Over the past two weeks financial markets have begun to re-price a higher probability of a recession as slowing global growth, increasing trade concerns and signals from the inverting yield curve have all created more uncertainty on future fundamentals. Despite the recent pullback, solid corporate fundamentals and attractive valuations at the beginning of the year have helped drive US high yield market returns +9.56% year-to-date (as measured by the ICE BofAML US High Yield Constrained Index, HUC0). Corporate earnings and cash flows have moderated from peak levels, but corporate balance sheets are sound as improved cash flow and modest spending plans have kept leverage moderate. Solid fundamentals, along with defaults well below long term averages, have provided a good back drop for impressive investment performance.
Technical strength in the high yield market is as important as solid fundamentals in the short term. Continued Central Bank global easing has driven rates down around the world, to a greater degree abroad than in the US. Currently over 20% of the global aggregate bond index is now negative yielding. This has created strong demand for positive yielding US assets in general, and specifically the relatively higher yielding US high yield bonds. Demand for high yield has far outpaced supply, creating a supply shortfall of over $150 billion since the beginning of 2017, providing a level of support for bond prices. And in 2019, the market has experienced over $15 billion of mutual fund inflows through the end of July, following negative net flows each of the last two years and five of the last six. Anecdotally, we have seen modest increases in institutional investors’ high yield exposure as well.
Bonds Paid Down or Refinanced as Other Financial Instruments
Fund and client flows on technicals are minor, however, when compared to the impact from the natural demand from high yield investors needing to replace calls, tenders and maturities within their portfolios. Gross new issuances, while running ahead of last year’s significantly depressed levels, remain well below normal. In 2018, new issuances of $187 billion trailed total calls, tenders and maturities by over $43 billion. Many high yield companies have been deleveraging their balance sheets and thus reducing total outstanding debt. When they do refinance their bonds, they have done so increasingly with other investment instruments, primarily leveraged loans. For example, high yield issuer Clear Channel Outdoor recently issued $334 million of equity, $1,260 million of secured bonds, and a $2 billion term loan for proceeds to refinance over $3.4 billion of bonds, reducing the company’s outstanding bonds by $2.2 billion.
In addition, the use of proceeds from new issuances has been increasingly for refinancing purposes, with approximately two-thirds of new issues, and less so for merger & acquisition or leveraged buyout finance, which are sources of new supply for the high yield market. A significant portion of the M&A/LBO marketplace has moved to loan-only financing as attractive, less restrictive covenants, or so-called “cov-lite” loans, have been offered and found more compelling than bonds to issuers.
Rising Stars with Few Falling Angels
Finally, in 2019 to-date, rising stars, bonds upgraded from high yield to investment grade, have significantly outpaced fallen angels, or bonds downgraded from investment grade to high yield, with over $38 billion upgraded versus less than $5 billion in fallen angels through the end of July. Company behavior continues to be disciplined, with deleveraging of balance sheets as opposed to an increase in leverage that typically occurs in the late innings of a credit cycle.
What Could Change?
So what could change to weaken market technicals? Although many sell-side strategists forecast continued moderate issuance for the balance of 2019, an acceleration could happen if M&A activity picks up dramatically. In addition, fund flows are volatile and could reverse rather rapidly to net outflows as they have the first few days of August. Finally, in the event of an economic downturn, fallen angels may be sizable as 50% of the investment grade market, or nearly $3 trillion, is rated just above high yield at BBB. However, while some are facing secular stress to their business that will be exacerbated by cyclical pressures and are likely subject to downgrades, a “tidal wave” of fallen angels is not expected at the end of the cycle. A quarter of BBB rated bonds are rated BBB-, and only about 12% of the BBB- subset have negative outlooks with at least one of the three major rating agencies. In general, despite the rise in BBBs as a percentage of corporate investment grade bonds, fundamentals remain reasonable with companies generating significant cash flow with which they could use to deleverage if necessary to maintain an investment grade rating.
While the strength of technicals has been persistent and provided some support for the high yield market, technicals alone are not enough to support strong returns. Strong technicals, in conjunction with solid market fundamentals and reasonable valuations relative to current default levels and other asset classes, make high yield an attractive investment option.
Leveraged loans offer investors a stable return profile relative to high yield bonds given loans lack of interest rate duration and senior secured status. Recent technical weakness has improved our view of valuations in the loan market. Given the spate of negative press surrounding the loan market, it is worth revisiting the relative importance of structural elements vs fundamental and technical drivers of value from an investor’s perspective.
Loans Are a Frequent Target for the Financial Press
Much has been made of the weakening of leveraged loan covenants. Covenant-lite, representing now 80% of the market, is frequently cited as exhibit A for the all-but-certain leveraged loan Armageddon. While loan covenant quality overall is weak, there are signs that investors are regaining bargaining power. Moody’s most recent North American Loan Covenant Quality Indicator (July 25, 2019) is subtitled, “As market pivots into bonds, loan covenants achieve best score since 2016.” We will forgive you if you missed the headline (there wasn’t one).
The rise of covenant-lite in leveraged loans is a red herring representing nothing more than the institutionalization of the market. No longer are broadly syndicated leveraged loans the “bank loans” they once were, although they are sometimes still referred to as such. The institutionalization of the loan market means a more diverse lender base comprised of specialist investors including credit funds, hedge funds, mutual funds, and CLOs. It isn’t surprising to us that covenants have fallen out of favor, as the holders of loans have shifted to institutional investors who often don’t have the company’s best interest at heart.
Don’t get us wrong. This lack of financial maintenance covenants may well enhance a stressed borrower’s ability to avoid default for longer than credit investors might like, or even perhaps allow them to avoid default altogether presuming the business environment improves. However, we take a much more in depth view of credit quality than the full covenant/cov-lite distinction. We are keenly aware of other investor protections including allowances for restricted payments, permitted investments, asset sales, and allowances for the creation and utilization of unrestricted subsidiaries of the borrower. These provisions can create real risk that must be managed. As first-lien creditors, we focus on the borrower’s flexibility to dilute our senior position in the capital structure by either issuing additional pari pasu debt, or stripping assets from the collateral that secures our claim.
Despite maintenance covenants making up only a portion of overall credit quality in the loan market, negative pieces highlighting covenant weakness have commonly been used to imply the end is near for loan investors. The implication in many published pieces is that loans will be at the center of the next downturn and their returns will be in line with their weakness in the financial crisis.
For example, Bloomberg published ‘A Leveraged Loan Collapses and Reveals Key Risk in Credit Market’ in mid-July. The article looks at a single (!) issuer where the loan price collapsed after a company with an out of date business model disclosed that it had lost its 2 major customers. Despite the risk being idiosyncratic in this case, the article goes on to highlight all the usual data points. “Indeed, Clover’s deal, like many these days, was known as “covenant-lite.’’… That meant that investors were left with little leverage over the company.” The article ignores the fact that covenants wouldn’t be able to save investors in any debt security from a weak business model and the loss of major customers. Instead of highlighting the importance of covenants for loans, the Clover example only serves to emphasize the importance of fundamentals being the most important driver of returns in leveraged credit.
Valuations and Technicals Should Support Loans, Especially Relative to High Yield
Technical weakness for most of 2019 has kept prices depressed in loans relative to their fundamentals and relative to high yield bonds. Rarely do we see a 10% return year in high yield where returns on loans lag by almost 400 bps. Falling rates, expected and realized Fed rate cuts, and the perceived structural weaknesses discussed above have all led to significant mutual fund outflows and contributed to loans relative weakness YTD. Stretching back to 2018, loan mutual funds have experienced 10 straight months of outflows, and YTD outflows from funds through 7/31 (-$22.6B) are double the combined inflows from 2017-2018. Loan mutual funds now represent only about 10% of the market.
Despite the technical weaknesses concentrated in mutual funds, we think the fundamentals, technicals, and relative value of the loan market offer an attractive risk/return opportunity. Looking forward regarding technicals, we believe that further mutual fund outflows would be well digested by the market. The CLO market remains an important driver of both primary and secondary loan demand. While net CLO creation has slowed in recent weeks, the market is only 8.6% behind 2018’s record rate of issuance, with almost $75B of new CLO structures being priced YTD. We see continued CLO activity both in pricing new deals and secondary market trading of the underlying facilities as being positive for loans moving forward.
Fundamentals have shown positive trends across the loan market, which, combined with current valuation levels, should benefit CLOs and loan investors generally. In addition, we see less leverage (relative to pre-financial crisis years) being employed by other loan market participants with mark-to-market risk, which decreases overall systemic risk in the market.
The senior secured, floating rate nature of the leveraged loan market means Sharpe ratios typically are superior compared to other corporate debt asset classes. Despite the degradation in loan covenants quality over the past several years, overall covenant quality as measured by Moody’s remains better in the loan market compared to high yield bonds. In addition, the first lien nature of leveraged loans means lower loss in the event of default when compared to high yield (Moody’s long term average recovery rates are 68.8% in loans and 43.9% in high yield). Better covenants and recoveries combine to keep volatility relatively low, especially in risk-off markets. Even if recoveries are lower in loans moving forward, we believe current valuations in the loan market fairly compensate investors for the risk. Finally, the loan market is also not exposed to interest rate duration in the same way that bonds are, further reducing their relative volatility.
With technicals driving weakness in loans YTD, we think an attractive opportunity exists in the asset class. Focusing on fundamentals and technicals instead of covenants and idiosyncratic risks reveals a reasonable level of compensation being offered to investors for the fundamental risks. We also think the run of mutual fund outflows should slow and that CLO activity will be the more important source of demand in the loan market moving forward. Taken together, the fundamentals, technicals, and valuations paint the picture of the second half of 2019 and 2020 being a reasonable time to maintain a loan allocation as part of a diversified fixed income portfolio.