Leveraged Credit Review and Outlook The Tale of the Taper

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1 CIO s Perspective January 214 VOLUME 1 Issue 1 Leveraged Credit Review and Outlook The Tale of the Taper > High yield bonds and leveraged loans were best credit performers in 213 > 213 sees an historic event for high yield bonds > Positive outlook for 214 but watch for late credit cycle behavior David J. Breazzano President, Chief Investment Officer Mr. Breazzano is a co-founder of DDJ and has more than 33 years of experience in high yield, distressed and special situations investing. At DDJ, he oversees all aspects of the firm and chairs both the Senior Management and Investment Review Committees. Stony Brook Office Park 13 Turner Street Building 3, Suite 6 Waltham, MA 2453 Phone Web ddjcap.com

2 213 Review Despite failing to keep up with the torrid pace set in 212, high yield bonds and leveraged loans, which together comprise the leveraged credit market, were the two best-performing asset classes in the global credit markets during 213. Despite a volatile pricing environment, high yield bonds essentially returned their coupon in 213 The BofA Merrill Lynch U.S. High Yield Bond Index ( HYBI ) returned 7.42% and the JP Morgan Leveraged Loan Index returned 5.33% versus -1.46% for high grade bonds, -2.89% for municipal bonds, and -1.32% for emerging market debt. 1 Furthermore, high yield bonds and leveraged loans significantly outperformed all other U.S. fixed income asset classes as Treasury rates backed up during the year, with the 1-year U.S. Treasury increasing 125 bps in yield to 3.3% and returning -7.73%. Figure 1: 212 vs. 213 High Yield Bonds and Leveraged Loans December 31, 212 December 31, 213 High Yield Bonds (HYBI) Total Return YTD Yield (YTW) Spread (OAS) Price Coupon Average Rating B1 B1 Eff. Duration Default Rate (Par) Leveraged Loans (JPM) Total Return YTD Yield (3-year) Spread (3-year) Price Default Rate (Par) Source: BofA Merrill Lynch and JP Morgan While there were many notable occurrences in 213 for the leveraged credit market, in this strategy update we focus on the high yield bond market, which saw an historic, at least judged by the last quarter-century, event. Specifically, high yield bonds nearly returned their coupon for the first time; i.e. returning almost exactly the current yield offered at the beginning of the year. 1 Indices used were Bank of America Merrill Lynch US Corporate Master, Municipal Master, and U.S. Emerging Market Liquid Corporate Plus. DDJ CAPITAL MANAGEMENT 2

3 Price volatility was primarily driven by the U.S. Federal Reserve s Taperspeak To clarify, the current yield, or the coupon of the HYBI as set forth on January 1, 213, divided by the price was 7.49%. While this figure could be off by a few basis points due to rounding (as the coupon figure is calculated using the weighted average of each of the bonds comprising the index), it almost exactly matches the 7.42% total return for 213. If an investor bought the high yield bond market 2 on the first day of 213 and prices had remained constant throughout the year, the total return generated by high yield bonds would be entirely attributed to the coupon income received. Consequently, at a 7.42% total return for the year, the high yield bond market essentially returned its coupon, which is often predicted but rarely realized. 5 Figure 2: Returning the Coupon : Starting Coupon Less Annual Total Return Percent Source: BofA Merrill Lynch More Volatile Than It Looks What makes 213 s high yield market particularly interesting is the dichotomy that it presents. Twenty-five years from now an observer might look back at the high yield bond market s 213 return and, because total return was driven almost entirely by current income, infer that 213 was a year of price stability. However, the tale of the tape, as displayed in the chart below, reveals a much more volatile pricing environment than the index s annual return and coupon might otherwise lead one to infer volatility that was primarily driven by the U.S. Federal Reserve s Open Market Committee s oral guidance on its intentions to continue its policy of quantitative easing. Indeed, 213 saw high yield bond prices drop by 3.2% in June nearly half the full year s return only to recover 1.3% the following month. 2 While it is not possible to buy the market, for the purpose of this example let us assume it can be done. DDJ CAPITAL MANAGEMENT 3

4 Figure 3: BofA Merrill Lynch U.S. High Yield Index: 213 Monthly Price Returns 2 1 Percent Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Sources: BofA Merrill Lynch, J.P. Morgan High Yield Market Monitor: January December 213 In the spring of 213, with the U.S. economy improving tenuously and interest rates engineered to historic lows, capital markets nervously awaited word from the Fed on any tapering of its debt purchases. On May 22, the Fed finally spoke and signaled its intention to begin reducing purchases in September. Unfortunately, the Fed s opinion that the economy and capital markets were ready for a measured disengagement was not shared by most investors, and its announcement was met with significant turmoil, as the 1-year Treasury bond and S&P 5 lost 4.15% and 4.85%, respectively, over the next thirty days. The high yield bond market lost 3.47% over the same period, though bank loans actually weathered the storm reasonably well and lost only 61 basis points. Once the Fed came to its senses and softened its tapering position, markets recovered with vigor. Record Bank Loan and Bond Issuance Companies in the leveraged loan and high yield bond markets took advantage of the favorable borrowing climate and issued new debt securities at a historic pace. All told, 213 saw new issuance of high yield bonds of $379bn and bank loans of nearly $67bn combining for over a trillion dollars. 3 These issuance totals set an annual record for the largest new issuance in history and the combined figure represents a significant proportion about 5% of the roughly $2tn combined bond/loan market. The dramatic pace of new issuance last year gives us some cause for concern and, as we discuss below, highlights the need for careful deal-by-deal research prior to investing. 3 Source: BofA Merrill Lynch for 213 high yield bond issuance and JP Morgan for 213 leveraged loan issuance figures. DDJ CAPITAL MANAGEMENT 4

5 While inflows into retail high yield bond mutual funds slowed somewhat from the record level of $29bn set in 212, bank loans were the beneficiary of historic retail inflows during 213 with $61.7bn of new cash entering leveraged loan mutual funds. 4 Retail investors embraced bank loans dramatically in 213 and almost doubled public participation in the loan market from 11% to 2%. We see heightened interest rate risk, but the cause of rising rates is of paramount importance. While some may be concerned that retail investors interest in leveraged loans may fade when the next hot investment comes along, we are comfortable with retail participation at the 2% level of market capitalization. By contrast, retail participation in the U.S. equity market averages about 25%. 214 Market Outlook The Fed s recent announcement to begin tapering in January 214 was met with a much better reception than its botched attempt last spring. The U.S. economy appears to be on better footing since the May 22nd head fake, and the global financial system appears to be back on the road to normality. These improvements have created a supportive environment for leveraged credit issuers, which have, in general, improved their operations and balance sheets since the 28 financial crisis. Total debt leverage in the market remains well below peak levels and interest coverage ratios remain high. Defaults are well below long-term averages and are expected to stay low in the near-term. Supporting this favorable default outlook is the maturity schedule of the market; currently only 7% of the leveraged credit market ($14bn) matures in the next two years, which presents fewer opportunities for failed re-financings and the ensuing defaults that can result from them. One note of caution is the risk that interest rates will continue to rise, threatening all fixed income investment returns. However, we believe that the underlying cause of the rate rise will be the critical variable that will ultimately determine the reaction of the high yield bond market. Rates typically rise during times of vibrant economic activity as a response to the intensifying forces that drive price inflation. Historically, the high yield market has performed relatively well in rising interest rate environments as economic tailwinds benefit company fundamentals, often resulting in spread tightening that somewhat offsets the effects of the rate increase. In fact, over the past 3 years, corporate spreads have generally moved in the opposite direction of interest rates, yielding a negative spread beta of -.7 during periods when 5-year U.S. Treasuries rise by over 1 basis points in a single year. 5 Looking ahead, if rates rise in concert with an economic uptick, we expect the associated negative effect on high yield bonds total return to be somewhat counteracted by spread compression. Leveraged loans, given their standard, floating-rate coupons, are relatively well-insulated from an increase in short-term rates. Additionally, their senior and oftentimes secured position in a company s capital structure can provide for better protection in adverse credit scenarios. 4 The fact that the S&P 5 returned nearly 3% last year makes retail interest in any form of debt even more remarkable. 5 BofA Merrill Lynch, High Yield Strategy 214 Year Ahead, November 26, 213, page 8. DDJ CAPITAL MANAGEMENT 5

6 Concern, but also a silver lining, from 213 s record debt issuance. Alternatively, a rate rise may not be associated with improving economic activity, as was the case following the Fed s Taperspeak flub in May of last year. During that time, interest rates and corporate spreads were positively correlated (hence positive spread beta), resulting in poor performance of high yield bonds. With Fed purchases at a pace of $65bn per month still ongoing, the potential for continued volatility caused by future on-again, off-again versions of Taperspeak remains high. Two Causes for Concern Two other issues will require close monitoring in 214: one is the increased frequency of lax underwriting standards and the second is the riskier use of issuance proceeds, which are typically seen in the later stages of a credit cycle. The record new issuance in leveraged credit during 213 was driven by consistently high and powerful investor demand. While buying was not entirely indiscriminate, eager investors more frequently accepted looser credit terms than may be appropriate. In fact, 213 saw record new issuance of covenant lite loans, along with a proportionally high amount of second lien loans. Covenant lite and second lien financings lack certain contractual and/or structural protections traditionally embedded in high yield debt instruments, which may lead to larger principal losses in the event of an adverse development, such as a default or financial restructuring. Many of these issues are actively traded in the secondary market, and astute investors should carefully scrutinize terms prior to making a purchase decision. On the other hand, the scope of new bond issuance last year creates the silver lining of pushing a potential default spike out several more years as, typically, bonds and loans do not default for two to three or more years after issuance. As shown in Figure 4 below, however, when default levels do spike, the number and scale of defaults can be dramatic. Figure 4: Easy Credit Availability Leads to an Increase in Defaults $ Number of Bond and Loan Defaults ,4 1,2 1, Number of Deals Number of Bond Deals Number of Loan Deals Total Bond and Loan Defaults Sources: J.P. Morgan, S&P LDC DDJ CAPITAL MANAGEMENT 6

7 Similarly, mature credit cycles are often accompanied by new issuance spikes as companies look to fund what we believe are riskier transactions such as dividend deals and leveraged buyouts. These types of financings typically come with higher debt leverage at the issuer level and an unproven repayment source often based on achieving projected synergies or predicted growth. As a result, both dividend and LBO financings have historically carried both low ratings and a greater frequency of defaults. One measure we are paying close attention to is the proportion of new issuance represented by these types of bonds: while 213 saw only 25% of new dividend and LBO bonds relative to total new issuance, if that ratio approaches the peak level of 53% seen in 27 (as shown in Figure 5 below), we believe that the credit cycle would be nearing an inflection point. Figure 5: High Yield Bond Issuance Totals and Percentage of Issuance by LBO and Dividend Bonds $ bn 2 3 Percent Total High Yield Bond Issuance Acquisition Finance/LBO/Dividend % Sources: BofA Merrill Lynch, J.P. Morgan High Yield Market Monitor: January December 213 Summary Despite the increased risks permeating the market discussed above, we believe that 214 will likely see positive returns for U.S. leveraged credit. With an improving economy and very few potential catalysts for widespread corporate defaults, we think that investors will once again be able to capture most, if not all, of the market s coupon while not suffering significant price degradation from rising interest rates and credit losses. At the same time, given the late credit cycle behavior we have witnessed, we believe that successful investors will need to be highly discerning in their credit selection process in order to find both issuers with resilient corporate cash flow streams as well as debt instruments that are well-positioned to withstand an uptick in rates. This all assumes, of course, that the Fed avoids tripping up the markets again with its tales of tapering. DDJ CAPITAL MANAGEMENT 7

8 JANUARY 214 VOLUME 1 ISSUE 1 Leveraged Credit Review and Outlook The Tale of the Taper ABOUT DDJ CAPITAL MANAGEMENT DDJ Capital Management s goal is to consistently produce superior long-term investment returns, while minimizing downside risk for our investors, which include: > Corporate pension accounts and public retirement plans > Endowments and foundations > Insurance companies > Other institutional clients The underpinning of DDJ disciplined investment philosophy and exhaustive research has remained constant since our founding in Our highly skilled team is steadfast and focused on executing our strategy to identify strong risk-adjusted investment opportunities in the leveraged credit markets. For information on DDJ s investment capabilities, please contact: Jack O Connor Head of Business Development and Client Service joconnor@ddjcap.com Phone Web ddjcap.com