High Yield Bond & Leveraged Loan Week(s) in Review

Posted on June 5, 2020

May 22 - June 4, 2020

Summary

  • Leveraged credit markets produced impressive gains during the period covered and have done so for two consecutive months.

  • We briefly analyze the performance of the CCC-rated bond market to better understand its relative underperformance since the recovery began.

Worldwide, confirmed cases of COVID-19 exceed 6.5 million, with cases in the United States accounting for 28% of the global total. The unprecedented steps taken in the U.S. and other countries during March and April to minimize the spread of the virus have resulted in a decline in infection rates in many areas. However, there remain several countries that continue to show a rapid growth in cases, such as Brazil and Russia. Although not unique to the U.S., the restrictive measures undertaken domestically to reduce the spread of the virus have had a major impact on economic activity. Unemployment has soared and GDP in Q2 2020, which includes the height of the lockdowns, is anticipated to show an annualized rate of decline between 30-50%. Nevertheless, with the lockdowns easing across the nation, many economists believe that the worst of the economic malaise is behind us.

Alternatively, growing civil unrest in the U.S. and abroad, as well as deteriorating relations between the U.S. and China, creates further uncertainty. We all hope for peaceful and diplomatic resolutions to these burgeoning crises; however, from a purely economic perspective, this type of uncertainty typically weighs heavily on the confidence of consumers and businesses.  As a result of these new risks, coupled with the heavy toll that the COVID-19 pandemic has taken on the economy, a return to pre-crisis levels of economic activity will likely follow a much longer path than the “V” shaped recovery originally hoped for by many.

Notwithstanding these recent events, over the past two weeks, the high yield bond and leveraged loan markets have generated impressive gains of 4.12% and 2.84%, respectively, as set forth in Chart 1 below. During the period, CCC-rated high yield bonds significantly outperformed B-rated and BB-rated bonds, as such segments produced gains of 7.54%, 4.26% and 3.34%, respectively. Similarly, within the leveraged loan market, CCC-rated loans were the top performers during the period, producing gains of 4.62% compared to B-rated and BB-rated loans, which returned 2.85% and 2.13%, respectively.

In addition, sector performance shows healthy gains across all sectors of the high yield market during the past two weeks. With economies gradually reopening and a healthy gain in oil prices during the period, it should not come as a surprise that the best performing sectors over the past two weeks were Leisure, Transportation and Energy, which produced gains of 7.13%, 6.30% and 6.08%, respectively. Similarly, among leveraged loans, the top performing sectors were Energy, Aerospace and Gaming/Leisure, which gained 6.02%, 5.38% and 4.12%, respectively.

Furthermore, performance by issue size shows that smaller deals in the high yield bond and leveraged loan market continue to lag their larger peers year-to-date. However, during the period, high yield bonds less than $500mn in size performed in-line with those high yield bonds that were larger than $500mn in size, perhaps signaling a reversal of the trend observed during the earlier stages of the pandemic. Meanwhile, for leveraged loans, performance by issue size over the past two weeks shows that loans smaller than $500mn in size modestly underperformed their larger peers. Lastly, year-to-date through June 4th, the ICE BofA US High Yield Index and Credit Suisse Leveraged Loan Index have produced losses of -3.72% and -5.14%, respectively.

 

Chart 1 – Leveraged Credit Daily Performance (%): May 22nd – June 4th Chart 1 – Leveraged Credit Daily Performance (%) May 22nd – June 4th

Sources: ICE, Credit Suisse

Turning our attention to flow data, as Chart 2 below shows, high yield bond mutual funds tallied a meaningful $12.1bn of inflows during the past two weeks. This recent activity marks the tenth consecutive weekly inflow for high yield bond mutual funds, a period that includes some of the largest weekly inflows on record. Given the low yields offered in other fixed income markets along with the Fed’s implicit backstop of “fallen angels” and high yield ETFs, positive flow activity over the past couple of months makes sense. Conversely, after experiencing a modest inflow last week, leveraged loan mutual funds saw another weekly outflow. Such funds have seen net outflows in 18 of the last 20 weeks for a total $15.8bn year-to-date. Furthermore, according to Lipper data, while high yield bond funds experienced their two largest monthly inflows on record during the past two months, leveraged loan funds have now seen outflows for 20 consecutive months through May.


Chart 2 – Weekly Fund Flows ($mn)
Chart-2-–-Weekly-Fund-Flows-($mn)

Sources: Lipper; J.P. Morgan

Meanwhile, as a result of the low yield environment, companies remain inclined to utilize the high yield bond market in lieu of leveraged loans to finance their businesses. In addition, during the past two weeks primary market activity for high yield bonds has seen a shift to more senior unsecured debt issuance. For context, senior unsecured bonds account for approximately 80% of the high yield market as measured using the ICE BofA US High Yield Index. Therefore, a shift away from senior secured debt offerings, which have dominated issuance since the crisis began, may indicate a further normalization of the market. Alternatively, new issue activity for leveraged loans remains subdued. According to data from S&P LCD, only $3.5bn of new first lien loans were priced during the past two weeks, while second lien loan issuance continues to remain non-existent. The demand environment for floating rate investment products remains mired by the low interest rate environment, outflows from retail funds and most importantly the relative lack of CLO formation. Nonetheless, after bottoming out in March, new CLO activity has continued to show improvement.

Default activity was relatively subdued during the last two weeks, with Hertz, which filed for Chapter 11 on May 23rd, being the largest default during the period. While the default rate is expected to continue to climb, default volume in May was well below that of April. In addition, the percentage of the high yield market trading at distressed levels has declined during the past two months, which could potentially reduce the volume of bonds that ultimately default as a result of the current economic crisis. This dynamic could also help explain the relief recently felt by the battered CCC-rated segment of the high yield market in particular.

Since the end of March, CCC-rated bonds have materially lagged their BB/B-rated peers. Given the Fed’s targeting of the upper echelons of the high yield market, this performance dispersion should not come as a surprise. For context, as of March 31st, CCC-rated bonds lagged BB-B-rated bonds by more than 10%. This performance differential has generally remained above 12%, peaking at 14.5% in mid-May before settling to 13.30% on May 31st.

The uncertainty as to the pace of economic recovery continues to weigh on CCC-rated bonds. However, upon digging a little deeper, it is clear that some CCC-rated bonds are performing much better than others since the onset of the market recovery. For the following analysis, we used the ICE BofA CCC & Lower US High Yield Index and the ICE BofA BB-B US High Yield Index as proxies for the CCC-rated and BB/B-rated markets, respectively. As one can observe from Table 1 below, the par amount of distressed issues (defined as bonds with an option-adjusted spread (OAS) greater than or equal to 1000 basis points) increased significantly during Q1 2020. One can also see that over the past two months the par value of such issues has declined rather sharply. However, the volatile swings in distressed bonds occurred in the higher-rated portion of the market, while distressed issues in the CCC-rated market have continued to increase (albeit at a much slower pace) since the end of Q1. Of course, a portion of the decline in BB/B-rated distressed bonds reflects downgrades into the CCC-rated segment of the market. Nevertheless, the vast majority of the BB/B-rated bonds categorized as distressed at the end of March remained in the BB/B index, with their spreads declining to a level below 1000 bps by the end of May as a result of price appreciation.

In addition, although not shown in Table 1 below, the relative size of BB/B-rated distressed bonds grew from less than 2% of the market value of the BB/B-rated universe as of December 31, 2019 to 16% at the end of March. Furthermore, during that same period, distressed CCC-rated bonds increased from 27.5% of the CCC-rated universe to a whopping 64%. Lastly, given the number and size of the downgrades from BB/B to CCC, together with the improvement in performance over the last two months, especially among BB/B-rated bonds, as of May 31st, distressed bonds accounted for approximately 5% of the BB/B-rated index, but still comprised nearly half of the CCC-rated index.

Table 1 – Par Amount of High Yield Bonds with OAS greater than
or equal to 1000bps (in millions)

Table 1 – Par Amount of High Yield Bonds with OAS greater than or equal to 1000bps (in millions) (2)

Source: ICE

As mentioned above, CCC-rated bonds have not participated in the rally within the high yield market that began in early April to the same extent as their higher-rated peers. This underperformance is largely driven by the distressed bonds in the CCC-rated index as detailed below in Table 2. The data shows that distressed CCC-rated high yield bonds, in particular those with an OAS of greater than or equal to 1500 bps, which produced year-to-date losses of approximately 50% through March 31st, have not improved at all during the past two months. As a result, this cohort of bonds has steadily accounted for about 35% of the CCC-rated index and has thus weighed heavily on relative performance especially when compared to BB/B-rated bonds. Conversely, the other two groups of CCC-rated bonds displayed in Table 2 show a significant improvement in performance during the past two months. Specifically, CCC-rated bonds with an OAS between 1000 and 1500 basis points have significantly outperformed the BB/B-rated index since the start of the recovery.

Table 2 – Year-to-Date Performance of High Yield Bonds by Rating and OAS (%)

Table 2 – Year-to-Date Performance of High Yield Bonds by Rating and OAS (%) (2)

Source: ICE

Although we have not provided a complete sector breakdown, approximately 60% of all CCC-rated bonds with an OAS of greater than or equal to 1500 bps fall within the Energy, Capital Goods and Healthcare sectors, with the majority having an OAS that exceeds 2000 bps. Additionally, bonds from the Energy and Capital Goods sectors account for the largest volume of bonds that have been downgraded into the CCC-rated index since the start of the crisis. Bearing in mind that the current crisis has proven to be very challenging for these sectors, it is no coincidence that such issuances would account for such a large portion of the overall amount of distressed/downgraded bonds. Specifically, most of these bonds have found their way into the cohort of bonds with an OAS of greater than or equal to 1500 bps. In addition, defaults by several bonds within this cohort further hindered performance through the end of March. Therefore, although several of the formerly BB/B-rated “new entrants” to the CCC-rated index have contributed to positive returns during April and May, as a group, these bonds have yet to overcome the losses generated earlier in the year.

Furthermore, in the case of distressed issues, existing investors that are involved in potential restructuring transactions oftentimes have access to material non-public information. As such, market prices may not yet reflect all available information. In general, we believe that the data above lends support to our long-held contention that “not all CCCs are created equal”, as there is wide dispersion within this category of the high yield universe. This dispersion has been further exacerbated by downgrades, and the subsequent increase in exposure to certain cyclical sectors such as Energy and Capital Goods. While CCC-rated bonds in general are more susceptible to losses brought about by an economic slump, the recovery in certain portions of the CCC-rated market over the past couple of months reveals that this segment of the market offers the opportunity to uncover attractive investments in resilient businesses.

To summarize, the gradual reopening of the U.S. economy will hopefully mark the beginning of the journey to the “new normal”. Given the novel nature of the COVID-19 virus, the picture remains unclear as to exactly what ongoing effects the virus will have as people try to regain some sense of normalcy. Will there be a second spike? How quickly can the global community develop effective treatments as well as a potential vaccine? Answers, or further progress to find answers, to these questions will go a long way towards eliminating people’s concerns and expediting a more fulsome re-opening of the economy. However, just as COVID-19 risks have begun to subside and workers nationwide have emerged from their home offices, investors are now faced with growing risks associated with heightened geopolitical tensions and domestic social unrest. At this time, it is unclear what influence, if any, that these nascent risks will have on the broader markets, but for now investors seem more focused on the positives associated with the restarting of the economy. On the back of this renewed optimism, the high yield market has strung together strong gains over the last couple of months. Moreover, we have seen these gains begin to filter their way from the higher-quality portion of the high yield market down to their lower-rated peers. Some may suggest that markets have moved too fast, too soon given the uncertainties and risks related to the pandemic, and that may prove to be the case; however, markets tend to overreact in both directions. In our view, it is important to stay the course during turbulent times as the investment opportunities generated in periods of short-term market volatility can frequently lead to long-term value creation.

 

Appendix I – Additional Charts as of June 4, 2020

Chart 3 – ICE BofA US High Yield Index Evolution of YTD Performance (%) by QualityChart 3 – ICE BofA US High Yield Index Evolution of YTD Performance (%) by Quality

Source: ICE

Chart 4 – ICE BofA US High Yield Index YTD Performance by Sector (%)Chart 4 – ICE BofA US High Yield Index YTD Performance by Sector (%)

Source: ICE

Chart 5 – Credit Suisse Leveraged Loan Index YTD Performance (%) by QualityChart 5 – Credit Suisse Leveraged Loan Index YTD Performance (%) by Quality

Source: Credit Suisse

Chart 6 – Credit Suisse Leveraged Loan Index YTD Performance (%) by SectorChart 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 June 4, 2020Chart 7 – ICE BofA US High Yield Index Option-Adjusted Spread in Basis Points (bps) – December 31, 1997 through June 4, 2020.

Source: ICE

Chart 8 – ICE BofA US High Yield Index Cumulative Performance (%) by Quality: January 1, 2019 to June 4, 2020Chart 8 – ICE BofA US High Yield Index Cumulative Performance (%) by Quality

Source: ICE

Table 3: ICE US High Yield Index Total Returns and Issue Size Return Dispersion (%)Table 3 - ICE US High Yield Index Total Returns and Issue Size Return Dispersion (%)

Source: ICE

Table 4: CS Leveraged Loan Index Total Returns and Issue Size Return Dispersion (%)Table 4 - 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.
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