CIO WM Research 11 August 20 High yield bonds US senior loans update Barry McAlinden, CFA, strategist, UBS FS barry.mcalinden@ubs.com, +1 212 713 3261 Philipp Schöttler, strategist, UBS AG US loans experienced less pressure recently than high yield (HY) bonds, even though they are both issued by speculative grade companies. European leveraged loans have performed better than their US counterparts so far this year. We believe the fundamental backdrop for speculative issuers, both in loans and bonds, will remain solid in the next six months. Although LIBOR floors will prevent US loan coupon rates from adjusting higher right away, we believe loans should still perform well in a rising rate environment, as has been the case historically. LIBOR floors are less prevalent on the European loan market. We still recommend US senior loans as an addition to other fixed income assets for investors with an adequate risk profile who can tolerate phases of illiquidity. For global qualified investors, we currently prefer European loans due to more attractive valuations and our outlook for higher total returns. Return expectations on track US leveraged loans are up 2.4% year-to-date, which is in line with our expectations for coupon-driven returns in the 4% to 5% range for the year. European leveraged loans even achieved total returns of 2.9% so far in 20 - in line with our preference for the region and return expectations of 5% to 6% for the full year. In many respects, loans are one of the few fixed income segments that are performing as we had anticipated without any major surprises. Longer duration segments of the bond market such as Treasuries and investment grade (IG) corporate bonds have benefited from the decline in long-term yields. Loans have underperformed the IG Index as a whole (+6.2% in US and +5.5% in Europe), but they have outperformed the Barclays Corporate 1-5 Year Index (+2%), as the short part of the Treasury yield curve has edged slightly higher, as has cash. Source: UBS database Fig. 1: Performance year-to-date (USD) Total return since 31 December 2013, in % 107 106 105 104 103 102 101 Dec-13 Jan- Feb- Mar- Apr- May- Jun- Jul- Barclays Corp 1-5 yr S&P LSTA Loans US HY Barclays Corp Treasuries Source: Bloomberg, UBS CIO, as of 5 August 20 This report has been prepared by UBS Financial Services Inc. (UBS FS) and UBS AG. Analyst certification and required disclosures begin on page 4.
Loans have not been immune to the market correction that has taken place in the HY bond market, but the extent of the weakness has been less severe. The price of the US S&P LSTA Index dipped by 0.3% from peak to trough, while HY bonds are down 1.5%. This a notable difference as both HY bonds and loans are issued by speculative grade companies that embody similar fundamental trends. We believe loans' resiliency suggests the cause of the recent HY weakness was more technical in nature than fundamentally driven. The US HY index reached a new historic low yield at the end of June and sentiment turned on the asset class as geopolitical events and Fed tightening expectations sparked retail fund outflows. This resembles previous instances when loans temporarily outperformed HY bonds during the "bull market" corrections in 2013, caused by higher interest rates, and during 2011, which stemmed from European and US sovereign credit concerns. Fund demand wavers, but CLOs pick up the slack Retail flows into leveraged loans took a breather in mid-april as the streak of 95 consecutive weeks of inflows came to a close. The magnitude of the fund outflows has been fairly consistent since then, averaging about USD 400m per week, with the exception of the first week of August when almost USD 1.5bn left the asset class on the back of falling market sentiment. This is a more benign pace still compared to the USD 12.5bn of outflows observed in the US HY bond market over the past four weeks. The cause of the loan outflows likely stemmed from a shift in duration preferences as investors became more comfortable with longer duration products, whereas the outflows in HY bonds stemmed from a shift in sentiment. In a year when leverage loan new issue volume in the US is running strong, demand from institutional investors remains solid. Collateralized loan obligations (CLOs) comprise the lion's share of the senior loan ownership structure, with USD 80bn in CLO issuance so far this year. Loan coupons to adjust higher with a time lag LIBOR floors cause the yield level on US loans to be propped up by about bps above where they otherwise would be if the floors didn't exist. The presence of LIBOR floors means that there will be a lag between the point in time when coupon rates adjust higher. With current LIBOR rates at 25bps, LIBOR would have to rise by about 75bps before the floor is breached. According to the LIBOR forward curve, this is not expected to happen until 2016. One concern of some investors is the possibility that loan prices adjust downward to account for this income lag. We do not believe this is likely, as the demand for lower duration investments should offset the fixed duration component that the floors create. LIBOR floors were not prevalent during the past Fed tightening cycle, but we can make some comparisons with floating rate preferreds that did exist in 2004-2006 and performed well even though their yields lagged what was attainable in other higher duration alternatives. Fig. 2: US loan flows influenced by rates Weekly flows left, in USD bn, and 10-yr Treasury yield, right 2,250 1,750 1,250 750 250-250 -750-1,250 Jul- Aug- Sep- Oct- 13 13 13 13 Nov- Dec- Jan- Feb- Mar- Apr- 13 13 weekly loan flows (left, in mn) 10-year Treasury yield (right, in %) May- Jun- Jul- 3.20 3.10 3.00 2.90 2.80 2.70 2.60 2.50 2.40 2.30 Aug- Source: S&P LCD, Lipper, UBS CIO, as of 4 August 20 Fig. 3: CLO issuance is running strong US loan retail fund flows and CLO issuance in bn USD 80 60 40 20 0-20 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 ytd Retail flows CLO issuance Source: JPM, UBS CIO, as of 8 August 20 Fig. 4: Average LIBOR floor near bps US rate, in bps 300 250 200 150 50 0 2010 2011 2012 2013 20 Average LIBOR floor 3mo LIBOR Source: S&P LCD, UBS CIO, as of 31 July 20 Covenant-lite may be more of a structural shift An aggressive trend in the US loan market is observable in the percentage of loans issued as "covenant-lite." The proportion of covlite issuance was historically high at 50% of all loan issuance last year and about 65% so far this year. We believe part of this trend stems from a structural shift in the loan investor base, rather than being purely a cyclical indicator of lax lending standards. Covenants first came about during a time when banks held a greater portion of loans than they do today. While covenant-lite loans often lack maintenance covenants, most of them do contain protection from additional debt incurrence, which is similar to the types of covenants found in HY bonds. For these reasons, we don't view the change CIO WM Research 11 August 20 2
in covenant trends as an indicator of an overheated market, but a trend that stems from the changing nature of the loan market. Historically, the risk of default of cov-lite loans has actually been lower than for loans with full covenant protection. So, an increase of cov-lite loans does not necessarily translate into higher credit risks for the overall loan market. Still recommend loans - preferring Europe We recommend US senior loans, offering a yield of 4.6% currently, as an addition to other fixed income assets. For global qualified investors, we particularly prefer European loans because they offer higher yields of currently 5.4% and greater potential for higher prices, trading around EUR 95 currently. As a consequence, our total return expectations are higher for European leveraged loans (5% to 6% for 20). Given the speculative-grade nature of loan issuers and low secondary-market liquidity, we recommend that senior loans be considered by qualified investors with an adequate risk profile who can tolerate phases of illiquidity. Fig. 5: Performance during rising rate periods since 1996 Total return, in % 20% 15% 10% 5% 0% -5% 16% 16% 13% interest rates fall 6% -3% -1% 9% interest rates rise Treasuries Investment grade corporate bonds High yield corporate bonds Senior loans Source: Bloomberg, UBS CIO, as of 31 July 20. Note: average annualized returns; the interest rate regime refers to the change of the 10-year Treasury yield 8% CIO WM Research 11 August 20 3
Appendix CIO WMR Corporate Bond Ratings Definitions Rating Definition Given our view of credit risk and valuation, we believe the bonds of these issuers may offer higher total return over the holding period relative to the bonds of other similarly-rated issuers. This performance may be driven by the bond s coupon income and potential for credit spread tightening. We regard Attractive securities on the Attractive List as appropriate for investors with a moderate to high tolerance for credit risk due to the possibility of somewhat greater credit spread volatility relative to other investment grade corporate bonds. Investors should review the issuer-specific comments in light of their risk tolerance profile and in the context of their overall portfolio. Issuers we deem to be Core Holdings offer relatively liquid bond curves and comparatively stable credit profiles. We generally expect bonds of these issuers to perform in line with their benchmarks as spreads Core are unlikely to tighten or widen more materially than peers. We regard securities on the Core List as most appropriate for fixed income investors with a low-to-moderate credit risk tolerance and a holdto-maturity strategy. We deem bonds to be Unattractive for fundamental reasons based either on an anticipated deterioration in an issuer s credit profile or valuation reasons based on the bond s rich credit spread level. In the case of fundamentals, bond valuations may be cheap but we have concerns that credit fundamentals may deteriorate, causing spreads to widen further. In the case of valuation, we believe Unattractive that spread levels do not adequately compensate investors for the credit risk inherent in the bonds. In this case, we believe credit spreads are rich and have potential to widen. The rationale for placing bonds on the Unattractive List will be detailed in the issuer-specific comments, in coordination with the issuer s credit quality indicator. CIO WMR Credit Quality Indicator Definitions Rating Definition The issuer demonstrates credit metrics that are in line or better than peers. We believe bonds are likely High to exhibit average to below-average credit spread volatility. The issuer demonstrates credit metrics that are in line to slightly weaker than peers. We believe bonds Medium have potential to exhibit above-average credit spread volatility. These securities should therefore only be held in diversified portfolios of risk tolerant investors. The issuer demonstrates credit metrics that are weaker than peers. We believe above-average credit Low spread volatility is likely to occur. These securities should therefore only be held in diversified portfolios of the most risk tolerant investors. Statement of Risk Bond market returns are difficult to forecast because of fluctuations in the economy, investor psychology, geopolitical conditions and other important variables. Corporate bonds are subject to a number of risks, including credit risk, interest rate risk, liquidity risk, and event risk. Though historical default rates are low on investment grade corporate bonds, perceived adverse changes in the credit quality of an issuer may negatively affect the market value of securities. As interest rates rise, the value of a fixed coupon security will likely decline. Bonds are subject to market value fluctuations, given changes in the level of risk-free interest rates. Not all bonds can be sold quickly or easily on the open market. Prospective investors should consult their tax advisors concerning the federal, state, local, and non-u.s. tax consequences of owning any securities referenced in this report. Analyst certification Each research analyst primarily responsible for the content of this research report, in whole or in part, certifies that with respect to each security or issuer that the analyst covered in this report: (1) all of the views expressed accurately reflect his or her personal views about those securities or issuers; and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by that research analyst in the research report. CIO WM Research 11 August 20 4
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