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High Yield and Bank Loan Outlook
INVESTMENT PROFESSIONALS B. SCOTT MINERD Chief Investment Officer ANTHONY D. MINELLA, CFA Co-Head of Corporate Credit MICHAEL P. DAMASO Co-Head of Corporate Credit JEFFREY B. ABRAMS Senior Managing Director, Portfolio Manager KEVIN H. GUNDERSEN, CFA Senior Managing Director, Portfolio Manager KELECHI C. OGBUNAMIRI Senior Associate, Investment Research
First quarter 2013 returns of 2.9 and 2.4 percent in the high yield bond and bank loan market, respectively, represent the weakest performance to begin a year since 2008. Extended valuations and historically low yields have begun to elicit warnings of a bubble in the high yield market. While leveraged credit is far from the bargain it was four years ago, discussions of a bubble are premature at this point. Although we have entered the advanced stages of the rally, historical precedent and the continuation of accommodative monetary policy suggest that spreads, particularly those of lower-rated credits, may tighten materially from current levels. With monetary policy mitigating credit risk in the near term, investor focus has shifted to interest rate risk. During the past quarter, rate-sensitive BB bonds underperformed floating-rate single B bank loans by over 100 basis points, a trend we expect to continue. Given the limited supply of net new bank loans, the robust demand from collateralized loan obligations (CLOs) and loan funds should continue to provide a strong technical bid. In the bond market, we remain focused on identifying select opportunities in upper middle-market tranches, where there is a greater ability to drive outcomes.
REPORT HIGHLIGHTS: • The typical credit cycle, following a recession, lasts approximately 60 months with spreads not beginning to widen until the 80th month. Discussions of a bubble may be early, considering that the current credit rally will just be entering its 46th month post-recession in April 2013. • Concerns of a sudden shift in monetary policy derailing the credit rally appear largely unfounded. The Federal Reserve has given no indication of plans to begin normalizing accommodation or tightening until 2015, at the earliest. Additionally, historical precedent shows that, in four out of the last five credit rallies, spreads continued to tighten even after the Fed began raising rates. • Retail demand for bank loans remains robust as investors seek to minimize interest rate risk. Dating back to last year, loan funds have registered 31 consecutive weeks of positive inflows through March 2013. Year-to-date inflows of approximately $13 billion have already exceeded the total for full year 2012. • The resurgence of the CLO market has contributed to the rise in loan issuance during the first quarter of 2013. Bank loan issuance totaled $150 billion in the first three months of this year, a level not reached until August last year. 64 percent of this year’s issuance has been used for refinancings, resulting in lower spreads and all-in yields.
94% 5.44 99.0% 2.4% 1.14 100.95% 5.80% 4.44% Spread 508 269 361 429 516 844 Mar-13 Yield 5.30 100.21% Spread 519 269 348 432 536 885 Jan-13 Yield 5.92% 4.22 100. PAGE 2 HIGH YIELD AND BANK LOAN OUTLOOK | Q2 2013 .256 Feb-13 Price 97.58% 5.34 100.3% 5.75% 9.1% 2% 0% Index Split BBB BB Split BB B CCC / Split CCC 0% Index Split BBB BB Split BB B CCC / Split CCC SOURCE: CREDIT SUISSE.85 DMM* 522 286 372 459 527 1.2% 2.27% 10.3% 1.48% 4.9% 2% 3.4% 2.48% 5.97 SOURCE: CREDIT SUISSE.4% 2.0% 3.68 100. *DISCOUNT MARGIN TO MATURITY ASSUMES THREE-YEAR AVERAGE LIFE.213 Mar-13 Price 98.03% 6.58 79.09% BANK LOANS Dec-12 DMM* Credit Suisse Leveraged Loan Index Split BBB BB Split BB B CCC / Split CCC 555 296 385 486 584 1.98 82.5% 3.54 100.5% 1.1% 5.80% 3.288 Jan-13 Price 97.5% 2.04% 9.Leveraged Credit Scorecard AS OF MONTH END HIGH YIELD BONDS Dec-12 Spread Credit Suisse High Yield Index Split BBB BB Split BB B CCC / Split CCC 554 302 376 442 566 958 Yield 6.16% 4.99% 3. DATA AS OF 03/31/2013.9% 8% 8% 6% 4% 5. CREDIT SUISSE HIGH YIELD INDEX RETURNS CREDIT SUISSE LEVERAGED LOAN INDEX RETURNS ■ Q1 2012 ■ Q1 2013 12% 10.359 Price 96.90% 4.54 81.50% 4.57 100.5% 3.8% 5.65 100.60 100.2% 1.4% 10% ■ Q1 2012 ■ Q1 2013 12% 10% 8.68 99.0% 3.8% 2. EXCLUDES SPLIT B HIGH YIELD BONDS AND BANK LOANS.86 99.50 100.56% Spread 521 274 358 428 536 880 Feb-13 Yield 5.26 98.40 100.5% 6% 4% 5.72 DMM* 499 279 354 444 514 1.7% 1.39 DMM* 531 290 370 479 536 1.96% 9.25% 4.75 80.0% 3.63 100.95% 3.04% 6.
nearly one out of every five new private sector jobs created has been in the construction sector. Recent rumblings regarding the inevitable normalization of monetary policy have created concern that a sudden policy shift could derail the credit rally. Sep-12 Dec-12 Mar-13 SOURCE: BLOOMBERG. Additionally.“During periods of strong fundamental valuation like we witnessed in 2008 and 2009. U. economic risk has been replaced by growing event and policy risk. While this is a very important distinction. or normalization. housing starts should continue to rise. this should drive increased consumption.000 jobs per month since March 2010. CONSTRUCTION JOB GAINS AS A SHARE OF TOTAL PRIVATE SECTOR JOB GROWTH 25% 20% 15% 10% 5% 3% 4% 0% -1% -5% -10% -15% Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 -14% Jun-12 -4% 3% 1% -2% -3% 15% 8% 5% 6% 3% 2% 3% 17% 14% 14% 9% 7% 9% 15% 19% 19% The rebound in the housing market has led to strong job growth in the U. the bottom line remains that we are still a long ways away from either. Fed tightening has historically been viewed as a positive for the broader economy since it signals the anticipation of sustained growth. Chief Investment Officer Macroeconomic Overview STRENGTH OF HOUSING AND EMPLOYMENT SHIFTS FOCUS FROM FUNDAMENTALS TO POLICY Macroeconomic Factors: Housing and Employment Providing Strong Tailwinds The U. If you purchased a portfolio of high yield assets and one or two securities within it performed badly. More importantly. January and February 2013 marked the best two-month period of new home sales since 2008. but it cannot hurt to figure out where they are. In the private sector. credit spreads continued to tighten after the first Fed rate hike on four occasions.S. the U.S. GUGGENHEIM INVESTMENTS. We have not reached the point where it is time to head for the exits.S. Given the low levels of existing home inventory. expansion is unlikely to be derailed given the strength of housing and employment. construction sector. home appreciation is generally viewed as a more permanent source of wealth.” – Scott Minerd. DATA AS OF 03/31/2013. Over the past four months. is not the same as tightening. providing a boon to construction employment. Turning to housing. the margin of safety is slowly being eroded as good value is being replaced with overvaluation. the strong return on the others would protect you from taking a loss. economy is currently adding an average of 175. The recovery in employment tends to be understated due to the sheer magnitude of the drawdown at the height of the financial crisis and continued softness in the public sector. Housing tends to be the largest asset on the balance sheets of American households and unlike rising stock portfolios. Today.S. Monetary Backdrop: Normalization vs. Tightening refers to the Fed raising interest rates with the intended purpose of restricting economic activity to prevent overheating. Following the previous five periods of extended monetary accommodation. the margin of safety in investing is high. The market is failing to distinguish between normalization and tightening. a rate that is over 20 percent higher than that of the prior expansion. PAGE 3 HIGH YIELD AND BANK LOAN OUTLOOK | Q2 2013 . Tightening As the economy powers along. Removing accommodation. with home values reaching their highest levels since 2007.
Tightening of monetary policy does not necessarily lead to an immediate widening in credit spreads. we describe how investors can position their leveraged credit portfolios in an effort to safeguard against future risks. respectively. skeptics questioned the ‘jobless recovery’. they can remain overvalued for an extended period of time. most notably in housing. but as market confidence grew. PAGE 4 HIGH YIELD AND BANK LOAN OUTLOOK | Q2 2013 . this period would also prove to be the formative years of asset bubbles. DATA AS OF 03/31/2013. HIGH YIELD BOND SPREAD PERFORMANCE FOLLOWING FED TIGHTENING 130 120 110 100 90 80 70 60 Maximum Range Average Since 1986 Minimum Range 0 2 4 6 Months Following the First Fed Rate Hike 8 10 12 Credit Spreads Continued to Tighten for 9 Months on Average SOURCE: CREDIT SUISSE. Investment Implications: Following the 2004 Script Piecing together current market sentiment with the macroeconomic and monetary backdrop. investors need to be alert to a sudden reversal of fortunes in the market. the credit market is not currently exhibiting the traditional characteristics of a bubble. we are not in a bubble yet but the chances of one forming increases the longer the Fed maintains its accommodative policies. These periods are generally referred to as bull markets. of the five instances when the Fed began raising rates following an extended period of monetary accommodation. bond spreads continued to tighten on four occasions. Given that bond spreads are still 200 basis points wide of all-time tights and we are likely to remain in a period of low defaults for the next several years. over the subsequent three-year period.S. THE RANGE IS GENERATED BY CALCULATING THE MAXIMUM AND MINIMUM VALUES FOR ALL FIVE PREVIOUS CYCLES. In the following sections. As we would later find out. It is important to make a clear distinction between an overvalued market and an asset bubble. the economy was entering its third year of expansion following the recession of 2001. present conditions appear very similar to those of 2004. At the time. represents a market reaching unjustifiably high valuations that have never been seen before. BLOOMBERG. U. on the other hand. While overvalued markets have lost much of the fundamental cheapness that provided a cushion against market noise and pullbacks. High Yield Bond Spreads (Normalized Spread = 100 at the First Fed Rate Hike) Since 1986. Back in 2004. An asset bubble.Credit Suisse U.S. GUGGENHEIM INVESTMENTS. risk assets continued their ascent with high yield bonds and equities rising 17 and 28 percent. Amid stretched valuations and lower margins of safety. While we believe the market will follow a similar script over the next three years.
but to a lesser extent. PAGE 5 HIGH YIELD AND BANK LOAN OUTLOOK | Q2 2013 .200 bps 70 800 bps AVERAGE: 88. bank loans returned 2. The dearth of net new supply has compelled many investors to participate in these transactions. their high prices. upper middle-market financings ($300 . For the quarter. *NOTE: PRICE IS INVERTED ON SECONDARY Y-AXIS.000 bps HIGH LOW LAST DMM (LHS) 1. coupled with weak call protection.14 50 1. In a trend that began during the latter half of 2012. the strong performance of the new issue market was one of the primary drivers of the sector’s success. the sector saw $95 billion of refinancings.842 466 499 PRICE * (RHS) 98. ■ DMM (LHS) ■ Price (RHS) 2.14 61.22 AVERAGE: 751 bps 80 400 bps 90 0 bps 2008 2009 2010 2011 2012 2013 100 SOURCE: CREDIT SUISSE. During the first quarter. Over the past three months. Although bank loans offer greater protection and strong relative value compared to the high yield bond market.$750 million). we saw the long beta trade come back into favor as CCC bonds outperformed BB bonds by 375 basis points during the quarter.4 percent.79 98. In select instances. driven by strong institutional and retail demand. which on average. During the quarter. • Reinvestment risk has become a serious concern for bank loan investors due to the wave of refinancings. floating-rate single B bank loans outperformed BB bonds by over 100 basis points. DATA AS OF 03/31/2013.600 bps 60 1. Additionally. interest rate risk has taken precedence. During the quarter. high yield bonds returned 2. resulting in lower spreads and weaker call protection. aggressive new issue bond pricing has begun to minimize investor upside. • The trend of favorable new issue deal terms for issuers has been prevalent on the loan side as well.9 percent. CREDIT SUISSE LEVERAGED LOAN INDEX HISTORICAL SNAPSHOT Institutional and retail demand for bank loans has driven the Credit Suisse Leveraged Loan Index to its highest price since inception. Leveraging our private debt platform. • With monetary policy largely neutralizing credit risk. investors have been able to push back against increasingly aggressive deal structures and pricings. • We continue to see superior relative value in lower-rated. the lowest first quarter return since the end of the financial crisis. representing $16 billion in proposed proceeds. lowered spreads by 90 basis points. limit the potential for meaning ful price appreciation from current levels. 22 deals were pulled. our deep relationships with these issuers have provided greater opportunities to offer guidance on deal structure and pricing levels.Q1 2013 Leveraged Credit Recap: Key Insights RATE RISK BECOMING A LOOMING CONCERN FOR INVESTORS • Last year.
In recent years. compared to inflows into bond funds of approximately $1 billion. As interest rate risk remains at the forefront of investor concerns. however. PAGE 6 HIGH YIELD AND BANK LOAN OUTLOOK | Q2 2013 . H. secured status. in the form of floating-rate coupons. has traditionally come at a considerable yield discount to high yield bonds. eclipsing last year’s total of $55 billion. The burgeoning relative value of bank loans has attracted strong retail flows into the sector. Based on attractive equity valuations and cheap debt financing. this yield discount has narrowed with the Credit Suisse Leveraged Loan Index currently yielding just 45 basis points less than the Credit Suisse High Yield Index. are projected to finish 2013 with full-year issuance of $70 billion. the bank loan market has been the recipient of strong inflows from both institutional and retail investors. however. 64 percent of total issuance went towards refinancing activity. CLOs. The more noteworthy development has been the reemergence of the CLO market. compared to 14 percent for leveraged buyouts (LBOs). we do anticipate LBO activity picking up over the course of the year.J. the loan market enjoyed inflows of $13 billion. this has resulted in limited incremental net new supply and has been easily absorbed by the market. During the first quarter. Due to the high level of refinancing activity. presumably at the expense of high yield bonds. Heinz. represented over half of the total. we would expect bank loans to outperform relative to higher duration BB corporate bonds. represent less than 25 percent of the high yield bond and bank loan market and tend to be less ‘sticky’ than institutional capital. The dearth in diversity and volume of new leveraged loans has forced many investors to accept lower spreads in refinancing transactions. which represent 60 percent of the buying base. Retail investors. Of the $51 billion in LBO volume during the first quarter. compared to the historical average of 160 basis points. Last: -45 bps 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 SOURCE: CREDIT SUISSE.Increasing Attractiveness of Bank Loans DEMAND OUTSTRIPPING SUPPLY CREATES STRONG TECHNICAL DYNAMIC The increased protection of bank loans. a single transaction. to this point. HISTORICAL YIELD DIFFERENTIAL BETWEEN CREDIT SUISSE LEVERAGED LOAN AND HIGH YIELD INDEX 200 bps 100 bps 0 bps -100 bps -200 bps -300 bps -400 bps -500 bps -600 bps 1992 PRE-2008 RECESSION AVERAGE: -160 bps Given the small yield discount of bank loans to high yield bonds. seniority in the capital structure and maintenance covenants. DATA AS OF 03/31/2013. Corporations have capitalized on the strong risk appetite to issue $150 billion in bank loans during the first quarter. it has yet to materially add new supply to the bank loan market.
Strong CLO issuance and inflows into loan funds have created robust demand for bank loans at a time of stagnant supply. Refinancings are removing an average of 90 basis points of spread on each deal. While we believe the leveraged credit sector has more room to the upside. leveraged loan market has increased by less than two percent since the end of 2012. it remains an optimal time to take prudent credit risk. EPFR. The slightest geopolitical provocation may give rise to a correction as investors seek to consolidate gains in the high yield market. Optimal Portfolio Positioning TRANSITIONING FROM OFFENSE TO DEFENSE As the Fed continues to engineer an environment of ample liquidity. we sit in a markedly different place in the credit cycle today than we did in 2008 when assets were so fundamentally cheap that investors operated with a much wider margin of safety. Due to their premium prices and stretched valuations. Extended valuations have made high yield bonds more susceptible to increased volatility. this positive technical is tempered by lower forward return forecasts. resulting in low defaults. nearly double that of the equity markets. while lenders are increasingly being forced to accept call protection of just six months compared to the standard 12 months. the total size of the U. After realizing annualized returns of 11 percent over the past five years. Factoring in loan redemptions and prepayments. The massive imbalance between demand and supply underscores our constructive view on the bank loan market. in the near term. there is one important caveat. While this is generally a positive technical for the sector. DATA AS OF 03/31/2013. LIPPER. it is unlikely that high yield bonds will continue to provide equity-like returns. it has also given rise to a wave of refinancings that has removed spread from the sector. However.S. CHANGE IN OUTSTANDING LOANS AND INFLOW ■ Change in Outstandings ■ CLO Issuance/Prime-fund Inflows $20Bn $15 Bn $10 Bn $5 Bn $0 Bn -$5 Bn -$10 Bn Feb-12 Mar-12 Apr-12 May-12 Jun-12 Jul-12 Aug-12 Sep-12 Oct-12 Nov-12 Dec-12 Jan-13 Feb-13 Mar-13 SOURCE: S&P CAPITAL IQ LCD. Recent market behavior has begun to reflect this sentiment as investors have begun transitioning from offense to defense through PAGE 7 HIGH YIELD AND BANK LOAN OUTLOOK | Q2 2013 .
PAGE 8 HIGH YIELD AND BANK LOAN OUTLOOK | Q2 2013 . TRAILING RETURNS AS OF 03/31/2013.4% 12. bank loans are the investment vehicles best positioned to provide this flexibility. CREDIT SUISSE.7% 10.0% 12. we would advise a more tactical and defensive shift towards bank loans. Based on current valuations.8% 9.5% 8% 6% 4% 2% 0% 2. ANNUALIZED RETURNS FOR 3YR. it is unlikely for bond investors to continue realizing equity-like returns. COMPARATIVE TOTAL RETURNS: STOCKS VS. For investors seeking to participate in the credit rally while remaining protected on the downside.8% YTD 1 Year 3 Year 5 Year 10 Year SOURCE: BLOOMBERG.8% 14. in the event of rising rates and deteriorating credit quality.6% 10% 8.9% 5. ■ S&P 500 ■ Credit Suisse HY Index 16% 14% 12% 10.9% 10. Given where we are in the credit cycle. 5YR AND 10YR.increased allocations to bank loans. upper middle-market bank loans offer comparable yields to BB bonds but provide a much greater degree of comfort. in the near term. Lower rated. HIGH YIELD BONDS Investors allocated to the high yield bond market over the past decade have realized returns exceeding those of equity investors.
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