April 24 - May 7, 2020
- The economic impact of the COVID-19 pandemic has pushed the U.S. into a recession.
- Leveraged credit markets managed to produce gains during a volatile couple of weeks.
- We briefly discuss distressed and coercive exchange proposals, as we have recently seen an uptick in this type of activity.
Confirmed cases of COVID-19 have surpassed one million in the U.S. and are approaching four million globally. However, the severity of the pandemic has varied region to region. As a result, certain governments have taken steps to loosen some of the stay-at-home orders, as well as restrictions placed on non-essential businesses, in the hopes of allowing for a modest reopening of the economy. In the U.S., states like Georgia and Florida come to mind as examples where certain businesses have been allowed to reopen albeit at a reduced capacity. Conversely, the hardest hit areas of the country, such as New York, and the Northeast in general, continue to compel citizens to stay at home and mandate that non-essential businesses remain shuttered.
As economic data continues to be released, the impact from the pandemic is unprecedented. On April 29th, the Department of Commerce reported that the U.S. had officially entered into a recession, with Q1 GDP contracting -4.8%. Additionally, during the past two weeks, another seven million Americans filed for unemployment benefits, bringing the total over the last seven weeks to an astounding 33.48 million. As a result of this massive amount of joblessness and the continued stay-at-home orders put in place to stem the surge in COVID-19 cases over the past seven weeks, the outlook for Q2 GDP remains grim.
To help the economy navigate through this challenging time, fiscal and monetary policies continue to be enacted and further refined. On April 24th, legislation was signed to replenish the exhausted Paycheck Protection Program, and the federal government is already discussing an additional fiscal stimulus similar in size to that of the original CARES Act that would be focused on assisting hard-hit states and municipalities. Similarly, the Federal Reserve indicated that it would soon begin purchasing corporate bonds via its Primary and Secondary Market Corporate Credit Facilities to support credit to large employers.
Furthermore, the Fed refined the language for its Main Street Expanded Loan Facility (MSELF), which should make the program accessible to more issuers in the high yield and leveraged loan universe. As an example, the Fed increased the cap on employees from 10,000 to 15,000 and revenue from $2.5 billion to $5 billon as it relates to an issuer’s eligibility to participate in the program. While an issuer’s eligibility will be determined on a case-by-case basis, hopefully these refinements will help make accessing this program more efficient.
Turning our attention directly to leveraged credit markets, year-to-date through May 7th, the ICE BofA US High Yield Index and Credit Suisse Leveraged Loan Index had produced losses of -9.36% and -9.18%, respectively. Daily performance during the past two weeks continued to be volatile. As Chart 1 below details, while the leveraged loan market advanced during the period, high yield bonds were able to produce a relatively larger gain.
That said, most of the gain in the high yield bond index during the last two weeks can be attributed to the spike in performance on May 5th, which coincided with a significant rally in oil prices. Perhaps not surprisingly, among both bonds and loans, the Energy sector was the top performing sector over the last two weeks. However, performance was not evenly distributed across quality spectrums. Within the high yield bond index, BB, B and CCC-rated Energy sector bonds produced gains of 5.70%, 11.01% and 2.37%, respectively. Meanwhile, loan performance for the Energy sector was also mixed as BB, B, and CCC-rated loans returned -1.01%, 5.91% and 1.84%, respectively. Recent gains aside, the current oil price environment creates a challenging backdrop for many businesses within the Energy sector. As such, it is likely that the increase in default activity expected over the coming quarters will be skewed higher by defaults in the Energy sector.
Chart 1 – Leveraged Credit Daily Performance (%):
April 24th – May 7th
Be that as it may, as shown in Chart 2 below, high yield bond mutual funds continue to attract the attention of investors. Over the past two weeks, high yield bond funds have experienced close to $4.5bn of inflows, pushing the year-to-date total inflow to just under $7.0bn. This represents a pretty remarkable turnaround given that high yield bond funds had experienced more than $19bn of outflows during the five weeks ending March 25th. Conversely, leveraged loan funds continue to be very much out of favor with investors, as they have experienced outflows in 16 of the last 17 weeks.
Chart 2 – Weekly Fund Flows ($mn)
Sources: Lipper; J.P. Morgan
In addition, primary market activity for high yield bonds continues to grow in 2020 and is well ahead of the new issue total produced during the same period last year. While still strong, new issuance over the past two weeks was not as robust as the two weeks ending April 23rd. Such period included the record $8bn three tranche deal priced by Ford on April 17th. In a somewhat unusual twist, several investment grade issuers have been marketing new bond issues in the high yield market. For example, on April 28th, Delta Airlines, while still technically considered investment grade, priced a $3.5 billion first lien secured bond offering through high yield syndicate desks. On a related note, investment grade new issue activity continues to pile up. After producing a record amount of issuance in March, the IG market wasted no time breaking that record in April. Over the past two months, IG net new issue activity totaled $419bn, accounting for most of the $511bn year-to-date, which is an increase of 216% year-over-year. With the Fed providing an explicit backstop for investment grade and fallen angel debt, it is no wonder that market participants are so receptive to IG and fallen angel new issuance; as such, this elevated activity should come as no surprise.
Meanwhile, the primary market for leveraged loans has begun to thaw, and issuance continues to pick up. During the last two weeks, approximately $8.7bn of new loans priced, all of which were first lien loans used for acquisitions or general corporate purposes; there have been no new second lien loan deals priced since the early part of February. Between very low interest rates and meager CLO formation, demand for leveraged loans continues to be challenged and it is likely that loan issuance will remain well behind the pace set over the past several years.
As we mentioned earlier, we anticipate that defaults will increase in the coming months led by issuers in the sectors hardest hit by the economic fallout created by the pandemic. Sectors such as Energy, Leisure, Transportation and Retail will likely make up the lion’s share of default activity this cycle. Most recently, according to JP Morgan, 19 companies either filed for bankruptcy or missed an interest payment in April 2020, affecting $35.7bn of face value of high yield bonds and leveraged loans. This activity brings 2020’s total defaults to 32 companies and $59bn of face value of bonds and loans. Although we are only four months into 2020, this year’s total dollar amount of defaulted high yield names already ranks as the sixth highest annual total on record.
In addition, an increase in default activity is often accompanied by an increase in distressed exchanges. In most cases, an issuer attempts to effectuate a distressed exchange in an effort to improve its balance sheet out-of-court and otherwise avoid a bankruptcy filing. In order to entice bondholders to participate, and reduce holdouts, the company will often offer attractive terms, or incentives, in the “exchanged” bonds, such as structural seniority, a claim against collateral, a higher coupon, and/or consent fees.
For example, suppose Company A has an existing $500mn unsecured bond that pays a 6% coupon and matures in two years. Largely as a result of current market conditions, the bond is currently trading at $0.40 on the dollar. In an effort to reduce its outstanding liabilities, Company A proposes that its bondholders exchange their existing holdings into a new first lien secured note that pays 9% and matures in four years, at a value consistent with the current price of the existing bonds. Therefore, the bondholders, which were expecting to be repaid $500mn in aggregate at maturity, would instead exchange into a new secured bond equaling 40% of the principal value of the original bonds. A bondholder may choose to participate in this type of transaction for a number of reasons, including its more favorable economics in the form of a higher coupon as well as the belief that the secured note will provide a better recovery in the event that Company A subsequently defaults. Following a successful exchange (and assuming 100% participation), Company A would have eliminated the $500mn issuance of unsecured bonds, instead replacing them with $200mn of new “exchanged” secured bonds. Such an exchange would reduce Company A’s indebtedness (i.e., de-lever its balance sheet) by $300mn.
Oftentimes, distressed exchanges are debt-for-debt transactions, but they can also include equity as part of the exchanged package. In either case, the issuer aims to achieve the goals of de-levering the balance sheet, improving liquidity, and/or extending its maturity profile. In addition, distressed exchanges are typically voluntary, and the success of the exchange is contingent upon getting a sufficiently large percentage of the affected bondholder class to participate.
However, in some cases, the exchanges may be more coercive in nature, as the issuer attempts to pressure bondholders through incentives or disincentives in an effort to compel them to participate in the exchange. In these situations, the incentives as described above remain the same. What is different is that those bondholders who do not participate are effectively penalized through various means, including subordination of their bonds and the dilution of protections under the existing bond indenture resulting from their unwillingness to “play along”.
As a result of the current economic crisis, an increasingly large amount of high yield debt is trading at distressed prices. Therefore, today’s environment appears ripe for this type of coercive activity as issuers struggle with liquidity, pending maturities, and excessive leverage. We have already observed several coercive exchanges presented in the current market, most of which have been proposed by issuers in the Energy sector. It would not surprise us in the least to see this trend continue and even potentially accelerate over the coming months as companies take all permissible actions in an effort to remain solvent.
Although the details are beyond the scope of this bi-weekly review, coercive type exchanges highlight the importance of carefully reviewing and understanding the contract associated with a given debt investment. Given the complexity of these transactions it is important that investors have a clear picture of the rights and remedies afforded to bond and loan holders via the underlying indenture or credit document. Such information is critical in assisting debt holders in their efforts to preserve value for themselves rather than allowing value to leak to other stakeholders in the capital structure, such as (potentially out-of-the-money) equity holders. As a result, given all available information, it is sometimes more advantageous to forego participation in a bad exchange offer and instead force a company to file for court-supervised bankruptcy protection, where creditors can assert their legal rights with the assistance of specialized restructuring counsel.
In summary, as the pandemic and ensuing economic crisis unfolds, markets will undoubtedly continue to be volatile. Based upon the current information available, we believe that a measured approach to reopening the economy is necessary to reduce the amplitude of a potential second spike in cases. Undoubtedly, the stay-at-home orders, while helping to “flatten the curve” of the disease and prevent healthcare resources from being stretched to the breaking point, have exacted a heavy toll on economic activity and thus the lives and well-being of people in communities across the country. While the government has attempted to fill the void in demand created by the crisis with massive intervention and stimulus efforts, the lasting impact of these actions remains an unknown and accordingly has created another layer of uncertainty with respect to any eventual economic recovery. Until such time, corporate entities will look to exercise any and all permissible transactions in an effort to continue as a going concern. While we keep an eye on the leveraged credit market, as well as economic and COVID-19 related news flow, we remain steadfastly focused on our current portfolio holdings and continue to seek new investment opportunities to put capital to work on behalf of our clients.
Lastly, going forward we will likely circulate this summary of leveraged credit markets on a bi-weekly basis, as we use other mediums to stay connected with our clients, consultants and prospects. For example, we recently distributed an audio file containing a Q&A session with our Energy sector analyst Sameer Bhalla, who provided his insights on the tumultuous oil price environment and its effect on the sector. Of course, as these unprecedented times continue to unfold, we will reach out with more frequent communications as necessary. Stay healthy and stay safe.
Appendix I – Additional Charts as of May 7, 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
Source: Credit Suisse
Chart 7 – ICE BofA US High Yield Index Option-Adjusted Spread in Basis Points (bps) – December 31, 1997 through May 7, 2020.
Chart 8 – ICE BofA US High Yield Index Cumulative
Performance (%) by Quality: January 1, 2019 to May 7, 2020
Table 1: ICE US High Yield Index Total Returns
and Issue Size Return Dispersion (%)
Table 2: 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.