Fundamental factors underlying the corporate sector continue to underscore our constructive stance on leveraged credit, however, investors should prepare for heightened Q4 volatility amid shifting technical dynamics in the bank loan market.
prepared by Guggenheim Partners LLC
Fundamental factors underlying the corporate sector continue to underscore our constructive stance on high yield bonds and bank loans. Although leverage ratios have ticked higher, strong interest coverage ratios and our expectations for continued low default rates help alleviate concerns arising from increased debt burdens in the near term. We believe credit risk should remain benign for the next few years.
Over the past year, the technical backdrop in the loan market has led to meaningful spread compression. Attractive relative value of bank loans and a renewed focus on interest-rate risk have resulted in positive performance driven by record-setting inflows into loan funds and robust collateralized loan obligation (CLO) issuance. In contrast, flows into high yield bond funds have been extremely volatile, contributing to mixed monthly returns. As technical dynamics can quickly change, this may be an opportune time to consider the implications of the increased prominence of retail capital and its potential to exacerbate policy-driven volatility.
- The U.S. Federal Reserve (Fed) on September 18 announced it would not taper quantitative easing (QE) and reiterated that asset purchases are not on a preset course. This announcement is likely to keep volatility elevated as investors continue to speculate on when tapering might begin.
- Buoyed by $17 billion of inflows in the third quarter, bank loans rose by 1.5 percent. Amid inflows of $7.9 billion, the high yield sector posted a third quarter return of 2.4 percent, rebounding from over $10 billion of outflows and a negative return of 1.4 percent in the second quarter.
- Recent regulatory changes have caused CLO liability costs to rise by 25 basis points since April 2013. Over the same period, loan spreads tightened by 80 basis points, causing CLO asset-liability spreads to narrow. This reduced arbitrage has led to a slowdown in new CLO origination.
- Since 2008, the retail share of the loan market has grown to 24 percent from 3 percent. The decline in CLO activity may cause the primary loan market to become increasingly dependent on retail demand, a technical dynamic that may induce greater volatility in bank loans.
Leveraged Credit Scorecard as of Month End
Source: Credit Suisse. Excludes split B high yield bonds and bank loans.
*Discount margin to maturity assumes three-year average life.
Source: Credit Suisse. Data as of September 30, 2013.
“As the world awakens to the realization that the damage to economic growth and the housing market caused by higher mortgage rates is more severe than anticipated, we may see interest rates decline further. If retail investors then decide to make withdrawals from floating-rate funds or simply stop allocating to them, spreads would have to widen to attract new marginal buyers. While I remain bullish on credit for the cycle, bank loans are becoming less attractive given market dynamics.”
- Scott Minerd, Global CIO
Fed Speak Sparks Interest-Rate Volatility
Speculation on the future of QE dominated financial headlines this summer, causing increased interest-rate volatility and driving investor demand for low-duration assets. The yield on the 10-year Treasury note hit a two-year high of 3 percent, over 100 basis points above lows seen in May, before eventually ending the third quarter at 2.61 percent following the Fed’s September 18th announcement that it would not yet begin tapering its asset purchases. In the five-month period between the beginning of May and the end of September, investment-grade bonds, Treasuries, and high yield corporate bonds recorded negative returns of 4.5 percent, 2.8 percent, and 0.8 percent, respectively. Bank loans recorded positive performance of 1.2 percent.
The Fed’s decision to not taper QE came amid a cautionary outlook on the U.S. economy, based on high unemployment, rising mortgage rates, and restrictive fiscal policy. As the majority of investors had priced in expectations of a modest taper, the Fed’s decision came as a surprise and caused the 10-year Treasury yield to fall by 16 basis points between the Fed’s announcement and market close.
The Fed stressed that asset purchases are not on a preset course and remain dependent on the economic outlook. The Fed’s assertion that it will monitor data “until the outlook for the labor market has improved substantially in a context of price stability,” lacks specificity and will likely keep market volatility elevated in the fourth quarter.
The recent rise in interest rates has been the most violent on record on a percentage basis and we see evidence of the negative impact that rate volatility can have in the economy. As rate volatility persists, we believe the next few months will be characterized by a period of extreme uncertainty.
Source: Bloomberg, Guggenheim Investments. Data as of September 30, 2013.
A Fundamentally Stable Credit Environment
Interest Coverage, Leverage Ratios and Low Default Rates in Focus
In the years following the 2008 financial crisis, a combination of fundamental and technical factors culminated in an incredible bull run for the below investment-grade market. Since January 2009, high yield bonds have returned 18.3 percent on an annualized basis, and yields set new record lows as investors sought income alternatives.
As we approach the latter stages of the credit cycle, investors may wonder whether it is time to reduce exposure to leveraged credit. Despite the volatility experienced in the third quarter of 2013, we maintain our constructive stance on corporate credit based on the underlying fundamentals – primarily, healthy coverage ratios, low borrowing costs, and our expectation for low default rates.
Leverage, as measured by net debt to EBITDA, declined steadily between 2008 and 2011, amid the deleveraging cycle that followed the financial crisis. In 2011, leverage in the high yield sector fell as low as 3.1x, just off the 15-year historical low of 2.9x. Recently, the opportunistic issuance of debt to lock in historically low borrowing costs has caused leverage to rise to 3.9x, the same level observed during the peak of the financial crisis.
During previous periods, an uptick in leverage was usually accompanied by a fall in interest coverage ratios (EBITDA divided by interest expense), signaling a significant deterioration in credit. Prior to the 2001 recession, leverage among high yield issuers rose to 4.7x as coverage ratios fell to 2.4x. Similarly, the 3.9x leverage at the peak of the 2008 financial crisis was accompanied by coverage ratios of 2.9x. While leverage has steadily climbed over the past two years, interest coverage remains healthy. Today, coverage ratios stand at 3.5x, above the pre-financial crisis average of 3.2x.
Source: Bank of America Merrill Lynch. Data as of June 30, 2013.
Strong coverage ratios are largely a result of a wave of refinancing. Over the past five years, refinancing higher-coupon debt at historically low interest rates has represented over 55 percent of new issuance. Refinancing activity has also extended the so-called maturity wall to approximately six years, with roughly 75 percent of bonds in the Credit Suisse High Yield Bond Index maturing between 2017 and 2021. (The maturity wall is important because if it coincides with a lack of liquidity like that experienced in 2008, defaults can spike as issuers are unable to pay down maturing debt.) A similar story occurs in bank loans, where the average maturity is five years and 85 percent of the loans in the Credit Suisse Institutional Leveraged Loan Index mature between 2017 and 2020.
In addition to lower borrowing costs and an extension of the maturity wall, current Fed policy supports our view that default rates will remain low for some time. Fed guidance has indicated that the target for short-term rates will remain low at least until mid-2015. Our research shows that, on average, default rates have remained low for approximately 20 months following the first Fed rate hike after a sustained period of monetary accommodation. As a result, we do not expect any meaningful rise in defaults over the next three to five years.
A Review of the Bank Loan Investor Landscape
Understanding Collateralized Loan Obligations
Over the past year, bank loans benefitted from numerous tailwinds. The combination of strong fundamentals, attractive relative value and an increased focus on interest-rate risk was the catalyst for positive momentum in the sector. Over the five weeks between July 22 and August 23, loan fund inflows set new records, reporting over $1.8 billion of weekly inflows three times. Significant interest-rate volatility caused by market uncertainty over possible Fed tapering helped ongoing positive inflows into the bank loan sector, which recorded 67 consecutive weeks of positive inflows.
As demand for bank loans grew, the CLO market thrived. Over $50 billion has been issued in the U.S. CLO market year-to-date, with almost $30 billion completed in the first quarter alone. This year’s total issuance already exceeds full year 2012 issuance. A robust CLO market is important for loans, as CLOs have historically represented a more sustainable, long-term source of demand. However, activity in the CLO market has recently begun to decline. We believe it is important for investors to understand the factors causing this shift.
CLOs issue several classes of liabilities, or tranches, with each tranche varying in level of seniority, risk and return. Senior tranches are well-insulated from losses due to overcollateralization (value in the underlying pool of loans exceeding CLO liabilities), excess spread (interest cash flow from the underlying loans greater than CLO liabilities debt service) and diversion triggers (if loan performance deteriorates, CLO equity cash flows are redirected to retire senior tranches). Owing to these structural protections and historical loan performance through multiple credit cycles, senior CLO tranches carry investment-grade ratings. Equity tranches, at the bottom of the capital structure, receive excess proceeds once debt tranches have been paid off. While typically leveraged 8-12 times, equity investors assume the most risk, but also enjoy the greatest potential for enhanced returns.
An important metric which equity investors monitor is the asset-liability spread, or the difference between bank loan spreads and the spreads paid on CLO debt tranches. In order to maintain the economic incentive to originate new CLOs, this arbitrage must exist for equity investors. As this spread tightens, this diminishes the return potential for equity investors. Below is a theoretical example outlining the economics behind CLOs.
Regulatory changes have caused CLO liability costs to rise this year. New FDIC insurance assessment calculations treat CLOs similarly to bank loans, triggering punitive risk-based capital charges for large banks who own even AAA-rated CLO tranches. The new FDIC insurance assessment rule took effect on April 1, 2013, and has caused large banks to demand higher spreads for CLO investments.
The highest rated AAA tranche often represents the majority of the CLO capital structure. This year AAA tranches, on average, represent 60 percent of new CLO issuance. Since the passage of the new FDIC assessment rule, CLO AAA spreads have widened by 25 basis points, to 140 basis points, resulting in higher liability costs for CLO issuers.
On the asset side, strong demand for bank loans and refinancings have caused spreads to tighten. Since the FDIC rule change took effect in April, bank loan spreads have narrowed by 80 basis points. As liability costs rise while asset yields fall, the arbitrage in CLOs has quickly dissipated. Consequently, we have seen a decline in CLO activity from the first quarter of 2013, when U.S. CLO origination approached $30 billion.
Source: JP Morgan. Data as of September 30, 2013.
Caution in the Technicals
Shifting Technicals May Foreshadow Increased Volatility in Loans
While positive fundamentals should help sustain the credit cycle in the near term, there are several notable trends that investors should continue monitoring. Particularly, the growing prominence of retail investors in the bank loan market can contribute to volatility, as we have witnessed in the high yield sector.
Source: Barclays, Credit Suisse. Data as of September 30, 2013.
In 2011, high yield bonds benefited from $14.4 billion in net inflows from mutual funds, followed by $23.5 billion of inflows in 2012. During these years, high yield bonds recorded positive returns of 5.5 percent and 14.7 percent, respectively. This year, high yield bond funds experienced volatile monthly flows, with the greatest volatility occurring in June, when outflows exceeded $10 billion. In June, high yield bonds posted a negative return of 2.6 percent, the worst monthly decline in the sector since September 2011.
Year-to-date inflows of $52 billion into loan funds have increased the retail market’s share of bank loans to 24 percent. As new CLO issuance slows, we anticipate that retail’s influence on the bank loan market could increase. This has shaped our more cautious outlook on bank loans as we enter the fourth quarter. We believe that further decline in interest rates may cause retail investors to make withdrawals from loan funds or simply stop allocating to them, causing spreads to widen in order to attract new marginal buyers.
Source: Standard & Poors LCD. Data as of September 30, 2013.
Lastly, in August 2013, Fitch highlighted the use of ETFs as a vehicle for investors to enter and exit the market quickly during volatile periods. This trend may ultimately be increasing market volatility. Average daily trading volume for the five largest high yield ETFs rose to $1.5 billion in June from $470 million in May. Meanwhile, broker dealers that generally provide liquidity in leveraged credit markets are reducing inventories as they seek to reduce risk and meet new regulatory requirements. Shrinking dealer inventories at a time of rising retail influence could serve to exacerbate volatility in the leveraged credit market.
We Remain Constructive on Leveraged Credit But Positioned For Volatility
Heading into the fourth quarter, we caution that volatility will likely remain elevated as investors continue speculating on the future of QE. Investors should use market volatility to selectively ease into positions that may have become oversold. This year, investors who have employed this disciplined, opportunistic approach to credit investing have been rewarded. Amidst the rate volatility that began in May, high yield bond spreads widened to 554 basis points and yields rose to 7.0 percent in late June despite the fundamental environment for credit remaining largely unchanged. As of the end of the third quarter, spreads narrowed to 503 basis points, and yields fell to 6.3 percent. The decline in the 10-year Treasury yield has helped ease short-term interest-rate concerns and reignited the search for yield in high yield bonds. This positive technical catalyst may lead to additional spread tightening during the fourth quarter.
Increased opportunistic loan issuance in September has brought net new loan supply to $126 billion for the year, exceeding the aggregate $113 billion of demand from CLO origination and mutual fund flows. If supply continues to exceed demand throughout the rest of the year, this would represent a significant reversal of the trend observed over the past six months. Heavy supply weighing on the market would lead to spread widening in order to attract the next marginal buyer. A continued slowdown in CLO issuance would place greater importance on retail capital in the loan market. This dynamic would make the loan market more susceptible to increased volatility given the ease with which retail investor sentiment can change. Based on the views highlighted above, we believe that high yield bonds will outperform bank loans in the fourth quarter. While we remain constructive on the sector as a whole, we would advise leveraged credit investors to increase allocations to high yields bonds.
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