High-Yield and Bank Loan Outlook

High-Yield and Bank Loan Outlook

High Quality High-Yield in a Maturing Bull Market

Certain areas of leveraged credit are overvalued, particularly CCC-rated bonds and bank loans, but often some of the best profits come in the final phase of a cycle. Low yields on U.S. Treasury bonds and European sovereign debt have kept the global search-for-yield theme alive and have lured more capital into U.S. credit markets, helping the ongoing rally in high-yield bonds and bank loans, which gained 2.4 percent and 1.2 percent (as represented by the Credit Suisse High Yield Index and Credit Suisse Institutional Leveraged Loan Index) in the second quarter of 2014, respectively. With valuations frothy, we believe now is the time to start moving up in credit quality. Our analysis finds value in BB-rated and B-rated bonds and we are most positive on BB-rated and B-rated bank loans, where discount margins still trade wide of ex-recession averages.

We remain concerned about weak structures, such as covenant-lite loans, payment-in-kind bonds and second liens — all growing trends amid increased leveraged-buyout activity. These trends are adding risk to an already richly valued high-yield bond market and are evocative of the weak debt underwriting standards that culminated in the 2008 financial crisis. However, a comparison of the current environment to that of 2006 and 2007 shows that while the market is certainly exhibiting signs of frothiness, we are still early in the speculative phase of the current cycle.

Report Highlights

  • CCC-rated corporate bonds and CCC-rated bank loans are the richest groups in leveraged credit and should be avoided. Spreads have some room to run before reaching historically low levels, but now is the time to move up in credit quality.
  • Our outlook remains positive on BB-rated and B-rated bank loans. Their discount margins still trade wide of ex-recession averages and should tighten once the U.S. Federal Reserve begins raising interest rates.
  • We continue to emphasize relative value, deep credit analysis, and proper risk management — particularly as we enter the final stretch of the bull market. The value of these tools is highlighted by manager performance during the previous recession, when the bottom 20 high-yield managers underperformed the Credit Suisse High Yield Index by 10 percent, while the top 20 outperformed the Index by 8 percent, on average.

  

Macroeconomic Overview

Depressed Global Yields Bring Foreign Assets to U.S. Treasuries

While the U.S. Federal Reserve is slowly withdrawing stimulus to U.S. financial markets, low inflation in Europe has prompted the European Central Bank (ECB) to take more action. On June 5, 2014, the ECB announced additional stimulus, which included a negative deposit rate and a targeted Long Term Refinancing Operation intended to direct credit to small- and medium-sized enterprises in Europe and boost economic growth in the region. European sovereign bond yields declined before the ECB’s announcement, attracting foreign investors to higher-yielding U.S. Treasuries. This caused Treasury yields to fall, as demand from foreign yield-seekers added to already existing demand from investors seeking a safe-haven from other events, such as the ongoing conflict in Ukraine and the depreciation of China’s renminbi against the U.S. dollar. The 10-year U.S. Treasury yield dropped to as low as 2.44 percent on May 28, the lowest since June 2013. As the ECB continues fighting low inflation, potentially devaluing the euro, we may see U.S. Treasury yields fall again.

The decline in U.S. Treasury and European sovereign bond yields has kept the search-for-yield theme alive, while duration is becoming a secondary concern and strong demand is pushing U.S. markets further into a realm of overheating. Spreads across several fixed-income asset classes — including certain categories within investment-grade corporate bonds, municipal bonds, and high-yield corporate bonds — have passed their ex-recession averages and are making their way toward their all-time lows. These valuations have prompted increased speculation that we are in a market bubble, but we do not believe valuation is a good signal of market peaks. There are three phases that typically follow an economic downturn, with the final phase still offering rewards to those who can identify the best value:

·         During the first phase, asset prices recover as the market emerges from the worst of the downturn (2009 – 2011).

·         In the second phase, the economy accelerates as fundamentals fall into place (2012 – 2013).

·         In the third and final phase, market speculation begins with a wave of more aggressive activity such as mergers, acquisitions, leveraged buyouts and even borrowing to pay dividends to private equity sponsors.

Now 60 months beyond the end of the last recession, there has been an increase in aggressive activity as we cross into the final “speculative” phase of the cycle. We are still some time away from the U.S. Federal Reserve raising interest rates to curb economic growth, suggesting that this cycle is shaping up to be among the longest in history. Nevertheless, even in a normal time frame, credit spreads have historically not widened until about 80 months following the end of the last recession. If this pattern holds, we have at least 20 months before we see spreads change direction.


Measuring Stages of Overvaluation

Time to Step Up In Quality

 

Leveraged credit markets posted gains for the second quarter of 2014, with the Credit Suisse High-Yield and Institutional Leveraged Loan Indexes gaining 2.4 and 1.2 percent, respectively. June was the 12th consecutive month of positive returns for bank loans, with the sector benefiting from $61 billion of collateralized loan obligation (CLO) issuance year to date — now on track to exceed 2013’s volume and potentially set a new annual record. A robust CLO market has offset the reversal in bank loan mutual fund flows, which turned negative in April after 95 weeks of inflows. Falling mutual fund demand for bank loans was caused by the decline in Treasury yields and was not fundamentally driven, so we believe this temporary shift will reverse when interest rates rise. The decline in interest rates was a positive for high-yield bonds, which have outperformed bank loans by 3.1 percent this year, and June marked the 10th consecutive month of positive returns for the sector.

High-yield corporate bond spreads were relatively flat over the quarter. With spreads stable against declining Treasury yields, the Credit Suisse High Yield Index yield declined to 5.2 percent and sits only 10 basis points above the all-time low set last year. Given low yields, high prices and the tightest spreads post-crisis, the relative overvaluation of high-yield bonds has been in the spotlight, leading some to characterize them as extremely rich.

At Guggenheim, we rank fixed-income assets by stages showing different gradations of overvaluation. We create spread quartiles by measuring the range between each sector’s all-time low and the ex-recession average, with the fourth quartile indicating that spreads are very close to their all-time low. Our quartile analysis is also supplemented by an evaluation of the instances in which a fixed-income sector trades within each quartile in order to identify those at the greatest risk of retracing.


CCC-rated bonds are in the third quartile and are the most overvalued within leveraged credit. We have been warning of eroding safety in the form of high valuation and weaker covenants (Moody’s Investors Service has been tracking covenant strength since 2011 and it fell to its weakest level in February 2014), so we urge investors to become increasingly selective in CCC-rated bonds. Within high-yield corporate bonds, we favor B-rated corporate bonds, which are not as richly valued and are also less interest-rate sensitive than BB-rated bonds.

Applying our quartile analysis to bank loans highlights our more positive stance on the floating-rate sector. BB-rated and B-rated bank loans do not register within our stages of overvaluation because discount margins continue to trade wide of their ex-recession averages. The same cannot be said for CCC-rated bank loans, which like CCC-rated high-yield corporate bonds are among the most overvalued.

Historically, we have seen the largest decline in discount margins when short-term interest rates climb and the yield curve flattens as a result of the Fed beginning to tighten. We believe this pattern will repeat and discount margins will tighten as investors benefit from the floating coupons of bank loans.


Entering the Speculative Phase of the Cycle: Evolving Supply Trends Remind Markets of Pre-Crisis Excess

Rich valuations have room to get richer, but this credit environment evokes memories of pre-crisis excesses. Key trends suggesting that we are in the speculative phase of the current bull market cycle include:

·         Covenant-lite bank loans becoming increasingly standard, accounting for 62 percent of institutional bank loan issuance during the first half of 2014.

·         Refinancing activity has declined this year as a share of new issue activity, representing 41 percent of leveraged credit issuance compared to its 55 percent average between 2009 and 2013. In its place, merger and acquisition (M&A) and leveraged buyout (LBOs) activity has increased to 36 percent, its highest share since 2008.

·         Higher LBO activity has been accompanied by rising new issue leverage multiples of 4.9 times, approaching the 2007 level of 5.3 times. Estimated leverage for the full outstanding high-yield market already exceeds 2007 levels.


Covenant-lite loans have been in a worrisome trend since 2012, when they reached 33 percent of total loan issuance. Now, they are almost double that amount at 62 percent of institutional bank loan issuance during the first half of 2014 and they are edging their way to becoming the standard. Investors are having trouble avoiding covenant-lite loans as they now represent 52 percent of the total bank loan market, according to S&P LCD. The prominence of such loans has sparked controversy and bifurcated investors into those who believe the lack of covenants portend higher default rates and lower recovery rates ahead, and those who do not believe covenants indicate greater credit risk.

Those who say the increase in covenant-lite loans is not indicative of a deterioration of standards point to a Moody’s 2011 study, which reviewed recovery rates of covenant-lite loans and a group of loans that defaulted during the financial crisis. The report found that the covenant-lite group had fewer defaults and a better recovery rate than the broader set of defaulted loans. Lower default rates are not surprising given fewer covenants to trigger defaults in covenant-lite loans, and some argue that covenant-lite loans were reserved for the highest-quality borrowers in the last cycle, which ultimately led to higher recovery rates. For the latter, it is hard to say the same standard applies today, with an overwhelming amount of bank loan issuance being covenant-lite; but careful credit analysis will ultimately trump generalizations about quality.

While there is much debate on the topic of covenant-lite loans, there is broad agreement that shifts in the drivers of issuance indicate rising risks in leveraged credit. After refinancing activity driven by falling interest rates overtook primary markets between 2009 and 2013, activity driven by M&A and LBOs has begun to take its place. As our previous table shows, the share of M&A and LBO driven activity is now 36 percent of issuance year to date, up from 26 percent in 2013. This level is still far from its 62 percent share in 2007, so for now it remains neutral.

The recent flurry of LBO activity has pushed new issue leverage metrics closer to 2007 levels as shown in our table, but for some time borrowers have been trending toward higher leverage. In addition to monitoring leverage, we continue to keep a close watch on interest coverage for new transactions, which remains above 2007-2008 levels. A deeper examination of recent LBO activity also makes us hesitant to draw direct parallels to 2007. In addition to lower volume, recent deals still have higher equity contributions, lower leverage, and higher interest coverage than was the case in 2007. These metrics suggest that LBO deals today are of higher quality than they were seven years ago and do not reflect the excessive exuberance at the peak of the last cycle.

Lessons from the Last Downturn

Credit Selection and Relative Value Matter

 

Credit selection will become increasingly important as it becomes more difficult to identify value in a market that has grown to a record size. We compared the performance of the top 20 and bottom 20 managers during the previous economic downturn to highlight that selecting the right manager can make a significant difference. The top 20 managers and bottom 20 managers, as shown in the chart below, are based on 3-year performance as of December 31, 2009, according to e-Vestment Alliance. During this period, the top 20 managers outperformed the Credit Suisse High Yield Index by 9 percent, on average, while the bottom 20 managers underperformed the Index by 13 percent, on average. Specifically, during the recession between December 2007 and June 2009, the Credit Suisse High Yield Index lost 6 percent, but the top 20 high-yield managers averaged a positive 2 percent return, outperforming the Index by 8 percent, while the bottom 20 managers underperformed the Index by 10 percent, on average. We believe this performance disparity is the result of differences in credit selection, relative value analysis, and risk management.


Extended valuations do not signal the end of the rally, particularly as macroeconomic tailwinds continue to support leveraged credit. The strengthening U.S. economy and declining global yields are mitigating the impact of deteriorating fundamentals, but it remains especially important to be mindful of the balance between risk and return in this environment. Deep credit work and relative-value analysis allows us the potential to capture gains without taking excessive risk as we seek to deliver for our clients.

 Important Notices and Disclosures

INDEX AND OTHER DEFINITIONS
The referenced indices are unmanaged and not available for direct investment. Index performance does not reflect transaction costs, fees or expenses.

Leveraged loans are represented by the Credit Suisse Institutional Leveraged Loan Index, a sub-index of the Credit Suisse Leveraged Loan Index which contains only institutional loan facilities prices above 90, excluding TL and TLa facilities and loans rated CC, C, or in default. It is designed to more closely reflect the investment criteria of institutional investors.

The Credit Suisse Leveraged Loan Index which tracks the investable market of the U.S. dollar denominated leveraged loan market. It consists of issues rated “5B” or lower, meaning that the highest rated issues included in this index are Moody’s/S&P ratings of Baa1/BB+ or Ba1/ BBB+. All loans are funded term loans with a tenor of at least one year and are made by issuers domiciled in developed countries.

High yield bonds are represented by the Credit Suisse High Yield Index, which is designed to mirror the investable universe of the $US-denominated high yield debt market. Investment-grade bonds are represented by the Barclays Corporate Investment Grade Index, which consists of securities that are SEC-registered, taxable and dollar denominated. The index covers the U.S. corporate investment-grade fixed income bond market.

Treasuries are represented by the Barclays U.S. Treasury Index, which includes public obligations of the U.S. Treasury with a remaining maturity of one year or more.

The S&P 500 Index is a capitalization-weighted index of 500 stocks, actively traded in the U.S., designed to measure the performance of the broad economy, representing all major industries.

Spread is the difference in yield to a Treasury bond of comparable maturity.

A basis point (bps) is a unit of measure used to describe the percentage change in the value or rate of an instrument. One basis point is equivalent to 0.01%.

Discount margin to maturity (dmm) is the return earned at maturity that is over and above a specific reference rate associated with some type of floating rate security. Discount margin to maturity assumes three year average life. Spreads and discount margin to maturity figures shown throughout this piece are expressed in basis points.

Yield-to-worst is the lowest potential yield that can be received on a bond without the issuer actually defaulting.

Covenant-lite Loan is a type of loan whereby financing is given with limited restrictions on the debt-service capabilities of the borrower. The issuance of covenant-lite loans means that debt is being issued, both personally and commercially, to borrowers with less restrictions on collateral, payment terms, and level of income.

Payment-in-kind Bonds is a type of bond that pays interest in additional bonds rather than in cash. The bond issuer incurs additional debt to create the new bonds for the interest payments. Payment-in-kind bonds are considered a type of deferred coupon bond since there are no cash interest payments during the bond’s term.

Duration refers to a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. Duration is expressed as a number of years. Rising interest rates mean falling bond prices, while declining interest rates mean rising bond prices.

EBITDA stands for earnings before interest, taxes, depreciation and amortization and is essentially net income with interest, taxes, depreciation, and amortization added back to it, and can be used to analyze and compare profitability between companies and industries because it eliminates the effects of financing and accounting decisions. Past performance is not indicative of future results. There is neither representation nor warranty as to the current accuracy of, nor liability for, decisions based on such information.

Risk Considerations

Fixed-income investments are subject to credit, liquidity, interest rate and, depending on the instrument, counter-party risk. These risks may be increased to the extent fixed-income investments are concentrated in any one issuer, industry, region or country. The market value of fixed-income investments generally will fluctuate with, among other things, the financial condition of the obligors on the underlying debt obligations or, with respect to synthetic securities, of the obligors on or issuers of the reference obligations, general economic conditions, the condition of certain financial markets, political events, developments or trends in any particular industry and changes in prevailing interest rates. Investing in bank loans involves particular risks. Bank loans may become nonperforming or impaired for a variety of reasons. Nonperforming or impaired loans may require substantial workout negotiations or restructuring that may entail, among other things, a substantial reduction in the interest rate and/or a substantial write down of the principal of the loan. In addition, certain bank loans are highly customized and, thus, may not be purchased or sold as easily as publicly-traded securities. Any secondary trading market also may be limited, and there can be no assurance that an adequate degree of liquidity will be maintained. The transferability of certain bank loans may be restricted. Risks associated with bank loans include the fact that prepayments may generally occur at any time without premium or penalty. High-yield debt securities have greater credit and liquidity risk than investment grade obligations. High-yield debt securities are generally unsecured and may be subordinated to certain other obligations of the issuer thereof. The lower rating of high-yield debt securities and below investment grade loans reflects a greater possibility that adverse changes in the financial condition of an issuer or in general economic conditions, or both, may impair the ability of the issuer thereof to make payments of principal or interest. Securities rated below investment grade are commonly referred to as “junk bonds.” Risks of high-yield debt securities may include (among others): (i) limited liquidity and secondary market support, (ii) substantial market place volatility resulting from changes in prevailing interest rates, (iii) the possibility that earnings of the high-yield debt security issuer may be insufficient to meet its debt service, and (iv) the declining creditworthiness and potential for insolvency of the issuer of such high-yield debt securities during periods of rising interest rates and/ or economic downturn. An economic downturn or an increase in interest rates could severely disrupt the market for high-yield debt securities and adversely affect the value of outstanding high-yield debt securities and the ability of the issuers thereof to repay principal and interest. Issuers of high-yield debt securities may be highly leveraged and may not have available to them more traditional methods of financing.

Past performance is not indicative of future results.
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1Guggenheim Partners’ assets under management are as of 03.31.2014 and include consulting services for clients whose assets are valued at approximately $39 billion.

2Guggenheim Investments’ total asset figure is as of 03.31.2014 and includes $12.9 billion of leverage for assets under management and $0.4 billion of leverage for serviced assets. Total assets include assets from Security Investors, LLC, Guggenheim Partners Investment Management, LLC, Guggenheim Funds and its affiliated entities, and some business units including Guggenheim Real Estate, LLC, Guggenheim Aviation, GS GAMMA Advisors, LLC, Guggenheim Partners Europe Limited, Transparent Value Advisors, LLC, and Guggenheim Partners India Management. Values from some funds are based upon prior periods.

Guggenheim Investments represents the following affiliated investment management businesses of Guggenheim Partners, LLC: 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. This material is intended to inform you of services available through Guggenheim Investments’ affiliate businesses.

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