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

Posted on May 22, 2020

May 8 - May 21, 2020

Summary

  • Economic data still dire, though signs of gradual improvement from March/April lows
  • Leveraged credit markets generated strong returns as progress on reopening the economy overshadowed negative news regarding the current economic situation
  • Oil prices rallied in face of declining supply and modest improvements in demand
  • Flows and new issuance strong for high yield bonds, less encouraging for bank loans
  • We briefly discuss how a surge in fallen angels can alter the composition and risks of high yield market

A clearer picture of the dire unemployment situation in the U.S. emerged on May 8th when the Department of Labor reported that U.S. payrolls decreased by 20.5 million workers in April, causing the unemployment rate to surge to 14.7% from 4.4% as reported as of the end of March. Both the number of monthly job losses together with the unemployment rate reflected levels not seen since the Great Depression; however, both metrics came in slightly below the forecasts provided by most economists. Unsurprisingly, the Leisure and Hospitality sectors accounted for over one-third of the total number of job losses, as the COVID-19 pandemic has significantly disrupted travel on a worldwide basis. Additionally, initial unemployment claims reported on May 14th and 21st came in with 3 million and 2.4 million first time filers, respectively, bringing the nine-week cumulative total to almost 39 million initial filers. While initial claims remain elevated, the silver lining is that such claims have at least declined for seven straight weeks.

Economic data outside of the employment numbers was not much better, with historic declines in many key metrics reported during the period. For example, retail sales fell 16.4% in April, almost double March’s then-record decline of 8.3% and well below forecasts for a 12.3% drop. Likewise, industrial production and manufacturing output both plunged by the largest amount on record. Conversely, consumer sentiment unexpectedly rose in May, coming in well above expectations for a significant decline, as stimulus from the CARES Act adopted by the federal government combined with heavily discounted prices appeared to boost the optimism of American consumers. In addition, the IHS U.S. Composite PMI Output Index for May was released on Thursday, increasing from 27 in April to 36.4 in May as the economy began to reopen; despite this improvement, the figures still indicated a significant contraction in business activity (as 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.

Despite the deluge of negative news regarding the current state of the economy, there are some positive developments to highlight. For example, on Monday, May 18th, reports of promising early results from Moderna’s experimental COVID-19 vaccine study contributed to the best daily gains for stocks and high yield bonds during this two-week period. In addition, since we last produced this bi-weekly piece, progress towards reopening the U.S. economy has been made, with all 50 states having loosened restrictions to some extent; as of the date of this writing, early indicators have not pointed to a spike in cases in the days following the relaxation of mitigation efforts in states that have eased restrictions most aggressively. Furthermore, over the past two weeks, oil prices, as represented by West Texas Intermediate (“WTI”), have rallied close to 45%, benefiting from many factors including progress on reopening the U.S. economy; Saudi Aramco’s decision to reduce its sales to the U.S.; lower supply as the number of active oil rigs in the U.S. declined from 683 to 284 over the past nine weeks, the lowest levels seen in a decade; and signs that demand is increasing globally. For example, per government data, the amount of gasoline supplied by energy companies in the U.S., a proxy for driving demand, rose nearly 40% in the three-week period ending May 8th. Nonetheless, oil prices are still down over 40% year-to-date, a sobering reminder of the challenges likely to face many high yield issuers within the Energy sector in the weeks and months ahead.

Moving to the leveraged credit markets, on a year-to-date basis through May 21st, the ICE BofA U.S. High Yield Index and Credit Suisse Leveraged Loan Index have produced declines of -7.53% and -7.76%, respectively. However, over the past two weeks, high yield bonds returned 2.03% while leveraged loans returned 1.56%. B-rated and CCC-rated high yield bonds performed in-line and outperformed higher-quality BB-rated high yield bonds. Within leveraged loans, both BB-rated and CCC-rated loans performed in-line, underperforming B-rated loans. That said, on a year-to-date basis, higher-quality high yield bonds and loans are still significantly outperforming their lower-quality peers. Unsurprisingly, given the spike in oil prices during the period, Energy was the best performing sector in both the high yield bond and leveraged loan market over the past two weeks; however, Energy remains the worst performing sector in both markets on a year-to-date basis. Recent gains aside, the current oil price environment creates a challenging backdrop for many businesses within the Energy sector to generate a sustainable profit. As such, we anticipate that higher defaults in the Energy sector will otherwise skew the overall increase in default activity that will likely take place over the coming quarters.


Chart 1 – Leveraged Credit Daily Performance (%):
May 8th – May 21st

Chart 1 – Leveraged Credit Daily Performance (%) May 8th – May 21st

Sources: ICE, Credit Suisse

In addition, as shown in Chart 2 below, high yield bond mutual funds continue to generate significant inflows in the current environment. Since May 7th, high yield bond funds have experienced $7.8bn of inflows, pushing the year-to-date total inflows to just under $9.0bn. Given that high yield bond funds had experienced more than $19bn of outflows during the five weeks ending March 25th, this figure represents a pretty remarkable turnaround. Conversely, leveraged loan funds continue to experience moderate outflows, with outflows of $338mn since May 7th; year-to-date, outflows have totaled $19.6bn, with such funds experiencing outflows in 75 of the last 78 weeks.

Examining fund flows and fund assets under management (“AUM”) from a broader perspective, leveraged loan fund flows have steadily declined over the last year-and-a-half, with fund AUM almost halving since the third quarter of 2018 down to levels last experienced in 2012. Furthermore, assets in leveraged loan funds currently represent just 5.4% of the total leveraged loan market, which is the lowest percentage since 2010. Conversely, net flows from high yield bond funds have been positive over the last year-and-a-half, with such fund AUM currently representing almost 21% of the total high yield market. In addition, high yield ETFs currently represent a record high amount of total high yield mutual fund AUM, standing at roughly 20%. It is worth noting that assets in high yield ETFs have increased by almost 20% since the Fed announced on April 9th that high yield ETFs would be eligible for purchase under the Fed’s Secondary Market Corporate Credit Facility. The increase in ETF assets occurred before such purchases were set to begin on May 12th. Despite the increase in AUM, high yield ETFs still represent less than 5% of the total high yield market while leveraged loan ETFs account for less than 1% of the total leveraged loan market.


Chart 2 – Weekly Fund Flows ($mn)

Chart 2 – Weekly Fund Flows ($mn)

Sources: Lipper; J.P. Morgan

In addition, after the primary market for high yield bonds essentially shut down in March, its resurgence that began in April has continued in May. However, while refinancing activity accounted for only a quarter of April’s new issuance, the majority of new issue activity thus far in May has been for refinancing purposes, which is consistent with the first two months of the year. Conversely, issuance for general corporate purposes, which represented almost 75% of April’s volume as companies sought to strengthen their cash positions, declined in May alongside the pick-up in refinancing activity. 

Meanwhile, after experiencing heavy new issuance over the first two months of 2020, the primary market for leveraged loans experienced no new issue activity for four straight weeks from mid-March to early-April. Since then, issuance has fallen well below normalized levels and significantly lags the pace seen in the high yield bond market. Notably, all of the new loan issuance since the crisis began has been first lien in nature, the majority of which has been 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, mutual fund outflows, and relatively meager CLO formation activity, demand for leveraged loans continues to be challenged and loan issuance in all likelihood will remain well behind the pace set over the past several years.

In our “Week in Review” covering the week-ending March 26th, we discussed the likelihood that a flood of fallen angels would enter the high yield market in the coming months, which accordingly would have a meaningful impact on both the size and composition of such market. Almost two months later, the year-to-date fallen angel total is approaching $175 billion, already representing the largest annual total on record, with that number expected to continue to rise. Thus, we thought it would be worthwhile to analyze the impact, if any, that this development has had on the composition of the high yield market.

The most apparent result of an increase in fallen angels will be an increase in the BB-rated weighting of high yield indices. Using the ICE BofA U.S. High Yield Index as a proxy for the high yield market, April 2020 was the second largest month-over-month increase in the weighting of the BB-rated quality segment in the index (behind only May 2002) since monthly data became available in December 1996. BB-rated high yield bonds now represent almost 56% of such index, a record high and an increase of almost four percentage points in April and seven percentage points year-to-date. The fallen angel phenomenon has also affected sector weights in the index. For example, the largest increases month-over-month occurred in the Automotive and Energy sectors, with both sectors increasing by over three percentage points. What is notable about the Automotive sector is that one fallen angel – Ford Motor Company – accounted for virtually all of the sector’s increase, with the sector’s weight more than doubling from 1.9% on March 31st to 5.0% on April 30th.

These relatively meaningful changes in the composition of the index over such a short period of time can present particular challenges for high yield managers with portfolios that must adhere to tight guideline sector/quality bands around a broad market index. Using the Automotive sector as an example, one fallen angel now has a greater weighting than all of the previous issuers in the sector combined, which can make it challenging for a manager to achieve a sector-neutral weighting if it does not believe in the merits of an investment in Ford. Furthermore, as a result of fallen angel activity, that same manager may be required to increase its exposure to the Energy sector, not exactly the most compelling sector in the eyes of many investors given the oil price environment. 

This highlights another important characteristic of many fallen angels. Investment Grade issuers are typically much larger than the average high yield issuer, resulting in fallen angels oftentimes becoming some of the largest issuer weightings in high yield indices during periods of heightened downgrade activity. According to Goldman Sachs, the top ten issuers in the high yield market increased from 12% of the market at the beginning of the year to 17% today. This level of concentration represents a high since year-end 2012, a spike driven largely because the three largest issuers in the high yield market are recent fallen angels. Finally, the impact of the current fallen angel wave may magnify the fact that the size of the high yield bond market has grown very modestly over the past five-plus years while the size of the BBB-rated segment of the investment grade market has grown substantially over the same period. As a result, even if the percentage of BBB-rated downgrades remains on par with past fallen angel cycles (and all indications are the current wave will surpass such prior cycles), such downgrades would have a larger impact on the composition of the overall high yield market than has historically been the case. 

Another potential result from a large increase in the number of fallen angels entering high yield indices in short order is that the duration of such indices will increase. This outcome would occur because the (former) investment grade bonds often have lower coupons, longer maturities, and are not callable prior to their maturity. Any corresponding extension in the duration of a high yield bond index would likewise increase the interest rate sensitivity of such index.

We believe that the changes described above increase, to some extent, certain risk characteristics of the high yield market. Specifically, such index has effectively become more concentrated “up-top”, more weighted towards cyclical sectors (such as Automotive and Energy), and more sensitive to changes in interest rates. In addition, we suspect that it will become more challenging for traditional benchmark-driven managers to differentiate their portfolios from one another, as they may conclude that they have no choice but to increase exposure to certain large issuers and industries. Such technical elements could create certain market inefficiencies that opportunistic high yield managers are able to exploit. 

In conclusion, the current economic picture remains fairly bleak, and DDJ believes that a material improvement in the near term is unlikely. However, the progress that has been made in reopening the U.S. economy in recent weeks should not be discounted. Going forward, we believe that a measured approach to reopening the economy will hopefully reduce the risk of a resurgence of the coronavirus. Some risk markets, particularly the equity markets, are pricing a swift and smooth return to economic prosperity, which we view as an unlikely outcome. Accordingly, DDJ does not expect a swift “V” shaped recovery in the near term, but rather a non-linear recovery over the medium term. For this reason, we believe that market volatility will remain heightened as investors absorb the latest economic and virus-related medical news. Nonetheless, we remain confident in the ability of the U.S. (and global) economy to rebound over the medium term. In addition, the market dislocation created by the COVID-19 pandemic has resulted in attractive investment opportunities in the current high yield market. At DDJ, through continued bottom-up fundamental due diligence, we are focused on confirming that our investment thesis remains intact for current portfolio holdings as well as identifying new investment opportunities in issuers that we believe will emerge as survivors over the longer term.

 

Appendix I – Additional Charts as of May 21, 2020

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

Chart 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 Quality

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 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 21, 2020

Chart 7 – ICE BofA US High Yield Index Option-Adjusted Spread in Basis Points (bps) – December 31, 1997 through May 21, 2020

Source: ICE

 

Chart 8 – ICE BofA US High Yield Index Cumulative
Performance (%) by Quality:
January 1, 2019 to May 21, 2020

Chart 8 – ICE BofA US High Yield Index Cumulative Performance (%) by Quality January 1, 2019 to May 21, 2020

Source: ICE

 

Table 1: ICE US High Yield Index Total Returns
and Issue Size Return Dispersion (%)

Table 1 ICE US High Yield Index Total Returns and Issue Size Return Dispersion (%)

Source: ICE

 

Table 2: CS Leveraged Loan 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.

Q&A with the PMs of DDJ's U.S. Opportunistic High Yield Strategy