DDJ Capital Management Blog

June 5 - June 18, 2020

Summary

• Despite an increase in volatility driven by renewed concerns regarding a resurgence of the coronavirus, leveraged credit markets produced modest gains.
• Flows and new issuance remain strong for high yield bonds, though not as much for leveraged loans.
• We briefly analyze the industry standard calculation of the recovery rate on defaulted debt, highlighting some of the limitations of such measure.

On June 5^th, investors were greeted with a much better than anticipated May U.S. employment report, with an increase in non-farm payrolls of 2.5 million relative to consensus for a decline of 7.5 million. The report also reflected a decline in the unemployment rate  from 14.7% in April to 13.3% in May, also moving in the opposite direction as forecasts, which called for an increase in the unemployment rate to 19%. Such a rate would have represented the highest level since the 1930s. In addition, retail sales for May increased by a record 17.7% month-over-month, handily beating expectations for an increase of 8%. Such reports added to an already optimistic outlook amongst investors for a strong economic recovery beginning in the third-quarter, driven by a largely successful reopening of the U.S. economy.

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.

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 8^th 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 14^th and 21^st 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.

April 24 - May 7, 2020

Summary

• 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.

April 17 - April 23, 2020

Summary

• 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 17^th 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.

1st Half 2019 Review

After experiencing the worst quarterly performance in over three years in the fourth quarter of 2018, the high yield market bounced back in 2019, particularly in the first quarter, generating the strongest first half performance since 2009. A major driver of this rebound in performance occurred at the beginning of the year when the U.S. Federal Reserve (“the Fed”) signaled a more accommodative monetary policy stance going forward. 

1st Half 2018 Review

During the first half of 2018, high yield bonds produced a modest gain of 0.08% (as measured by the ICE BofA Merrill Lynch U.S. High Yield Bond Index (“HYBI”)), representing the worst first half performance by the asset class since the financial crisis of 2008. 

2017 High Yield Market Review

For 2017, high yield bonds produced a gain of 7.48% (as measured by the ICE BofA Merrill Lynch U.S. High Yield Bond Index (“HYBI”)), representing the second consecutive year where the total return of the HYBI exceeded its start-of-the-year coupon. As reflected in Exhibit 1 below, strong gains during the first six months of the year largely drove high yield bond performance in 2017. 

1st Half 2017 Review

During the first half of 2017, seemingly unwavering economic optimism and sustained accommodative monetary policy by many developed market central banks outside of the U.S. led to strong performance in the high yield market. This economic optimism, largely attributed to expected pro-growth policies from the new U.S. presidential administration, has continued largely unabated despite no significant new policies actually being implemented.

High yield bond performance in 2016 (as measured by the BofA Merrill Lynch U.S. High Yield Bond Index (“HYBI”)) recovered from early losses to post the asset class’s third highest annual total return during the past twenty years (17.49%), trailing only 2009 (57.51%) and 2003 (28.15%), respectively. As Exhibit 1 below shows, after generating an impressive gain of 9.32% through the first six months of the year, high yield bonds added an additional 7.47% in 2H16. High yield bond spreads compressed considerably in 2016, tightening a total of 273 basis points, including a 199 basis points decline in the second half of the year (“2H16”).