lower-rated bonds that exhibit better fundamentals even in the face of weaker equity performance and elevated volatility. DDJ agrees with this sentiment and has for some time posited that this trend of “bargain hunting” would play an important role in normalizing the relationship between the higher- and lower-rated segments of the high yield market. Historically, this type of activity among market participants has helped return the high yield market back into a steadier state following a dislocation, such as the one observed in the high yield market throughout most of 2019 and into early 2020.
In summary, the recent surge in COVID-19 cases has been digested relatively well by markets. However, President Trump’s recent diagnosis, and related news on his well-being, will undoubtedly move markets for the next several weeks. Having said that, an increase in cases will likely decelerate the reopening of the economy, which would then exert further financial strain on individuals and businesses alike. As mentioned earlier, markets have been anticipating another round of fiscal stimulus; however, Congress has yet to deliver. In the meantime, the high yield bond market had been on an impressive rally since the end of March, in part because of unprecedented monetary policy and the fiscal stimulus that was previously injected to fill the gap in output created by mitigation efforts undertaken to slow the spread of COVID-19. However, that rally came to an end in September, as volatility increased, equity markets softened, and the prospects of further stimulus were called into question. Conversely, leveraged loans, which have lagged high yield bonds through most of the recovery, gained ground on their fixed rate peers in September. Summer is officially over, and winter is coming. As of this writing, there is only a little over a month to go before the election, and we anticipate a volatile October filled with more tricks than treats.
Appendix – Additional Charts as of September 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
Source: Credit Suisse
Chart 6 – ICE BofA US High Yield Index Option-Adjusted Spread in Basis Points (bps) – December 31, 1997 through September 30, 2020.
Chart 7 – ICE BofA US High Yield Index Cumulative Performance (%) by Quality:
January 1, 2019 to September 30, 2020
1US Credit Alpha: A Tale of Two Markets - Composition Changes CCC Compression, Rogoff, B., Shcachter, S. and Darfus, J.
2CCC-rated includes bonds rated CCC+ or Worse.
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.