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.

April 13 - April 16, 2020

Summary

• Economic activity has declined at a record setting pace brought on by the COVID-19 pandemic.
• Leveraged credit markets experienced a less eventful week and generated positive returns.
• The Fed’s expanded intervention had its desired effect on the “fallen angel” market in particular.
• The bifurcation between the lower and upper tier of the high yield market continues

Last Thursday April 9^th, the U.S. Federal Reserve (“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 long weekend. The Fed’s latest action is potentially the strongest indication that it is willing to do whatever it takes to keep the capital markets functioning properly. As such, in the context of the heightened volatility experienced during the past several weeks, the current week was relatively calm.

April 3 - April 9, 2020

With respect to the leveraged credit market, the most important event that occurred during the week was the announcement on Thursday April 9^th by the  U.S. Federal Reserve (“the Fed”) that it had expanded its asset purchase programs and direct lending facilities to include recent “fallen angels”, high yield ETFs, and new-issue CLOs.  The stated purpose of this program is to assist households and employers of all sizes and bolster the ability of state and local governments to deliver critical services during the COVID-19 pandemic.  While our weekly review released on Friday, April 3rd highlighted the importance of the massive fiscal stimulus recently passed by Congress to alleviate the economic consequences wrought by the COVID-19 pandemic, DDJ believes that this monetary stimulus by the Fed will be a “game changer” in terms of access to capital for many issuers and accordingly lead to improved functioning of leveraged credit markets going forward.  First, some high-level details:

March 27 - April 2, 2020

Last week, markets received two “shots in the arm” in the form of unprecedented fiscal and monetary stimulus. In our view, the CARES Act, which was signed into law by President Trump on March 27^th and is expected to provide the economy with a $2 trillion stimulus, has done more to stabilize leveraged credit markets than any actions thus far taken by the Fed, as such legislation more directly addresses the macro and fundamental challenges presently facing high yield companies. That said, the Fed’s recent actions, which have included several lending facilities designed to provide support to numerous fixed income markets, has also helped further stabilize the high yield and leveraged loan markets. Largely as a result of these actions, high yield bonds and leveraged loans rallied between March 23^rd and March 31^st.  This rally included the best five-day return for the high yield market dating back to 1996, even eclipsing any five-day rally witnessed during the 2008-09 Great Recession and its ensuing recovery.

However, following a sobering press conference delivered by the White House Coronavirus Task Force on the evening of March 31^st in which Americans were warned to essentially prepare for the worst over the next couple of weeks, market sentiment soured considerably. As part of this update, the federal government extended its guidelines for social distancing and mitigation efforts through April 30^th, with many states and local governments decreeing similar policies.

March 20 - March 26, 2020

On Thursday, March 19^th, in an effort to mitigate the burgeoning COVID-19 outbreak, California enacted the strictest state “lockdown” to-date, with similar actions then followed by multiple other states over the next few days. As a result, the economic implications associated with the essential closure of large parts of the U.S. economy have begun to set in. Meanwhile, in Europe, new COVID-19 cases and fatalities continued to increase at an alarming rate, an ominous sign for the U.S., which is believed to be a few weeks behind Europe in terms of progression of the virus. Major investment banks, such as Goldman Sachs and Morgan Stanley, slashed their U.S. economic growth estimates, with such firms now expecting record declines in second quarter 2020 annualized GDP of -24% and -30%, respectively. On Monday, March 23^rd, in response to the deteriorating economic outlook and declining liquidity across multiple sectors and markets, the U.S. Federal Reserve announced an expansion in both the size and reach of its asset purchase program as well increased direct lending for small and medium-sized enterprises, with a pledge to do more as needed. Despite these actions, the failure of Congress to pass a stimulus package over the weekend contributed to a down day across risk markets to begin the week. In our view, with significant uncertainties regarding the length of state lockdowns and the size of the total fiscal and monetary policy response, DDJ believes that it is still premature to forecast the economic impacts of the current crisis over the next three-to-six months.

March 13 - March 19, 2020

After a tumultuous five days of market activity ending Thursday, March 12^th, the high yield bond and leveraged loan markets were enjoying a day of moderate gains and relative calm last Friday. Subsequently over the weekend, several actions taken by various levels of government led market participants to conclude that the COVID-19 outbreak would begin impacting economic activity far more tangibly than perhaps originally contemplated. The unexpected announcement by the Federal Reserve, which included a reduction of the Fed Fund’s rate to near zero as well as the re-initiation of its quantitative easing program, further confirmed these fears. These combined events sent equity futures tumbling on Sunday evening. Not surprisingly, when markets opened on Monday, all markets, including the high yield market, reacted negatively to this news. In our view, market participants likely perceived the actions taken by the Fed as a signal that things in the market and economy were much worse than originally thought.