Improving U.S. macroeconomic conditions should spur additional investor demand for high-yield bonds and bank loans, particularly with defaults exceptionally low. Still, investors should monitor trends pointing to an erosion of safety in leveraged credit.
High-yield bonds and banks loans enjoyed a fifth consecutive year of positive returns in 2013 with annual returns of 7.5 percent and 6.1 percent, respectively. In 2014, the strengthening U.S. economy and a growing need to keep within duration targets should be the most prominent themes driving high-yield demand. However, investors should temper return expectations in high-yield bonds to single digit levels largely sourced from coupons and cushioned by low spread duration.
Given record low yields, aggressive capital market activity and record demand in bank loans, we sense an erosion of safety beneath the surface. The prominence of covenant-lite loans, the gradual uptick in payment-in-kind (PIK) toggle notes and the acceleration of corporate bond rating downgrades are concerning. Much as an eroding dam can remain standing until tested by floodwaters, leveraged credit may be undergoing similar degradation but will not ultimately be tested until the rising tide of defaults appears, which we believe to be years away. Careful credit analysis is of upmost importance in these markets, but we see little immediate risk of a meaningful downturn that would test leveraged credit.
- Covenant-lite loans represented 57 percent of total bank loan issuance in 2013 and now represent nearly half of the bank loan market. Investors should closely monitor trends indicating diminishing investor protections.
- The consequences of weaker covenants lie beyond the horizon, as the U.S. Federal Reserve continues to inject liquidity into the bond market. The expectation of short-term rates at the zero-bound over the next 18 months to 2 years further reduces the risk of a meaningful economic downturn.
- The low spread durations carried by high-yield bonds – currently averaging 3.9 years – indicate that price declines should be limited in the midst of additional spread volatility.
- While return expectations should be tempered to single digit levels, investors may outperform indexes by opportunistically buying on market weakness, particularly if macroeconomic conditions remain unchanged.
Leveraged Credit Scorecard as of Month End
Source: Credit Suisse. Excludes split B high yield bonds and bank loans.
*Discount margin to maturity assumes three-year average life.
Source: Credit Suisse. Data as of December 31, 2013.
“Although investors today have a much shorter fuse, the end of the Fed’s program of quantitative easing is not the same as raising rates. The policy change was based on the belief that the U.S. economy’s expansion is sustainable and that the labor market is improving amid muted inflationary pressures. The Fed’s statement after its two-day meeting was exceptionally dovish.”
- Scott Minerd, Global CIO
Clearer Roadmap to Rising Rates
Last year wound down with a series of stronger-than-expected economic data releases. ISM manufacturing data (historically indicative of expansion or contraction) rose to its highest level in over two years, U.S. auto sales were strong in November, new home sales surged, and the job market strengthened. Citing improved labor market conditions and a sustainable economic expansion, the Fed announced in December that it would reduce its monthly bond purchases by $10 billion, to $75 billion, starting in January. Yet, at the same time, the Fed lengthened the time frame before which it will raise rates by promising to keep the Fed funds target rate at 0-0.25 percent at least as long as the unemployment rate remains above 6.5 percent and perhaps “well after” this target is reached. For the first time, the Fed also added a lower-bound target for inflation of 2 percent – lengthening the expected time frame before rates rise.
Reducing the monthly value of the Fed’s program of quantitative easing may have short-term implications for fixed-income markets, but we remain constructive given that the Fed’s forward guidance suggests that short-term rates will be kept zero-bound for another couple of years. Since 1971, it has taken about nine months from the Fed’s first rate hike during a period of tightening monetary policy for credit spreads to widen materially, and 28 months for the United States to enter a recessionary period – not precluding short-term setbacks. The risk that the Fed will unexpectedly tighten monetary policy in 2014 is minimal, in our opinion.
Source: Credit Suisse, Guggenheim Investments. Data as of December 15, 2013.
As the U.S. economy slowly strengthens, we may return to an environment where taking credit risk is not just a consequence of staying within duration targets or reaching for yield, but rather a proactive choice driven by a positive outlook on the economy. To sustain optimism, the Fed will need to monitor the unintended consequences of tapering and avoid negative economic repercussions, as happened in the summer of 2013 when a spike in 10-year Treasury yields dampened pending home sales. For markets, the Fed must convince investors that the economy is strong enough to withstand steady reductions of its asset purchases. These will likely be Janet Yellen’s top priorities as she takes over the helm of the Federal Reserve.
2013 Leveraged Credit Recap
A Year of New Records
High-yield bonds and bank loans posted their fifth consecutive year of positive returns in 2013, with the Credit Suisse High Yield and Leveraged Loan Index posting gains of 7.5 percent and 6.1 percent, respectively. High-yield bonds compressed to 436 basis points by year-end, their tightest post-financial crisis level. Though spreads remain above historical lows, the same cannot be said for yields, which set a new record low of 5.1 percent in May 2013. A number of factors contributed to a good year for leveraged credit, albeit one marked by volatility.
Bank loan funds have recorded 77 consecutive weeks of positive flows, with inflowing assets amassing to $65 billion over this time. Strong loan demand also stemmed from robust issuance in collateralized loan obligations (CLO) which recorded its third highest U.S. volume of $87 billion. High-yield bond demand was more volatile than bank loans, evidenced by $11 billion withdrawn from high-yield bond funds in June as Treasury-rate volatility spread into the fixed-rate sector. Between May and September, high-yield bonds declined by 1.86 percent and spreads widened by 40 basis points. Following the Fed’s decision not to taper QE in September, high-yield bonds posted four consecutive months of positive returns and spreads tightened by 60 basis points to close the year at their tightest post-financial crisis level.
Source: Credit Suisse. Data as of October 2013.
Despite fund flow volatility, gross issuance in high-yield bonds totaled $340 billion, the second best issuance ever, trailing $347 billion gross issuance in 2012. Institutional bank loans set a new record with $578 billion of gross issuance, outpacing the previous record in 2007 by 26 percent. Refinancing represented 42 percent of primary market activity in 2013 and limited net supply, which was a positive for prices and spreads as investors were forced into secondary markets.
Gradual Weakening of the Dam
Safety Erosion in an Issuer-Friendly Market
A prevalent theme in new issue activity has been a gradual weakening of investor protections, noted by the dramatic increase in covenant-lite loan issuance and an uptick in payment-in-kind (PIK) toggle notes. Loans have traditionally been regarded as safer than high-yield bonds due to their higher position on the capital structure and their stronger covenants – a form of investor protection which demands prudent borrower decisions. Affirmative covenants dictate actions the issuer must take, negative covenants forbid the issuer from taking certain action, and maintenance covenants outline financial ratios the issuer must maintain. A broken covenant triggers a “technical default” and allows lenders to take certain actions or may increase the cost of debt to the borrower, depending on the covenant that is breached.
Covenants have weakened recently as evidenced by fewer maintenance requirements and provisions allowing for future issuance of more senior debt, diluting the senior secured position of a loan. Covenant-lite loan issuance represented 57 percent of total bank loan issuance, more than three times the average of 23 percent between 2009 and 2012. Covenant-lite loans now represent 46 percent of all bank loans, or $320 billion.
Source: Standard & Poors LCD. Data as of December 31, 2013.
In the high-yield bond market, PIK toggle issuance is a sign of safety erosion, as they allow the borrower to pay interest either in cash or in kind by delivering additional bonds to the investor. PIK toggle notes may offer more attractive yields north of 7 percent, but investors are moving down in quality as they are also deeply subordinated. PIK toggle notes had a brief eight-month hiatus between July 2011 and February 2012 before returning with $6.7 billion raised in 2012 and $12 billion raised in 2013. Their re-emergence has not reached a level that is overly worrisome; they have been marked by lower leverage, shorter maturities with one-year call protections, and several deals include leverage and coverage tests that limit in-kind payments. Accounting for less than 5 percent of bond supply, PIK toggle notes are much less troublesome than the covenant-lite trend, but a trend to monitor in bonds nonetheless.
Source: Standard & Poors LCD. Data as of December 31, 2013.
In the secondary market, tracking rating upgrades and downgrades may offer some insight into credit conditions. When the market experiences greater downgrades than upgrades, it is referred to as negative ratings drift. Historically, corporate bond ratings drift lower prior to maturity, on average, with about 5 percent more downgrades than upgrades on a monthly basis. Following a period of elevated defaults in 2009, where the weakest borrowers were flushed out of the market, corporate bonds entered a two-year period of positive ratings drift between July 2010 and May 2012. It has remained above the historical average trend since then. However, as leverage stealthily ticks up, new borrowers enter the market, and covenants disappear, downgrades have accelerated relative to upgrades, thus pushing the drift further toward its long-term average.
Source: Moody’s, Credit Suisse, Guggenheim investments. Data as of December 1, 2013.
Regulators are aware of weakening lending standards. In September, the Federal Reserve, the FDIC, and the OCC published their annual Shared National Credit (SNC) Review providing a high level assessment of a pool of large syndicated loans held by U.S. banks, foreign banks, and nonbanks, such as securitization pools, hedge funds, insurance companies, and pension funds. The report noted weaknesses in underwriting practices based on leverage, a lack of financial covenants, and loose repayment terms in recently originated debt. The agencies also revised guidelines for leveraged lending, the first such update since 2001. Increased attention from regulators may ultimately put pressure on banks to limit credit extension to the riskiest borrowers.
Leveraged Credit Outlook
Risks Mitigated in the Near-Term
Increased regulatory involvement in leveraged lending activity may make it harder for borrowers to access capital markets against upcoming maturities. Now, however, the maturity wall has largely been pushed beyond 2016. As a result of the high levels of refinancing activity over the past five years, less than 5 percent of high-yield bonds and bank loans are expected to come due over the next two years.
The issuance of bonds and loans with weaker investor protections would be worrisome in an environment where default rates were rising, however, at 2.1 percent for high-yield bonds and 2.2 percent for bank loans, default rates remain below their historical averages of 4.9 percent and 3.4 percent, respectively. Echoing the overarching theme from our last quarterly report, we believe that taking credit risk continues to be supported by low borrowing costs, an improvement in coverage ratios to 4.2x EBITDA from their crisis low of 3.2x EBITDA, and the lack of upcoming maturities eliminating the urgency to extend or replace debt. Given these factors, we do not see a near-term catalyst for defaults to rise.
Source: Credit Suisse. Data as of December 1, 2013.
The current default environment suggests that credit spreads should continue to tighten, based on historical precedent. We characterize periods of exceptionally low default rates based on a six-month moving average of trailing default-rates less than 3.5 percent. These periods have generally lasted for 20 months, with spreads tightening to 386 basis points toward the end of the period, on average. Following an uptick in defaults in the second half of 2012, we re-entered an exceptionally low-default period in 2013 and are now 10-months beyond the starting point, while defaults have declined for six consecutive months.
Source: Moody’s, Credit Suisse, Guggenheim investments. Data as of December 1, 2013.
Building from Fourth Quarter Momentum
On a relative basis, we continue to find compelling value in bank loans. A comparison of current spreads relative to historical averages gives reason for our proclivity to remain overweight bank loans in this environment. Excluding recessionary periods, bank loan spreads continue to trade 63 basis points wider than their historical average, excluding recessions. While monitoring the deteriorating credit quality in leveraged credit, investors should bear in mind that bank loans present an opportunity to move up the capital structure. Historically, bank loans have also exhibited lower defaults and higher recovery rates, mitigating default-risk.
At post-crisis spreads tights of 436 basis points and yields of 5.8 percent, investors may be considering reducing high-yield bond allocations. However, valuation alone is not a sell signal. Prices, spreads, and yields must be monitored in conjunction with market sentiment, technical factors, and the macroeconomic backdrop for signs of overheating and exhaustion. We believe several indicators point to a risk-on mentality that will benefit high-yield bonds over the near-term.
Equity markets, which may serve as a barometer for a risk-on market, recorded the best annual performance in a decade last year, closing out a year which saw a 32.4 percent annual return with a fourth quarter gain of 9.5 percent. Over the past 85 years, nearly 70 percent of positive fourth quarter performances have been followed by a positive first quarter performance, and 93 percent of strong fourth quarter performances with greater than 9 percent returns have been followed by positive first quarter returns. Adding to the positive sentiment, key risks have dissipated and the policy roadmap is easier to read – we know who the next Fed Chairman will be, monetary policy uncertainty has been largely removed by increased forward guidance, there are no expectations of a government shutdown in 2014, and the uncertain fiscal drag of sequester has been replaced by expectations of lower spending and higher tax revenues. A positive first quarter for U.S. equities should bode well for high-yield bonds, since S&P 500 Index quarterly returns have been 70 percent correlated with Credit Suisse High-Yield Bond Index returns over the past 15 years.
While the correlation between equity markets and high-yield bond performance points to upside potential, the downside is mitigated by low spread duration and high coupons. Spread duration is a measure of a bond’s price performance given a 100 basis point change in its spread. With spread durations currently averaging 3.9 years in high-yield bonds, a 100 basis point spread widening would cause a 3.9 percent price decline, on average. Low spread durations in high-yield bonds should largely limit price volatility against the potential for spread widening. Comparatively, spread durations average 6.6 years for investment grade bonds, making high-yield bond prices less risky assuming comparable declines in spreads.
Given average high-yield bond coupons, prices would need to decline by greater than 7.4 percent for returns to fall into negative territory. With the exception of 2008, the last time prices declined by at least 7 percent was in 2002. Investors may expect single-digit returns in 2014 sourced primarily from coupons. However, this cushion may not exist in the future, as coupons have declined to their lowest level in over a decade, allowing other factors such as spread widening and rising interest-rates to become the largest drivers of total performance.
Source: Credit Suisse. Data as of December 15, 2013.
For 2014, investors should bear in mind that the Fed will continue injecting liquidity into financial markets even as it tapers its asset purchases. Assuming that the Fed continues the same pace of reductions at each Federal Open Market Committee meeting, it would still purchase more than $500 billion of bonds in 2014 – nearly the size of the Fed’s QE2 from November 2010 to June 2011. This should help support credit spreads. An accelerated pace of tapering from the Fed would signal faster-than-expected economic growth and spark higher demand for risk assets. On balance, we expect the impact of tapering to be neutral. Barring economic weakness, we expect relatively benign market conditions with no major spike in volatility. Against this backdrop, investors should build positions at more attractive valuations by opportunistically buying on dips around FOMC meetings, especially if high-yield bond or bank loan prices decline below par.
IMPORTANT NOTICES AND DISCLOSURES
Past performance is not indicative of future results. There is neither representation nor warranty as to the current accuracy or, nor liability for, decisions based on such information. This article is distributed for informational purposes only and should not be considered as investment advice, a recommendation of any particular security, strategy or investment product or as an offer of solicitation with respect to the purchase or sale of any investment. This article should not be considered research nor is the article intended to provide a sufficient basis on which to make an investment decision. The article contains opinions of the author but not necessarily those of Guggenheim Partners, LLC its subsidiaries or its affiliates. The author’s opinions are subject to change without notice. Forward looking statements, estimates, and certain information contained herein are based upon proprietary and non-proprietary research and other sources. Information contained herein has been obtained from sources believed to be reliable but is not guaranteed as to accuracy. The value of any financial instruments or markets mentioned in the article can fall as well as rise. Securities mentioned are for illustrative purposes only and are neither a recommendation nor an endorsement. Individuals and institutions outside of the United States are subject to securities and tax regulations within their applicable jurisdictions and should consult with their advisors as appropriate.
Guggenheim Investments represents the following affiliated investment management businesses of Guggenheim Partners, LLC (“GP”): GS GAMMA Advisors, LLC, Guggenheim Aviation, Guggenheim Funds Distributors, LLC, Guggenheim Funds Investment Advisors, LLC, Guggenheim Partners Investment Management, LLC, Guggenheim Partners Europe Limited, Guggenheim Partners India Management, Guggenheim Real Estate, LLC, Security Investors, LLC and Transparent Value Advisors, LLC. Guggenheim Partners Investment Management, LLC (GPIM) is a registered investment adviser and serves as the adviser to the Core Fixed Income Strategy. GPIM is included in the GIPS compliant firm, Guggenheim Investments Asset Management, and is also a part of Guggenheim Investments. This material is intended to inform you of services available through Guggenheim Investments’ affiliate businesses. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Guggenheim Partners, LLC. © 2014, Guggenheim Partners, LLC.
© Guggenheim Partners