Performance of leveraged finance asset classes was mixed in July. High yield bonds were able to generate positive total returns as the benefit of lower Treasury rates more than offset the impact of wider spreads. Bank loan total return performance was more or less flat; the weighted-average bid price was slightly lower, on average. Both markets were marked by a brief period of volatility and spread-widening midmonth as investors grew concerned that an acceleration in delta variant cases could darken the economic growth outlook. And in both markets, lower quality CCC-rated issuers generally underperformed.
Recent volatility has improved the risk-reward profile in both markets, in part due to a pullback in issuance that has had the technical impact of limiting supply. Assuming subsequent infection waves become progressively smaller, resulting in lower peak hospitalizations and fatalities, we expect to see less significant impact on economic activity. And while we expect both markets will benefit from the twin pillars of accommodative monetary and fiscal policies, we maintain a slight preference for bank loan and CLO debt markets as we believe they stand to benefit from attractive relative valuations and a potential increase in demand for floating-rate asset classes as the Fed becomes more active.
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: Thus far, loan issuers have reported strong year-over-year (y/y) gains in their second-quarter earnings, driven by the reopening trade and a weak 2020 comparison. The market continues to expect economic growth to continue in the second half, although certain sectors, such as travel and leisure, have seen a slight pullback as concerns over the Delta variant have grown. That said, default rates remain below historical averages and ratings upgrades continue to outpace downgrades. The last-12-month (LTM) default rate for the period ended June 2021 by total amount outstanding was 1.25% (S&P/LSTA as of 30 June). Month-to-date (MTD) through 20 July, there were no defaults within the index. If July remains default-free, that will lead to an LTM default rate of roughly 0.58%, or the lowest LTM default rate by amount in more than nine years, due to roughly $8 billion of defaults rolling off.
Valuations: Valuations look marginally more attractive as spreads have widened slightly on fears related to Covid variants. The spread-to-maturity (STM) for the S&P/LSTA Leveraged Loan Index widened four basis points (bps) from 15 June to 20 July, with CCC-rated loans seeing the largest move, widening 28 bps. BBs and Bs have widened five bps and three bps, respectively, during this same time period. The Leveraged Loan 100 Index has widened 18 bps with the recent increase in market volatility. Spreads remain wide to 2018 levels, however yields remain low given current Libor.
Technicals: New-issue supply remains strong with issuance shifting toward M&A activity. LBO volume during the second quarter was at the highest level since the global financial crisis and the growing forward calendar indicates further acquisition and LBO activity in the pipeline. Despite the robust supply, demand for loans remains equally strong. New CLO formation set a record in the second quarter and notwithstanding a slower start to July relative to June, the pipeline for CLO transactions remains robust. Retail fund flows remain positive and the market is on track for its eighth consecutive month of inflows.
US High Yield
John Yovanovic, CFA
Head of High Yield
Portfolio Management
CS 2.8 (unchanged)
Fundamentals: Entering the earnings season, fundamentals remain positive. Delta variant concerns started to weigh on investors’ minds and we await comments during earnings reports. Covid flareups remain a risk, but one that still seems manageable due to vaccine efficacy in developed markets. Commodity prices have retraced a bit as supply and demand come into sync, but demand remains at healthy levels for producers.
Valuations: Continued declines in Treasury yields have kept demand for credit relatively strong. The recent equity drawdown caused option-adjusted spreads (OAS) to bounce off the 270 area and move back to the 300 area (PineBridge calculations as of 22 July). Spreads are fair near term, though the view on 2021 is that total returns will be positive on an absolute basis and still attractive relative to the other options. BBs have materially outperformed MTD with the curve move leading us to see BBs and Bs as equally attractive while CCCs are less favored. Credit dispersion among issuers remains small relative to history, and valuation remains rangebound near all-time tights.
Technicals: Tight dispersion of valuations leads to a steady bid in the market subject to volatile idiosyncratic price declines. Primary issuance continues at a steady pace with 2021 already at $333 billion, similar to annual levels from 2015 through 2019 (JP Morgan Securities, as of 16 July). JPM sees 76 new issues in high yield (HY), which is tracking toward a record of market debuts. While we’ve seen a steady stream of mutual fund outflows during 2021, BAML attempted a study of who owns HY to broaden the scope of flows beyond mutual funds. Unsurprisingly, it saw pension funds and insurance companies as large and steady buyers of the asset class. To summarize, there is a persistent bid, but at wider levels, leading to a neutral score.
US CLO Tranches
Laila Kollmorgen, CFA
Portfolio Manager, CLO Tranche
CS 2.4 (-0.6)
Fundamentals: CLO fundamentals continue to improve across all metrics. With lower anticipated defaults in the US, combined with active management and good credit selection, we expect this to continue.
Valuations: BBBs at 240 to 425, BBs at 540 to 750, and Bs at 700 to 1,050. BBB CLOs are cheap compared to BB-rated HY (305) and to BB-rated leveraged loans (300). BB-rated CLOs are trading wide of single-B HY (335) and leveraged loans (435) on an OAS basis. The three-month cross currency Japan yen/US dollar basis is approximately -10.5 bps as of 20 July, four bps more expensive over the month, with longer-term cross currency hedges also modestly more expensive over the month. US dollar assets remain attractive when hedged on any term. (Valuations based on Bloomberg and S&P/LCD data as of 20 July.)
Technicals: Demand remains good despite heavy new issue and refi/reset volumes with spreads softening over the last couple of months. Supply weighed on spreads over the course of July mainly due to lower levels of liquidity resulting from summer holidays. That said, spreads remained range bound.
European
Leveraged Loans
Evangeline Lim
Portfolio Manager,
European Leveraged Finance
CS 2.7 (unchanged)
Fundamentals: The resurgence of Covid and the resulting tightening of restrictions does not appear to have made any material dent in business and consumer sentiment. The eurozone private sector reportedly expanded at its fastest rate in 15 years during June, with growth coming from manufacturing and services. Supply chain constraints and labor shortages continue to be the recurring theme. So far, most businesses appear confident in their ability to pass along input price increases.
Valuations: Loans appear attractive now. Competition for investor attention in this busy primary issuance market has contributed to widening of new-issue spreads. Loans continue to look attractive, especially as the default rate is expected to remain at historic lows for the foreseeable future.
Technicals: The secondary loan market has held up surprisingly well despite the relentless pace of new issuance. At present there is a stronger investor preference for wider spreads than better credit quality. Due to the number of new issues in the market, new-issue spreads have widened slightly. Certain loans that were issued in late first quarter or early second quarter are now at or slightly below their new-issue price.
European High Yield
Evangeline Lim
Portfolio Manager,
European Leveraged Finance
CS 2.8 (unchanged)
Fundamentals: The resurgence of Covid and the resulting tightening of restrictions does not appear to have made any material dent in business and consumer sentiment. The eurozone private sector reportedly expanded at its fastest rate in 15 years during June, with growth coming from manufacturing and services. Supply chain constraints and labor shortages continue to be the recurring theme. So far, most businesses appear confident in their ability to pass along input price increases.
Valuations: The low default environment and improving fundamental outlook continues to be the main justification for staying in European HY.
Technicals: The pricing environment in the secondary bond market remained stable amid very strong first-half new-issue volume. The European HY market continues to enjoy support from traditional investment-grade (IG) investors seeking yield in high-quality BB-rated bonds.
European CLO Tranches
Laila Kollmorgen, CFA
Portfolio Manager, CLO Tranche
CS 2.4 (-0.6)
Fundamentals: European CLO fundamentals improved month over month. Similar to the US, active CLO management, combined with good credit selection, continue to provide positive tailwinds for CLO fundamentals.
Valuations: BBBs are at 220 to 425, BBs at 515 to 750, and Bs at 720 to 910. BBB CLOs are cheap 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 minus four bps means that, while European and US BBB, BB, and B CLOs are roughly the same on a spread basis, the benefit of the Euribor floor highlights the relative value of European CLO tranches. That said, the difference is very deal-specific when making comparisons in the secondary market. (Valuation data based on Bloomberg and S&P/ LCD data as of 20 July.)
Technicals: Similar to the US, there is strong demand for AAA and AA-rated tranches, particularly from entities such as banks and insurance companies that fund in Euribor. We already are seeing lower issuance levels as market participants recognize that people will be away on summer holidays. We anticipate spreads to remain range bound as a result of lighter issuance in August.
Global Emerging
Markets Corporates
Steven Cook
Co-Head of Emerging
Markets Fixed Income
CS 2.5 (-0.1)
Fundamentals: We see no change in our positive outlook as corporates across EM continue to show conservative balance sheets and recovering profitability. In terms of net leverage levels, HY is expected to outperform IG given regional and sector components, declining by -0.9X to 1.9X (the lowest level since 2011). We expect IG to decline by -0.5X to 1.2X, bringing the overall level to 1.4X, all driven by already visible increases in EBITDA across key sectors (JP Morgan as of 6 July).
Valuations: We view IG short-term valuations as slightly more attractive on the back of EM corporate spreads holding up well despite the move lower in US Treasuries. EM corporates outperformed US credit on this basis and are showing lower sensitivity to rates. Other factors, including a perceived recovery in China and strong liquidity, continue to lift global credit. This brings our IG score in-sync with our HY score. We also retain our bullish long-term score given the spread pick up on offer versus other asset classes.
Technicals: We held our score level as primary markets moderated in July after a strong June, which took second-quarter supply to $161 billion, close to the record $164 billion in the first quarter. Asia continued to dominate, with 61% of issuance (versus 57% YTD). China accounted for 39% of the total, albeit at more muted levels. We note the increased issuance in ESG/sustainable bonds to 8% of total issuance YTD (up from 4% in 2020). Net supply turned positive in June at $39 billion as the near-record gross supply was met by scheduled cashflows of $30 billion and elevated tenders/buybacks/calls of $8 billion, bringing the total YTD net supply number to $87 billion. The expected net issuance of $105 billion this year should be easily digested given it represents under 4% of the universe. (Technicals data from JP Morgan as of 6 July.)
About This Report
Leveraged Finance Asset Allocation Insights is a monthly publication that brings together cross-sector views within our leveraged finance fixed income group. Our global team of investment professionals convenes in a live forum to evaluate, debate, and establish top-down guidance for the asset classes that make up the leveraged finance investment universe. Using our independent analysis and research, organized by our fundamentals, valuations, and technicals framework, we take the pulse of each segment of the leveraged finance market.