High Yield Bond & Leveraged Loan Week in Review

Posted on April 17, 2020

April 13 - April 16, 2020

Summary

  • Economic activity has declined at a record setting pace brought on by the COVID-19 pandemic.
  • Leveraged credit markets experienced a less eventful week and generated positive returns.
  • The Fed’s expanded intervention had its desired effect on the “fallen angel” market in particular.
  • The bifurcation between the lower and upper tier of the high yield market continues


Last Thursday April 9th, the U.S. Federal Reserve (“the Fed”) stunned markets when it announced that it had expanded its asset purchase programs and direct lending facilities to include recent “fallen angels”, high yield ETFs, and new-issue CLOs. This new level of governmental intervention resulted in strong single day performance for leveraged credit markets and set a positive tone heading into the long weekend. The Fed’s latest action is potentially the strongest indication that it is willing to do whatever it takes to keep the capital markets functioning properly. As such, in the context of the heightened volatility experienced during the past several weeks, the current week was relatively calm.

Conversely, and as has been expressed by government officials, the past two weeks have been very difficult, not only in terms of the rise in the number of confirmed coronavirus cases, but also the rise in the number of those that have succumbed to the disease. The COVID-19 pandemic has wreaked havoc not only on overall economic activity, but also on the lives and well-being of many people as well. Notwithstanding these developments, the “shelter-in-place” mitigation and social distancing efforts appear to be successfully combating the spread of the coronavirus. As a result, government officials at the federal, state and local levels have begun discussing how and when to begin re-opening economies in an effort to soon ease some of the economic hardship caused by the pandemic.

Moreover, economic datapoints released this past week point to the sobering reality of the economic picture that is unfolding. On Wednesday, retail sales data showed a steep decline of -8.7% in March, far surpassing any figure reported during the Great Financial Crisis of 2008-09. In addition, the Fed’s Beige Book reported that economic activity across all regions in the U.S. contracted “sharply and abruptly”.  Furthermore, with respect to initial jobless claims in particular, another 5.2 million workers filed for unemployment benefits on Thursday April 16th, bringing the total number of claims filed in just the last four weeks to a staggering 22 million. For context, according to the Wall Street Journal, the largest number of Americans previously to file for unemployment benefits in a four-week stretch was 2.7 million, which occurred in the fall of 1982. Given the circumstances of this crisis, even if the jobless numbers prove to be more temporary in nature than past recessions, it is extremely unlikely that the job market will recover at the same rate that it has declined. Unfortunately, the negative effects from these heightened levels of prolonged unemployment will likely weigh on other economic datapoints for some time.

Pivoting our focus to the leveraged credit markets, as Chart 1 below shows, high yield bonds and leveraged loans produced an aggregate gain for the four trading sessions ending April 16th. Over the past several weeks, performance within the leveraged credit markets has improved as the unprecedented fiscal and monetary stimuli have helped thaw credit markets. As of April 16th, year-to-date losses generated by the ICE BofA US High Yield Index and Credit Suisse Leveraged Loan Index stood at -9.06% and -9.35%, respectively. It was only as of March 23rd that these indices had produced year-to-date losses of -20.56% and -19.76%, respectively. In addition, just four weeks ago, all 18 sectors within the ICE BofA US High Yield Index had produced a double-digit loss year-to-date; however, as of April 16th, just five sectors remain as double-digit losers (i.e., Energy, Leisure, Transportation, Real Estate and Automotive). Similarly, leveraged loan index performance has also improved during the past several weeks as it has seen the number of sectors that produced double-digits losses shrink from 19 out of 20 to 10 out of 20. Additionally, unlike the high yield bond index, the leveraged loan index now has one sector producing a year-to-date gain; this sector, perhaps not surprisingly, is Food and Drug, with its constituent companies, such as grocery retailers and grocery wholesaler/distributors in particular, benefitting from the “stay-at-home” advisories.

Chart 1 – Leveraged Credit Daily Performance (%):
April 13th – April 16th 

Chart 1 Leveraged Credit Daily Performance

Sources: ICE, Credit Suisse

As we mentioned in the opening, last week the Fed surprised market participants and expanded its monetary policy efforts into the leveraged credit markets, specifically targeting fallen angels and high yield ETFs. Largely in response to this announcement, the ICE BofA US High Yield Index gained 3.16% on Thursday April 9th, the second best day of performance by the index on record. Predictably, that same day was the strongest single day of performance on record for the ICE BofA US High Yield Fallen Angel Index, which gained a remarkable 6.29%. Much ink has been spilled on the topic of fallen angels and their potential impact on the high yield market given the growth of the BBB-rated bonds in recent years, so we will limit expounding beyond what is necessary to make our point. In 2020, the Fallen Angel Index’s par value has essentially doubled from $111 billion to $215 billion as a result of some large high profile downgrades in March. These issuers, as well as potential future downgrade candidates, were the target of the Fed’s most recent monetary stimulus. Therefore, it should come as no surprise that the best performing bonds in the Fallen Angel Index on the day of the announcement were its newest entrants, which as a group outperformed existing index constituents by 750 bps. As this data shows, the Fed’s recent actions, however unorthodox, had the desired effect as market participants flocked to these newly downgraded issuers, enhancing liquidity within the higher rated segment of the high yield market in the process. That said, with more than $300 billion of BBB-rated bonds with an option-adjusted spread wide of the BB-rated segment of the high yield market, it will be interesting to see how much monetary support the Fed can ultimately provide in the event of a more widespread wave of downgrades.

With regards to mutual fund flows, as Chart 2 below highlights, after $19.2 billion of outflows over the five weeks ending March 25th, high yield mutual funds have seen $14.9 billion flow back in over the last three weeks, including $7.6 billion in the last week alone. These additional flows, likely spurred by the Fed’s announcement last week, have helped fuel the surge in the prices of higher-rated, larger-sized bonds, which has resulted in increased performance dispersion amongst the segments of the high yield market. We have highlighted this dispersion in our prior weekly reviews, which is also reflected in Chart 4 and Tables 2 and 3 in the Appendix. That said, although smaller deals still lag larger deals on a year-to-date basis by a considerable amount, for the four days ending April 16th, smaller deals in both the high yield bond and leveraged loan indices outperformed larger deals.

Additionally, the Fed’s stimulus combined with recent mutual fund inflows has resulted in a more robust primary market for high yield bond issuances, as such activity has increased over the past couple of weeks. As a matter of fact, new issue activity in April has already surpassed March’s total, although admittedly the bar was pretty low given that no new deals priced in the market after March 5th for the remainder of the month. Conversely, although the Fed’s stimulus plan is designed to assist borrowers in both the high yield bond and leveraged loan markets, given the current level of U.S. Treasury yields coupled with the extremely low likelihood that such yields are headed higher anytime soon, the leveraged loan market, with its floating rate coupon, is presently viewed as a less attractive marketplace for both retail investors and borrowers. As such, flows continue to exit from leveraged loan mutual funds, and primary market activity for new loan issuances remains almost non-existent.

Chart 2 – Weekly Fund Flows ($mn)

Chart-2-Weekly-Fund-Flows

Sources: Lipper; J.P. Morgan

Over the last several weeks, we have presented a time series of the option-adjusted spreads (OAS) for the ICE BofA US High Yield Index to provide both the historical context of the OAS in the current market environment as well as the speed at which the spread has increased during this most recent period of volatility. While we continue to include this information in the Appendix (Chart 8), this week we focus on OAS moves not only for the broader high yield market, but also for the individual ratings tiers. As one can observe from Chart 3 below, today the OAS of the overall market, as well as the BB-rated, B-rated and CCC & lower-rated segments, stands at 758 bps, 524 bps, 846 bps and 1671 bps, respectively. These spread levels fall between the 80th and 90th percentile for observed spreads dating back to January 1, 1997. In our view, each of these levels offers an attractive entry point to the leveraged credit markets in their own right.

That said, the primary reason we chose to present this graph is that it further highlights how the fiscal and monetary response to the current crisis has amplified the dispersion between the ratings tiers within the high yield market. Specifically, while BB-rated bonds saw their spreads increase by 504 bps in the three weeks ending March 23rd, that same group saw their spreads contract 313 bps over the three weeks that followed through April 16th, or a retracement of 62% of the original increase in spread levels. In addition, and although not quite as robust a movement as their BB-rated peers, B-rated bonds retraced 52% of the widening that they had experienced from February 29th to March 23rd. Conversely, CCC & lower-rated bonds saw their spreads rise and fall during those same periods by 780 bps and 291 bps, respectively, which equates to a retracement of just 37%.

Chart 3 – ICE BofA US High Yield Index Option
-Adjusted Spread in Basis Points (bps)

Chart 3 ICE BofA US High Yield Index Option-Adjusted Spread

Source: ICE

Consequently, since the end of February, performance dispersion has been relatively high between the various ratings groups that comprise the ICE BofA US High Yield Index. As demonstrated in Table 1 below, higher-quality bonds outperformed lower-quality bonds significantly during the past 47 days following the volatility stemming from the COVID-19 pandemic and, to a lesser extent, the oil price war between Saudi Arabia and Russia. In particular, the dispersion since March 23rd, the date after which the high yield market started to recover, highlights the effect of the fiscal and monetary stimulus in supporting higher-rated credits. That said, in the intermediate-term, given where CCC-rated and B-rated spreads sit as of April 16th, DDJ has confidence that the lower-rated segments of the market will attract more attention from investors seeking investments that offer higher return potential. As a result, we believe that the performance gap between the lower-tier and upper-tier of the high yield market that has been created by the current crisis will narrow significantly over time. 

Table 1 – ICE BofA US High Yield Index Performance (%)
by Quality – February 29th through April 16th

Table-1-ICE-BofA-US-High-Yield-Index-Performance

Source: ICE

As we turn the page on another week, we continue to closely monitor the COVID-19 pandemic for signs of improvement. Early indications appear to show that the mitigation efforts undertaken in the U.S., as well as around the globe, are having the desired effect of “flattening the curve”. Nevertheless, the economic impact has been severe, and governments around the world are examining prudent ways to restart their economies. Of course, given the risk associated with another surge in infections, such measures in all likelihood will need to be phased in slowly over time. However, getting people back to work, and reversing the current unemployment trend, is an important first step in easing at least some of the hardships created by the coronavirus. Although we still do not know the true depths of the economic damage inflicted by the outbreak, datapoints thus far indicate that it may approach historic levels, as the current level of economic shutdown is truly unprecedented. During this time, as always, we continue to search for debt instruments that offer attractive relative value, with the burgeoning fallen angel market providing a fresh hunting ground for our team of research analysts in addition to our ever-present focus on opportunities within the less efficient lower-tier of the high yield market. While we at DDJ continue to manage our clients’ assets on an uninterrupted basis, there remains a lot of uncertainty as to what the “new normal” might look like once the pandemic has been eventually contained. However, even though it may take months for society to resemble what it used to be, there are glimmers of hope with governments believing that many locales are now past the peak of the virus outbreak. As a result, we are cautiously optimistic that the U.S. together with countries around the world can shift some of their focus to developing a plan to reopen economies, which, over time, will lead to a healthier and more prosperous future.

Appendix I – Additional Charts as of April 16, 2020

Chart 4 – ICE BofA US High Yield Index Evolution of YTD Performance (%) by Quality

Chart 4 ICE BofA US High Yield Index Evolution of YTD Performance

Source: ICE

Chart 5 – ICE BofA US High Yield Index YTD
Performance by Sector (%)

Chart 5 ICE BofA US High Yield Index YTD Performance

Source: ICE

Chart 6 – Credit Suisse Leveraged Loan Index YTD
Performance (%) by Quality

Chart 6 Credit Suisse Leveraged Loan Index YTD Performance

Source: Credit Suisse

Chart 7 – Credit Suisse Leveraged Loan Index YTD
Performance (%) by Sector

Chart 7 Credit Suisse Leveraged Loan Index YTD Performance

Source: Credit Suisse

 Chart 8 – ICE BofA US High Yield Index Option-Adjusted Spread in Basis Points (bps) – December 31, 1997 through April 16, 2020.

Chart 8 ICE BofA US High Yield Index Option-Adjusted Spread

Source: ICE

Chart 9 – ICE BofA US High Yield Index Cumulative
Performance (%) by Quality:
January 1, 2019 to April 16, 2020

Chart 9 ICE BofA US High Yield Index Cumulative Performance

Source: ICE

Table 2: ICE US High Yield Index Total Returns
and Issue Size Return Dispersion (%)

Table 2 ICE US High Yield Index Total Returns and Issue Size

Source: ICE

Table 3: CS Leveraged Loan Index Total Returns
and Issue Size Return Dispersion (%)

Table 3 CS Leveraged Loan Index Total Returns and Issue Size

Source: Credit Suisse

 


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.

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