Spreads on high yield bonds and bank loans continued to tighten in September. Energy-related credits performed well as oil prices remained above $70 a barrel and natural gas hit seven-year highs. Volatility has been concentrated in China, where the highly indebted real estate developer Evergrande caused market flutters, as did a regulatory overhaul by the Chinese government that could lead to greater oversight of gaming companies operating in Macau.
Outside of these areas, investors have seen a steady grind tighter from most segments of the leveraged finance market. Demand for credit remains robust despite investor concerns related to the impact of the Delta Covid variant, the potential for fading quantitative easing (QE) stimulus from the Fed and other central banks, less enthusiastic corporate and GDP growth outlooks, and the potential for higher corporate taxes in the US.
As we look ahead, despite tight valuations, we remain constructive on credit in general and leveraged finance asset classes in particular. While GDP forecasts have declined to about 3%, down from 6.6% in the second quarter, growth remains strong enough to provide a positive fundamental backdrop for the bank loan and high yield markets. Over the next 12 months we expect to see minimal default losses from most sectors.
In terms of relative value, we maintain a slight preference for bank loans vis-à-vis high yield bonds, as the former continue to benefit from a supportive technical backdrop given retail inflows and steady collateralized loan obligation (CLO) demand. Nonetheless, we continue to find attractive opportunities at the issuer level in both markets.
Conviction Score (CS) and Investment Views
The following sections reflect the investment team’s views on the relative attractiveness of the various segments of below-investment-grade corporate credit. Conviction scores are assigned on a scale from 1 to 5, with 1 being the highest conviction.
US Leveraged Loans
Kevin Wolfson
Portfolio Manager,
US Leveraged Loans
CS 2.8 (unchanged)
Fundamentals: Loan issuers reported strong second-quarter earnings, with many companies posting double-digit year-over-year (y/y) gains; some issuers are even seeing improvements relative to 2019 comps. Near-term input cost headwinds remain a concern, but many issuers have been able to mitigate the impact of higher material and labor costs. The semiconductor shortage continues to weigh on certain sectors, including automotive and hardware-focused technology. Leverage ratios and interest coverage for issuers continue to improve, driven by higher EBITDA, relatively low Libor rates, and declining spreads. The last-12-month (LTM) default rate by amount outstanding for the S&P/LSTA Leveraged Loan Index continues to decline, ending August at 0.47%. Expectations are for defaults to remain below 1% over the near to medium term.
Valuations: Spreads tightened over the last month. The spread-to-maturity for the S&P/LSTA Leveraged Loan Index went from Libor+408 as of 17 August to L+399 as of 14 September. CCC rated loans saw the largest movement, tightening roughly 25 basis points (bps) over the same period, while BBs and single-Bs came in 8 bps and 5 bps, respectively. The weighted average bid of the market increased approximately 44 bps month-over-month and now stands at 98.53 as of 14 September. CCC rated and liquid loans saw the largest gains in average price, moving up 69 bps and 51 bps, respectively. Loans appear fairly valued on a risk-adjusted basis at current levels.
Technicals: Demand for loans remains strong on the back of record-breaking CLO issuance in August and the continuation of positive retail fund flows. Despite the strong demand, the market experienced a supply surplus last month, driven by leveraged buyout (LBO)-fueled issuance. Notwithstanding a short reprieve in supply around the US Labor Day holiday, loan issuance has started to reaccelerate, driven by mergers and acquisitions (M&A) and refinancing activity. Similar to recent trends, new-issue supply remains heavily weighted to the single-B rating category. Overall, supply/demand technicals remain fairly in balance.
US High Yield
John Yovanovic, CFA
Head of High Yield
Portfolio Management
CS 3.0 (+0.2)
Fundamentals: Looking through next quarter into 2022, sales and earnings estimates for S&P 500 and high-yield (HY) equities are in the high single-digits, which is more in line with the long-term trend than the volatility seen over the past six quarters. Where 2021 was the year of early-cycle fundamentals versus late-cycle valuations, 2022 is looking to be a year of mid-cycle fundamentals. Bank of America Merrill Lynch models agree with Bloomberg estimates, with improvement in fundamentals expected to slow to more normal levels. With so many defaults in 2020, the 2021 LTM default rate is surprising to the downside at 1.14% (JP Morgan as of 31 August). The still positive, flattening trend should see more differentiation by sector going forward.
Valuations: As rates markets get more confidence in the Fed’s base case, buyers are returning to fixed-rate credit. Rising prices plus minor increases in US Treasury yields are driving Bloomberg US Corporate High Yield Index spreads back to the tight end of their recent range, with option-adjusted spreads (OAS) now at 280 (as of 15 September), near the 270-300 OAS target of our spread model. Spreads are fair near term, and we continue to see merit as the asset class remains attractive relative to the other options. Our spread model continues to suggest 4%-5% annual returns (PineBridge Investments calculations as of 15 September). Carry remains king. BB/B credit continues to be favored, and first-time issuers continue to provide value opportunities.
Technicals: Primary issuance remains heavy and has picked back up as expected. We’ve already seen 36 deals for $17.7 billion priced through 15 September, which puts the market on pace to meet or exceed the September average (JP Morgan Securities). Fund flows have returned at the margin but aren’t dominant. JPM and BAML continue to forecast an increase in net supply that is being accommodated by both retail and institutional flows, leading to continued growth of the universe. The steady new-issue calendar and range-bound spreads lead to neutral technical conditions, with sharp downside moves in specific issuers or volatility events possible.
US CLO Tranches
Laila Kollmorgen, CFA
Portfolio Manager, CLO Tranche
CS 2.6 (unchanged)
Fundamentals: CLO fundamentals, in general, remain good across all metrics. With lower anticipated defaults in the US combined with active management and good credit selection, we anticipate CLO fundamentals to improve.
Valuations: BBBs are at 240-425, BBs at 515-725, and Bs at 700- 1,000. BBB rated CLOs are fair value compared to HY OAS (280) and to BB rated leveraged loans (300). BB rated CLOs are trading wide of single-B HY at 325 and leveraged loans at 425 on an OAS basis. The three-month cross-currency Japan yen/US dollar basis is approximately -8 bps as of 14 September, almost unchanged over the month, with longer-term cross-currency hedges also roughly unchanged. US dollar assets remain attractive when hedged on any term. (Valuations based on Bloomberg and S&P/ LCD data as of 14 September.)
Technicals: Demand remains and continues to support spreads. We had anticipated heavy levels of supply in September and see that continuing in the next few months.
European
Leveraged Loans
Evangeline Lim
Portfolio Manager,
European Leveraged Finance
CS 2.7 (unchanged)
Fundamentals: The euro-area economy recorded another marked expansion in business activity during August, with momentum down slightly from July’s 15-year peak. Jobs growth continued at one of the fastest rates seen in over 20 years. Issuers across most sectors have reported strong improvement in operating results due to a combination of factors, including demand/top-line recovery and efficient cost management.
Valuations: So far, the new-issue spread remains at levels seen in July. Loans continue to look attractive.
Technicals: Despite the anticipation of a robust new-issuance pipeline post-summer, few loan investors were motivated to sell assets in August to raise cash for the new deals. So far, the pace of new issuance has been slower than anticipated. There have been a few BWICs (bids wanted in competition), but they have had very limited to no impact on secondary loan prices.
European High Yield
Evangeline Lim
Portfolio Manager,
European Leveraged Finance
CS 3.0 (+0.2)
Fundamentals: The euro-area economy recorded another marked expansion in business activity during August, with momentum down slightly from July’s 15-year peak. Jobs growth continued at one of the fastest rates seen in over 20 years. Issuers across most sectors have reported strong improvement in operating results due to a combination of factors, including demand/top-line recovery and efficient cost management.
Valuations: Valuations looks fair due to the low default environment, improving fundamental outlook, and an expected continuation of accommodative monetary policy versus the US.
Technicals: Technicals have been supported by the slower-than-anticipated pace of post-summer new issuance. Cash available for deployment appears to have been slightly augmented by trickling inflows.
European CLO Tranches
Laila Kollmorgen, CFA
Portfolio Manager, CLO Tranche
CS 3.0 (+0.4)
Fundamentals: As in the US, European CLO fundamentals remain good month-over-month. Active CLO management combined with good credit selection continue to show up in positive tailwinds for CLO fundamentals.
Valuations: BBBs are at 275-425, BBs at 575-825, and single-Bs at 750-935. BBB rated CLOs are fair value to BB rated HY and leveraged loans, while BB rated CLOs are cheap to European HY and leveraged loan single-Bs. European CLOs benefit from a Euribor floor of zero, which adds about 55 bps to their yield. The current euro/US dollar three-month swap, at about -3 bps, means that while European and US BBB/BB/B CLOs might be similar on a spread basis, the benefit of the Euribor floor highlights the relative value of European CLO tranches. That said, secondary market comparisons are very deal-specific. (Valuations based on Bloomberg and S&P/LCD data as of 14 September.)
Technicals: Similar to the US, primary supply looks to be higher in the next few months. In contrast to the US, the size of the European investor base is smaller, and we could see spreads widening on the back of heavy supply.
Global Emerging
Markets Corporates
Steven Cook
Co-Head of Emerging
Markets Fixed Income
CS 2.5 (unchanged)
Fundamentals: We left our scores unchanged given the positive skew in credit trajectories. Of the 306 companies within our coverage that have reported second-quarter/first-half numbers, nearly three times as many have a positive six-month credit outlook as those with a negative outlook. The main change over the month is the increase in default expectations with the inclusion of Evergrande, whose pending default is the main reason JP Morgan moved its full-year 2021 default expectations from 2.4% to 5.5%. Ex-China, the full-year default rate is expected to be 1.8% (JP Morgan as of 13 September).
Valuations: We maintain our valuations scores, as the spread-to-worst on the CEMBI BD Index has tightened slightly (-9 bps) over the last month to 251 bps but is virtually flat quarter-to-date. HY continues to slightly outperform investment grade (IG), although in China over the last month IG has tightened 25 bps while HY widened by 78 bps. We retain a bullish longer-term score given the spread pickup on offer versus other asset classes. (JP Morgan as of 14 September.)
Technicals: Issuance picked up this month with $21 billion in supply month-to-date (MTD), and year-to-date (YTD) issuance of $402 billion is up 12% y/y. The new issuance this month is being well digested given higher cash levels, which we expect to continue. Of the MTD supply, 75% has been IG (versus 63% YTD), but we expect HY issuance to pick up. We retain our bullish score based on continuing inflows to the sector, including new allocations to the asset class (JP Morgan as of 13 September).