December’s market movements were head-spinning. At the start of the month, spreads on high yield bonds and bank loans rallied sharply as concerns about the severity of the omicron Covid variant receded. Strength continued, and by the middle of week two, spreads had retraced a majority of November’s widening with strong demand for high yield from retail investors and for collateralized loan obligations (CLOs) for bank loans. From there, spread-tightening slowed as November core Consumer Price Index (CPI) inflation reached a 30-year high, Fed Chair Jerome Powell and committee members struck a relatively hawkish tone on monetary tightening, and omicron cases jumped in the UK and New York City, along with a spike in delta-variant cases.
Despite this uncertainty, we expect the downside risks related to omicron to fade in early 2022 and for its economic impact to be limited and temporary. Beyond that, investors will look to balance the many current positives – strong corporate earnings, positive rating changes, and very low default rates – against the negatives of tighter monetary conditions, still-high inflation driven by supply chain constraints, and geopolitical tensions in Europe and Asia.
Given this backdrop and the current valuations of various leveraged finance asset classes, we are finding attractive opportunities at the issuer level in high yield and leveraged loan markets. At the index level, we view aggregate valuations as fair given historically tight spreads but also a benign default backdrop and the potential for upward rating migrations. Within CLO debt, we view mezzanine tranches as inexpensive given the quality of underlying loans held in select CLO collateral pools. Globally, we view European high yield as relatively attractive vis-à-vis the US given current spread differentials and an attractive cross-currency basis for hedged US dollar-based investors. Finally, despite China’s property sector woes, we believe emerging market debt continues to offer attractive opportunities and that investors may benefit from a selective approach as quality names get caught up in negative headlines.
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
US Leveraged Loans
CS 2.8 (unchanged)
Fundamentals: With third-quarter reporting now complete, most loan issuers have exhibited solid year-over-year gains in their top and bottom lines. Growth should slow heading into 2022 given challenging comparable figures, pressured supply chains, and inflation concerns as input and labor costs rise. Corporate liquidity remains adequate, absent significant economic or structural catalysts driving greater reorganization activity, and we expect defaults to remain at historically low levels.
Valuations: Although spreads have tightened over the last couple of weeks, they still are wide compared to where they stood before omicron concerns emerged. From 17 November to 14 December, the spread-to-maturity of the S&P/LSTA Leveraged Loan Index widened seven basis points (bps) and now stands at roughly L+405. During the same period, the weighted average bid of the market declined 23 bps to 98.41. CCC rated loans have widened 33 bps, while BBs and single-Bs have widened 5 bps and 8 bps, respectively. Spreads appear near fair value, remaining relatively attractive on a risk-adjusted basis versus other risk asset classes. (Valuations based on S&P/LCD data as of 14 December.)
Technicals: Recent volatility associated with the omicron variant has begun to subside, and the market remains relatively in balance. On both the supply and demand side, new loan issuance and CLO formation began to slow heading into year-end. We expect activity to return in the new year, but 2022 should be slower overall relative to the record-breaking 2021.
US High Yield
John Yovanovic, CFA
Head of High Yield
CS 2.6 (-0.4)
Fundamentals: Fundamentals are largely unchanged from last month, remaining solid but facing stiffer comparisons as we shift into a mid-cycle recovery. The default rate remains very low, at 0.83% (JP Morgan as of 30 November). We expect default rates to remain around 1% into 2022. Rising labor and input costs continue to be noted by management teams, but companies generally are getting price increases to compensate, in some cases with incremental margin.
Valuations: Omicron-related volatility caused Bloomberg US Corporate High Yield Bond Index spreads to move out to 340 bps at the end of November before rapidly retreating to the 300-310 range (Bloomberg as of 16 December). We continue to believe that fair-value option-adjusted spreads (OAS) are in the 270-300 bps range due to positive fundamentals and our 1% default rate forecast. Our spread model continues to suggest annual returns of 4% to 5%. Carry remains king. BB and B credits remain favored, and first-time issuers continue to provide value opportunities.
Technicals: Primary issuance set a record of over $515 billion in 2021. Volatility led to four-week rolling outflows of $1.5 billion, reversing inflows of November and leading to year-to-date (YTD) outflows of $16.5 billion. Given our view of marginally higher interest rates and less accommodative central banks, we expect relatively neutral retail flows and lower but positive institutional inflows in 2022. (Technicals based on JP Morgan Securities data as of 10 December.)
US CLO Tranches
Laila Kollmorgen, CFA
Portfolio Manager, CLO Tranche
CS 2.6 (-0.4)
Fundamentals: Tail-risk metrics for loans in the CLO portfolio have continued to improve through 2021 and are currently at record lows, with the share of loans under $80 currently below 2%, indicating that default rates (currently at 0.2%) will remain low in the near term. The S&P 12-month trailing speculative-grade default rate was 2.0% in October, down from 6.6% in January. (Fundamentals based on S&P Global Research as of 14 December.)
Valuations: BBBs are at 236 to 425, BBs at 585 to 770, and single-Bs at 750 to 1,000. BBB rated CLOs are fair value compared to the OAS of 304 on high yield (HY) and 300 on BB rated leveraged loans. BB rated CLOs are trading wide of single-B HY at 337 and leveraged loans (415) on an OAS basis. The three-month cross-currency Japan yen/US dollar basis is approximately -24 bps as of 14 December 2021, roughly unchanged over the month. (Valuations based on Bloomberg and S&P/LCD data as of 14 December.)
Technicals: CLO supply is slowing into year-end, which is supportive of spreads into the end of 2021 and the beginning of 2022. We do not anticipate any issues with regard to the Libor-SOFR transition.
European Leveraged Finance
CS 2.7 (unchanged)
Fundamentals: Purchasing managers’ index (PMI) data showed growth reaccelerating in November, reflecting resilience in the service sector which masked the drag of supply-related constraints and price pressure in the manufacturing sector. But the vibrancy is likely to be short-lived. In the near term, omicron will inevitably slow the pace of recovery as social restrictions are implemented or tightened across Europe. A severe disruption of the recovery, however, seems less likely for now. Omicron also is likely to widen growth-rate differences among European economies, reflecting the variance in vaccination rates and reliance on manufacturing. We do not expect omicron to cause a spike in defaults.
Valuations: Loans look attractive in the current environment, where there is persistent noise from rates.
Technicals: The primary issuance market has shut down earlier than usual after an intensely busy year; through November, YTD volume surpassed full-year volumes for 2019 and 2020 combined. There continues to be healthy demand from newly issued CLOs and CLO warehouses. Absent a wave of risk sell-off in the first weeks of January, we expect technicals to be strong and to potentially drive the resurgence of repricing activity.
European High Yield
European Leveraged Finance
CS 3.0 (unchanged)
Fundamentals: PMI data showed growth reaccelerating in November, reflecting resilience in the service sector which masked the drag of supply-related constraints and price pressure in the manufacturing sector. But the vibrancy is likely to be short-lived. In the near term, omicron will inevitably slow the pace of recovery as social restrictions are implemented or tightened across Europe. A severe disruption of the recovery, however, seems less likely for now. Omicron also is likely to widen growth-rate differences among European economies, reflecting the variance in vaccination rates and reliance on manufacturing. We do not expect omicron to cause a spike in defaults.
Valuations: While current valuations appear attractive due to improving fundamentals and low default-rate expectations, they are being somewhat offset by an expected rise in volatility in 2022. The impact of the expected retreat of the quantitative easing program and healthy new-issue supply is likely to more than offset the impact of rising stars leaving the index.
Technicals: Considering the outflow in the first week of December, technicals held up reasonably well, suggesting the availability of cash amid a slowdown in new-issue supply. Demand for bonds with a high coupon or low cash price appear supported by demand from CLO rampers and credit opportunity funds.
European CLO Tranches
Laila Kollmorgen, CFA
Portfolio Manager, CLO Tranche
CS 2.6 (-0.4)
Fundamentals: European CLO fundamentals remain healthy and the default outlook remains low.
Valuations: BBBs are at 295 to 400, BBs at 550 to 670, and single-Bs at 690 to 900. BBB rated CLOs are cheap to BB rated HY at 250 and leveraged loans, while BB CLOs (at 328) are cheap to European HY and leveraged loan single-Bs. European CLOs benefit from a Euribor floor of zero, which adds about 60 bps to their yield. The current euro/US dollar three-month swap, at about -14 bps, means that European CLO tranches remain attractive vis-à-vis US CLOs. (Valuations based on Bloomberg and S&P/LCD data as of 14 December.)
Technicals: We expect spreads to be well supported into year-end. Supply should pick up in January, reinforcing the technical backdrop that we’ve observed throughout 2021.
Co-Head of Emerging
Markets Fixed Income
CS 2.5 (unchanged)
Fundamentals: From JP Morgan’s tracking of 250 companies that have reported third-quarter results, revenues increased 21% YTD, EBITDA was up 32%, capex up 9%, gross debt was up 2%, and net debt was down 2%. Gross leverage declined to 2.7x from 3.6x at year-end 2020 and net leverage to 1.5x from 3.1x. Investment grade last-12-month net leverage stands at 1.2x (versus 1.6x at year-end 2020) and HY at 2.3x (versus 3.3x). Expectations are for a slight improvement in the fourth quarter and similar leverage levels next year. (Fundamentals based on JP Morgan data as of 13 December.)
Valuations: The CEMBI BD spread-to-worst widened 16 bps on the month to 280 bps, with HY (wider by 24 bps) underperforming IG (wider by 7 bps). Through mid-month, HY retraced half of the widening seen in November, with most countries tightening except Turkey and China, driven by defaults in the property sector. We retain our bullish scores given that the market is currently mispricing the default risk on our coverage in Asia and because sovereign-driven moves elsewhere are creating value opportunities given the strong corporate fundamentals and outlook. (Valuations data from JP Morgan as of 15 December.)
Technicals: YTD issuance has reached $529 billion gross and $70 billion net. Gross issuance in 2022 is expected to be similar, but net issuance is expected to be virtually flat at $3 billion, compared to net issuance of $60 billion-$90 billion annually over the last three years. The only region expected to have positive net issuance is the Middle East, at $34 billion. We maintain our scores given muted supply expectations, fund flows that have been relatively unaffected, and continuing new allocations to the asset class. (Technicals based on JP Morgan data as of 13 December.)
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.