High Yield and Bank Loan Outlook – April 2012 Sector Report
April 25, 2012
The leveraged credit market began the year in strong fashion with yields across the credit spectrum approaching historical lows. Investors should realize that it is no longer early in the credit market rally. We are coming into the seventh inning stretch and it is getting tougher to find attractive opportunities. It is also important to watch for signs of overheating and to remain diligently focused on sound, fundamental credit work and security selection.
As we look ahead, we continue to see room for further price appreciation as investor demand should remain robust, while new issue supply wanes from its record first quarter pace. For institutional investors, we believe focusing on identifying value through security selection among lower credit quality companies should trump momentum-based strategies in higher grade credits. Guided by our constructive view of the U.S. macroeconomic environment, we view CCC bonds and single B bank loans as two sectors poised to outperform the broader leveraged credit market.
• The leveraged credit market enjoyed a prodigious start to the year with the high yield bond and bank loan markets returning 5.0 percent and 3.5 percent, respectively, amid record sector inflows.
• Taking advantage of strong demand for new issue bonds, high yield corporate issuers locked in long term financing at low nominal yields. In the first quarter, issuers raised a record setting $95 billion in new issue proceeds.
• The Credit Suisse High Yield Index ended the quarter yielding 7.23 percent – only 48 basis points above the historical low set in April 2011. On a spread-to-Treasuries basis, however, the Index remains approximately 350 basis points wider than the all-time tights set in May 2007.
• Historically, the performance of lower rated high yield bonds has had the strongest correlation with the overall economy. In line with our bullish view on the continued U.S. economic expansion, we continue to see value in high quality CCC bonds.
• Single B bank loans are trading at attractive valuations relative to similarly rated high yield bonds. We view this as a potential opportunity to improve risk-adjusted performance.
DATA CONFIRMS THAT U.S. ECONOMY HAS ENTERED A SELF-SUSTAINING EXPANSION
Prior to formulating specific views on the high yield and bank loan market, it is essential to understand the global macroeconomic landscape. The U.S. economy has continued to outperform all other major developed economies since the end of the financial crisis in 2009. Currently, we view the expansion as self-sustaining with the rate of growth accelerating modestly.
While we view the U.S. economy as the locomotive of the world at this point, we continue to keep an attentive eye abroad on the expected, prolonged period of restructuring underway in Europe, as well as the slowing growth in China. These slowing global dynamics increasingly highlight the growth of the U.S. economy as a valuable safe-haven for global investors.
At this juncture it is difficult to ignore the preponderance of positive economic data in the United States:
• Since January 2011, the U.S. private sector has added an average of 182,000 jobs each month, far more than the monthly average of 144,000 jobs added during the previous period of expansion following the recession in 2001.
• Economic activity in the manufacturing and non-manufacturing sectors has grown for 32 and 27 consecutive months, respectively, while the overall economy has grown for 34 consecutive months.
• Retail sales, a proxy for consumption, has not experienced a negative month of year-over-year growth since June 2010.
These data points represent just a few of the reasons why we believe the U.S. expansion is self-sustaining and unlikely to be derailed by slowdowns in Europe and China. Our outlook on the macro economy is the initial lens through which we view the world of high yield bonds and bank loans. As we will discuss, our bullish view on the U.S. leads our favorable outlook for lower quality corporate credits that have historically demonstrated the highest correlation to macroeconomic dynamics.
Leveraged Credit First Quarter 2012 Recap
RECORD SECTOR INFLOWS DRIVE RALLY IN HIGH YIELD MARKET
Looking back at the first quarter of 2012, both high yield bonds and bank loans registered robust returns as the Credit Suisse High Yield and Leveraged Loan Index returned 5.0 percent and 3.5 percent, respectively. The return in high yield bonds marked the seventh best quarter since 2004, while the performance of bank loans ranked as the tenth best quarterly return on record.
• During the first quarter of 2012, inflows into high yield mutual funds and exchange-traded funds (ETFs) totaled over $15 billion. Since December 2011, the high yield sector has experienced seventeen consecutive weeks of positive inflows.
• Attractive financing conditions created by strong demand and declining yields, drove a record level of high yield issuance. Through the end of March, $95 billion was raised in the new issue high yield bond market. This marks the highest quarterly level of issuance ever.
• Bank loan mutual funds recorded four consecutive weeks of positive inflows to end the quarter, bringing the cumulative inflow for the first quarter to $288 million.
Relative performance in the first quarter of 2012 reversed the trend of 2011 with the rally being led by lower rated issuers. CCC bonds, the worst performing group in 2011 with a negative 2.1 percent return, were the best performing group in the first quarter of 2012, with a return of 10.4 percent. A similar trend occurred in the bank loan market as CCC bank loans, which fell 5.9 percent in 2011, finished the first quarter up 8.9 percent in 2012. With the first quarter of 2012 in the books, we turn our attention to what lies ahead for the leveraged credit market in the coming quarters.
Leveraged Credit Scorecard
AS OF MONTH END
THREE THEMES TO FOLLOW IN Q2 2012
Guided by our bullish U.S. macroeconomic view, we maintain our risk-on trade operative in the high yield market, but caution that the rally is no longer in its early stages. Taking a moment to fully appreciate just how much the market has rallied over the past three years helps explain why it has become increasingly difficult to identify attractive opportunities. Since December 2008, the high yield market has returned 24 percent on an annualized basis, surpassing the 20 percent average returns, over a comparable number of periods following the 1991 and 2001 recessions. As we begin the second quarter of 2012, we are focused on three central themes that we believe could drive performance:
1. Our expectation of a moderation in new issuance during the second quarter of 2012 should be supportive of spread tightening as inflows continue into the sector.
2. Lower rated bonds, such as CCCs, are historically the most economically sensitive sector of the high yield market, and should outperform based on our bullish view on the U.S. economy.
3. Single B bank loans offer attractive valuation on a risk-adjusted basis relative to similarly rated high yield bonds.
In the next few sections of this report, we will provide the rationale for each of these three themes and show how each has the potential to help sustain the rally in the leveraged credit market.
1. Technical Dynamics Are Supportive of Further Spread Tightening
SECONDARY BOND PRICES ARE POISED TO BENEFIT FROM REDUCED PRIMARY ISSUANCE
We begin our discussion by explaining the technical factors that should be supportive of the broader leveraged credit market before turning our attention to specific areas of the high yield bond and bank loan market where we currently see value. As investment grade corporate credit yields languish around 3.4 percent, near the all-time historical low, we have seen strong demand in the high yield market from retail investors in search of yield. Over 40 percent of the record level high yield bond inflows during the first quarter of 2012 were directed into ETFs.
Historically, there has been a very strong correlation between high yield bond inflows and sector performance. Over the past several months, we have noticed a slight deterioration in this relationship between spread compression and inflows into the sector. While spreads narrowed by 107 basis points during the first quarter of 2012, considering the $15 billion of inflows, we would have expected a far more significant level of spread tightening. This recent breakdown may be attributable to the high level of new issuance. A large percentage of the sector inflows was likely absorbed by the $95 billion in primary issuance, leading to a muted effect on overall spreads relative to past periods. Our analysis suggests that spreads could be approximately 90 basis points tighter based on the level of sector inflows. Given our view that the current pace of issuance is unsustainable, a continuance of positive flows into the sector could lead to further tightening of spreads for high yield bonds.
At the end of 2008, $880 billion of bank loans and high yield bonds were set to mature between 2012 and 2014. This was commonly referred to as the maturity wall. Since then, refinancings have been the use of proceeds for 63 percent of total new high yield bond issuance, which helped flatten the maturity wall to $305 billion by the end of 2011. Considering the manageable level of near term debt maturities and tepid activity in the corporate M&A and private equity LBO markets, we do not anticipate sufficient demand for capital that would warrant a continuance of this elevated pace of issuance throughout the end of year. These refinancings have replaced high coupon, high priced bonds with predominantly par priced bonds and thus reduced the concern that call premiums will serve as impending limits to price appreciation. We believe this dynamic is supportive of high yield bonds appreciating further in price on continued strong demand. We will now identify specific areas of the market where we see value, beginning with high yield bonds.
2. “CCCs Are The Place to Be”
OVERWEIGHT HIGHER BETA CREDITS AMID THE IMPROVING U.S. ECONOMY
After four consecutive months of positive returns in both the high yield bond and bank loan market, focus has shifted to evaluating which sectors continue to offer value. Following recessions, spreads tend to contract as default rates stabilize around 2 percent. While default rates have reverted back to levels consistent with an expansion, spreads have remained elevated, ending the first quarter at 621 basis points. Based on the behavior of spreads following previous recessions, we believe current spreads could continue to narrow an additional 200 basis points. However, with interest rates near historical lows, significant compression in spreads may be constrained by the absolute level of bond yields. On a nominal yield basis, BB bonds appear close to fully priced at 28 basis points above the all-time low, while CCC bonds, currently 220 basis points wide of the all-time low, offer greater potential for further appreciation. As bond spreads tighten, we continually assess the relative trade-off to bank loans. Next, we will identify where this “capital structure arbitrage” trade looks attractive.
The performance of lower rated corporate bonds has historically been more sensitive to economic conditions than higher rated corporate bonds. Since the end of the most recent recession in June 2009, real GDP has risen 6 percent. During the previous ten recessions, dating back to 1949, the average increase in real GDP over a comparable period was 12 percent. With the pace of the current economic expansion lagging far behind the average pace of previous post-recession expansions, it is not surprising that CCC bond performance since the 2009 recession has fared poorly compared to previous experiences. Since the end of the most recent recession, CCC bond prices have risen 33 percent vs. 78 percent in the comparable period following the previous two recessions. Consistent with our positive view of the strengthening U.S. economy, we believe high quality CCC bonds offer high beta exposure to the continuing expansion and will outperform the broader high yield market.
3. Relative Value of Bank Loans vs. High Yield Bonds
MOVING UP THE CAPITAL STRUCTURE TO IMPROVE RISK-ADJUSTED PERFORMANCE
When evaluating relative value in the leveraged credit market, one of the considerations is the yield differential between similarly rated bank loans and high yield bonds. Relative to high yield bonds, bank loans offer seniority in the capital structure, maintenance covenants, and decreased sensitivity to interest rates due to floating rate coupons. As a result of these protections, investors traditionally have accepted less yield. We consistently work to identify arbitrage opportunities within capital structures, which allow us to increase seniority without giving up an excessive amount of yield. Currently, single B bank loans allow investors to move up in the capital structure and gain secured status at a relatively cheap cost. The current yield differential between high yield bonds and bank loans is 34 basis points less than the prerecession average.
In addition to increasing seniority in the capital structure, bank loans also exhibit lower duration and favorable convexity characteristics relative to high yield bonds. Bank loans’ floating rate coupons offer investors protection against rising interest rates. Their decreased sensitivity to interest rates have made bank loans effective inflation hedges and the performance of the sector has tracked very strongly with rising rates. Recently, we saw an uptick in retail interest in the sector coinciding with the backup in interest rates. The bank loan sector ended the first quarter of 2012 with four consecutive weeks of positive inflows into the asset class. Over that same four week period, the 10-year Treasury yield increased by 24 basis points and ended the quarter at 2.21 percent. The 10-year Treasury note ended the quarter closing above 2 percent for four consecutive weeks for the first time since late November 2011. We would caution against investing in bank loans solely as an inflation hedge. As close to 50 percent of the loans in the market contain LIBOR floors of approximately 1.5 percent, a significant increase in short term interest rates is needed before investors begin benefitting. With 3-month LIBOR ending the first quarter of 2012 at 47 basis points, rates would need to rise more than 100 basis points before investors begin accruing additional coupon interest. For long term investors, however, the short duration of bank loans increases their relative attractiveness, assuming interest rates are meaningfully higher in the years ahead.
With the average price of the Credit Suisse Leveraged Loan Index closing at $94.41 to end the first quarter, high quality bank loans trading at a discount to par can offer significantly greater potential for price appreciation if market yields continue to fall compared to high yield bonds trading at or near call prices. As we have just identified, there are still areas of the market where we believe value remains. However, just as it is important to assess the areas that offer value, it is equally important to be mindful of the signs of an overheating market.
WHAT TO WATCH OUT FOR
The surge of “fast” retail money funneled into the high yield bond sector helped lift the market in the first quarter but will likely have attendant implications in the coming quarters. As the investment horizon for retail investors tends to be shorter than that of institutional investors, greater retail flows into the sector may lead to increased volatility. As ETFs and mutual funds generally invest in the most liquid, on-the-run credits, sectors of the market can become overheated very quickly. There are several signs investors should be wary of as indications of an overheating market including:
• Increasingly aggressive high yield bond deals with longer maturities.
• Covenant-lite bank loan structures that afford less downside protection.
• Increased dividend recapitalizations and share buybacks that enrich equity holders at the expense of credit profiles.
In conclusion, the first quarter of 2012 was a memorable period of strong returns in the high yield market. Looking ahead, as we approach this seventh inning stretch, it will become increasingly difficult to find value in the market. Increased security selection and analysis are imperative to drive returns. Prioritizing momentum-based investing over fundamental research may leave investors resigned to clipping coupons as many sectors of the market, like BB high yield bonds, appear close to being fully priced. We continue to see value in high quality CCC bonds and moderate opportunity in single B bonds. On the bank loan side, attractive opportunities to move up the capital structure are generally present in single B loans.
IMPORTANT NOTICES AND DISCLOSURES
Past performance is not indicative of future results. There is neither representation nor warranty as to the current accuracy or, nor liability for, decisions based on such information. This article is distributed for informational purposes only and should not be considered as investment advice, a recommendation of any particular security, strategy or investment product or as an offer of solicitation with respect to the purchase or sale of any investment. This article should not be considered research nor is the article intended to provide a sufficient basis on which to make an investment decision. The article contains opinions of the author but not necessarily those of Guggenheim Partners, LLC its subsidiaries or its affiliates. The author’s opinions are subject to change without notice. Forward looking statements, estimates, and certain information contained herein are based upon proprietary and non-proprietary research and other sources. Information contained herein has been obtained from sources believed to be reliable but is not guaranteed as to accuracy. This article may be provided to certain investors by FINRA licensed broker-dealers affiliated with Guggenheim Partners. Such broker-dealers may have positions in financial instruments mentioned in the article, may have acquired such positions at prices no longer available, and may make recommendations different from or adverse to the interests of the recipient. The value of any financial instruments or markets mentioned in the article can fall as well as rise. Securities mentioned are for illustrative purposes only and are neither a recommendation nor an endorsement. Individuals and institutions outside of the United States are subject to securities and tax regulations within their applicable jurisdictions and should consult with their advisors as appropriate.
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