April 17 - April 23, 2020
- Discussions regarding reopening the economy increased; individual states divided on timeframe.
- Oil prices experienced historic volatility and double-digit declines given oversupply concerns.
- Economic data signals an extraordinary decline in 2Q 2020, brought on by the COVID-19 pandemic.
- Additional government stimulus approved with additional measures likely in near future.
- Volatility continued as the leveraged credit markets generated negative returns.
- YTD performance bifurcation between smaller and larger issue size in the high yield market remains significant.
Investors ended the week on Friday April 17th on a positive note as risk markets broadly appreciated on encouraging reports regarding drug trials for Gilead Sciences’ drug Remdesivir and its potential effectiveness in treating patients with COVID-19. In addition, the previous evening, the White House Coronavirus Task Force introduced a three-phased approach as guidance for states to gradually begin reopening their economies, providing investors with optimism that that there was a “light at the end of the tunnel.” However, the diversity amongst the state governors with respect to plans to end “stay at home” orders and other virus mitigation efforts was on full display this week as some states extended the duration of such orders while others announced plans to begin rolling back restrictions and reopen their respective state economies in the coming weeks. The differences in perspective are largely driven by the degree to which a particular state has been impacted by the virus with the leaders of less affected states desiring to ease the economic hardship caused by the virus and the associated mitigation efforts sooner rather than later.
Oil came sharply back into focus on Monday April 20th as the futures contract for May delivery underwent significant volatility, with the contract price experiencing a precipitous decline before ending the day at negative $37.63, the first time in history such contract has traded in negative territory. The contract price itself was not the most concerning aspect of such price volatility; rather, it was the signal that it sent regarding the dramatic decrease in demand created by the global economic shutdowns. There is a significant supply/demand imbalance in the oil markets; not only is there not enough consumption of petroleum to consume what is being presently produced, but the U.S. is also rapidly running out of storage capacity for such excess production. Not surprisingly, following these developments on Monday, talk of government support for the Energy sector increased.
On Tuesday April 21st, the Senate passed another coronavirus relief bill that will provide an additional $500 billion in stimulus. The House of Representatives passed the bill on Thursday, April 23rd, and President Trump is expected to sign it into law on Friday. The majority of this funding will be used to replenish the Payroll Protection Program, which itself provides aid to small businesses so that they can keep their workers on their payroll. In addition, $75 billion will be used to support hospitals that have struggled financially due to the coronavirus pandemic with another $25 billion earmarked to increase much-needed coronavirus testing nationwide. Preliminary talks are already underway for a larger “phase 4” stimulus bill that could focus on aid to state and local governments as well as infrastructure spending.
The week ended with another 4.4 million Americans filing initial unemployment claims, bringing the cumulative total over the past five weeks to over 26 million first-time filers, an amount that exceeds all of the jobs gained since the financial crisis in 2008/09. The number, which was largely in-line with forecasts for 4.3 million initial unemployment claims, declined week-over-week for the second consecutive week. Meanwhile, oil ended a very volatile week for the commodity on a high note, as prices increased on each consecutive day Tuesday through Thursday on the prospects for production cuts in the U.S. In addition, the IHS U.S. Composite PMI for April was released on Thursday, declining from 40.9 to 27.4 in March, representing the lowest reading since the series began in October 2009. (A reading below 50 indicates that market conditions are contracting). The Composite PMI includes both the services and manufacturing sectors and is viewed as a reliable leading indicator for GDP growth. Additional PMI data released for April included the Eurozone, UK, and Japan, each of which also recorded record lows, an ominous sign for second-quarter global GDP levels.
Before moving on to commentary specific to the leveraged credit markets, it is worthwhile to include a summary of recent actions announced by the U.S. Federal Reserve (“the Fed”), given the significant anticipated impact that they will have on the high yield market over the near-term. As previously highlighted in last week’s review, on Thursday April 9th, 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 Easter weekend. This action is potentially the strongest indication that it may be willing to do whatever it takes to keep the capital markets functioning as close to normal as possible.
Volatility in the markets remained elevated this week, particularly during the first three trading days, as investors struggled to balance the problems facing the Energy sector and the slew of negative economic news released in recent weeks (with more bad news likely on the way) on the one hand with the additional stimulus measures and the prospects of reopening the economy on the other. Chart 1 below displays the daily returns of the high yield bond market as represented by the ICE BofA US High Yield Index and the leveraged loan market as represented by the Credit Suisse Leveraged Loan Index, in each case for the week ending April 23rd. High yield bonds generated negative returns of -1.16% over the week, with higher-quality bonds continuing to outperform their lower-rated peers. All sectors in the high yield bond market generated negative performance over the period, with the Insurance, Utility, and Telecommunication sectors being the top three performing sectors while the Energy, Transportation, and Services sectors being the three worst performers. Leveraged loans generated negative returns of -0.12% over the week; unlike high yield bonds, lower-rated loans outperformed higher-rated loans. The top three performing sectors in the loan market were the Consumer Durables, Food and Drug, and Utility sectors, while the Aerospace, Retail, and Media/Telecommunications sectors were the three largest underperformers. As of April 23rd, year-to-date losses generated by the ICE BofA US High Yield Index and Credit Suisse Leveraged Loan Index stood at -10.12% and -9.46%, respectively.
Chart 1 – Leveraged Credit Daily Performance (%):
April 17th – April 23rd
Sources: ICE, Credit Suisse
Despite the volatility in performance during the week, high yield bond mutual funds continued to attract investors. As Chart 2 below highlights, after $19.2 billion of outflows over the five weeks ending March 25th, high yield mutual funds have seen over $18 billion flow back over the last four weeks, including a record $7.6 billion in the week after the Fed announced its new stimulus measures. These additional flows have helped fuel the surge in the prices of higher-rated bonds in recent weeks, resulting in increased performance dispersion amongst the quality tiers of the high yield market. Leveraged loans, however, remain out of favor among retail investors as flows continue to exit leveraged loan mutual funds, albeit at a very moderate pace over the past few weeks.
Chart 2 – Weekly Fund Flows ($mn)
Sources: Lipper; J.P. Morgan
Additionally, the Fed’s stimulus combined with recent mutual fund inflows have resulted in a more robust primary market for high yield bond issuances. New issue activity in the high yield bond market has increased over the past two weeks after a nearly four-week stretch with no primary market activity in either the high yield bond or leveraged loan market. Notably, on Friday April 17th, recent fallen angel Ford Motor Company placed $8 billion of senior notes across three tranches, marking the fourth largest high yield offering on record, according to J.P. Morgan. 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 low likelihood that such yields are headed meaningfully higher anytime soon, there remains little appetite in the market for floating rate debt. As such, primary market activity for new loan issues remain very subdued. Furthermore, while liquidity is still below levels that we would categorize as normal, activity in the secondary market has noticeably improved since it essentially dried up during the sharp selloff in mid-March, with the Fed’s actions undoubtably contributing to such improvement. That being said, bid/ask spreads are still wider than normal, while the increased liquidity in the high yield market is disproportionally benefiting the larger, higher-quality names.
Despite the enactment of significant fiscal and monetary stimulus measures since the onset of this crisis, there has been a material increase in the number of defaults this month given the sheer negative economic impact caused by shutting down a large portion of the economy over most of the past month. As of April 20th, 15 companies in the leveraged credit market have filed for bankruptcy or missed a coupon payment, representing over $33 billion in bonds and loans in the aggregate. The number of issuers that have defaulted month-to-date in April is already the most since April 2009, and the $33 billion in defaulted principal value represents the third largest monthly total on record. At DDJ, we expect that default activity will remain heightened over the short-term as the economic impacts of the shutdown persist, oil prices remain significantly depressed, and economic activity in all likelihood rebounds slowly as states gradually ease COVID-19 related restrictions; this new economic reality will continue to flush out issuers with unsustainable debt dynamics.
Below in Table 1, we have presented the performance of the ICE BofA US High Yield Index broken down into different issue size buckets. In past editions of our week in review, we have highlighted the significant dispersion in performance amongst such buckets, with larger issue sizes experiencing meaningful outperformance relative to smaller issue sizes. This week, we have separated performance into four distinct time periods that have occurred in leveraged credit markets during 2020.
- The first time period, labeled as “Pre-COVID-19”, captures market performance before COVID-19 began to impact such performance, which we define as 1/1/2020 through 2/19/2020.
- The second timeframe, labeled “Selloff”, encompasses the significant market selloff that began slowly in late February and picked up steam in mid-March, covering 2/20/20 through 3/23/2020.
- The third timeframe is labeled as “Pre-Fed” and runs from 3/24/2020 through 4/8/2020, the day before the Fed announced its new stimulus plan described in the opening page of this edition. Note that this period also includes the passage of the CARES Act and marks the turnaround in high yield bond performance following the selloff that occurred during the previous period.
- Finally, the last period, labeled as “Post-Fed”, covers the time period since the Fed’s announcement beginning 4/9/2020 and lasting through 4/23/2020.
We have also provided market value breakdowns for each issue size bucket (as a percentage of the total index) as of 12/31/2019, as well as the total return for each segment for the year-to-date period through 4/23/2020 to provide additional context.
Table 1: ICE US High Yield Index Total Returns
and Issue Size Return Dispersion (%)
One can make some interesting observations from Table 1. Firstly, the performance of each issue size bucket was relatively uniform during the “Pre-COVID-19” period when the market and economy were in a more “normalized” state. Additionally, and perhaps surprisingly, this uniform performance largely continued during the short, but sharp “Selloff” period that occurred from late February through late March. It is really during the "Pre-Fed” recovery period, during which time markets were just beginning to thaw and trading volume was lower than normalized levels, where the dispersion in returns highlighted amongst issue sizes really began to occur. Accordingly, if one were to simply examine the year-to-date performance in isolation, a natural assumption may be that smaller issue sizes sold-off more during the drawdown period. In fact, the opposite is true, as such issue sizes performed largely in line with larger issue sizes during such timeframe and then subsequently did not recover as sharply during the roughly two-and-a-half-week “Pre-Fed” recovery period that began in late March. One final observation that is noteworthy is that smaller issue sizes ($1 billion and under) have actually modestly outperformed larger issue sizes during the “Post-Fed” period that began the day of the Fed’s announcement on April 9th. One theory is that the Fed’s announcement caused investors to quickly bid up the price of fallen angels along with larger, more liquid issues eligible for the Fed’s purchase program, forcing investors to expand their opportunity set to include smaller issue sizes in the search for new investment opportunities. In fact, if one were to look at performance on the day of the Fed’s announcement, larger issue sizes outperformed smaller ones by over 150 basis points, and if that one day’s performance is excluded from the “Post-Fed” period above, the outperformance of smaller issues is even more robust.
At DDJ, we continue to closely monitor the COVID-19 pandemic for signs that recent improvements in the trajectory of the virus, particularly in the hardest hit regions, continue. 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 recent data points to a historic decline in second quarter GDP. In addition, the number of companies, particularly small businesses, that have been adversely affected by the shutdowns, coupled with the associated staggering rise in unemployment claims, remains a primary risk to the health of the economy over the longer-term. The ability of government efforts to support both such individuals and the impacted businesses in the interim will ultimately prove critical in any eventual successful reopening of the economy. That said, the desire to reopen the economy needs to be balanced with the risk associated with another surge in infections that could slow or otherwise halt any purported economic recovery. As a result, any measures to restart the economy will need to be phased in slowly over time.
During this time, as always, we continue to search for debt instruments that offer attractive relative value, with recent fallen angels already providing several attractive investment opportunities for our team of research analysts to evaluate. While we at DDJ continue to manage our clients’ assets on an uninterrupted basis as we work remotely consistent with the Massachusetts “stay at home” advisory, there remains a lot of uncertainty as to what the “new normal” might look like once the pandemic has been eventually contained and talk shifts to a return to work. However, even though we expect this process to take several months, there are glimmers of hope on the public health front 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 implementing measured plans designed to reopen their economies.
Appendix I – Additional Charts as of April 23, 2020
Chart 3 – ICE BofA US High Yield Index Evolution of YTD Performance (%) by Quality
Chart 4 – ICE BofA US High Yield Index YTD
Performance by Sector (%)
Chart 5 – Credit Suisse Leveraged Loan Index YTD
Performance (%) by Quality
Source: Credit Suisse
Chart 6 – Credit Suisse Leveraged Loan Index YTD
Performance (%) by Sector
Chart 7 – ICE BofA US High Yield Index Option-Adjusted Spread in Basis Points (bps) – December 31, 1997 through April 23, 2020
Chart 8 – ICE BofA US High Yield Index Cumulative
Performance (%) by Quality: January 1, 2019 to April 23, 2020
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
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.