High-Yield And Bank Loan Outlook – Summer Headwinds In Leveraged Credit by Guggenheim Partners
Risk assets rallied in the latter half of the first quarter of 2016, led by a dovish pivot in Federal Reserve communication that helped spur a rally in crude oil and a reversal of recent dollar strength. This in turn snapped two consecutive quarterly losses in high-yield corporate bonds and bank loans. The primary driver of wider spreads in the high-yield market persists, however, as the oil market is still characterized by a significant supply-demand imbalance. Near-term risks include further weakness in oil, the impact of a potential Fed hike over the summer, and the meaningful wave of downgrades that lie ahead in oil and basic materials.
Nevertheless, our fundamental outlook for leveraged credit remains constructive. Spreads exceeded 900 basis points in February 2016, levels that are consistent with implied six-month forward default rates in the 9–10 percent range. We believe this default risk is overestimated in the current environment. While spreads have since narrowed, we are still finding bargains in high-yield bonds and bank loans, but we remain mindful of the potential for another bout of market volatility.
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High-Yield & Bank Loan – Report Highlights
- The Credit Suisse High-Yield Bond and Leveraged Loan indexes posted gains of 3.1 percent and 1.3 percent in Q1 2016, respectively, following a rebound across risk assets that began in the middle of the quarter.
- Technical headwinds remain. In high-yield, a slew of downgrades may oversupply the market and push spreads higher. Bank loans may see some pressure given their positive correlation with high-yield bonds.
- Fundamentally, both markets are performing well. Bank loan borrowers, in particular, may benefit from the Federal Reserve’s decision to delay raising interest rates, keeping borrowing costs at historically low levels.
- As 10-year U.S. Treasury yields decline further, loss-adjusted yields in high-yield bonds and bank loans look especially attractive, even when stressed for the level of credit losses experienced during the financial crisis.
Macroeconomic Overview – The Gravitational Pull of Global Rates
This year opened with what we called The Great Recession Scare of 2016. Forecasts for U.S. and global economic growth were downgraded, and recession fears surged along with market volatility, but we continue to believe that near-term recession odds are low. Estimates for first quarter gross domestic product (GDP) in the U.S. have been marked down, with the Federal Reserve Bank of Atlanta’s GDPNow model tracking estimate for Q1 GDP growth at 0.4 percent annualized as of April 5. While disappointing, weakness in the first quarter is also not surprising: Q1 GDP has undershot full-year growth rates in six out of the last seven years. Over that period, the growth rate of real GDP in Q1 has been 1.9 percentage points lower, on average, than full-year growth.
Quarterly GDP numbers are also subject to numerous revisions. In addition to the advanced quarterly GDP estimates undergoing two rounds of revisions in the months following the initial release, the Bureau of Economic Analysis (BEA) also conducts annual benchmark revisions of the National Income and Product Accounts (NIPA), which result in restated historical figures. Following the 2015 revisions to the NIPA accounts, average real GDP growth rates in the first quarter were revised up to 1.1 percent from 0.7 percent before the revisions. With all of these adjustments in mind, we continue to expect real growth of about 2.5 percent in 2016. The rebound in risk assets in the second half of the quarter may also reflect diminished recession risks in the eyes of many market participants.
The outlook for economic growth outside of the United States softened in the first quarter. A further deterioration in the euro zone inflation outlook prompted the European Central Bank (ECB) to announce an increase in the size of its monthly asset purchases by €20 billion to €80 billion per month, and a 10 basis-point reduction in the deposit rate to -40 basis points. The ECB also expanded its program to include purchases of high-quality corporate bonds and launched a new four-year, fixed-rate targeted long-term refinancing operation (TLTRO), a program that allows banks to borrow from the ECB based on the total amount they lend to the nonfinancial private sector. European government bonds rallied following the announcement, with the 10-year German bund ending the quarter with a yield of just 16 basis points. The strong correlation between the 10-year German bund yield and the 10-year U.S. Treasury yield highlights a gravitational pull that global yields are exerting on U.S. yields. The focus on efforts to ease euro zone credit conditions also had positive spillovers for the U.S. high-yield and bank loan markets.
Ongoing stimulus efforts in Asia are also likely to contribute to low U.S. rates. Chinese industrial production growth continued to slow in early 2016, prompting the People’s Bank of China (PBOC) to cut its bank reserve requirement ratio at the end of February. This is intended to stimulate credit growth by allowing banks to hold fewer reserves against deposits. But with China’s total nonfinancial debt-to-GDP ratio having risen at an alarming rate since 2008, a further increase in leverage is not what China needs. In our opinion, China must devalue the renminbi in a way that does not exacerbate the problem of rapid capital outflows but stimulates its economy. As things stand, the crisis in China does not appear to be ending soon.
After years of struggling with stagnant growth and low inflation, the Bank of Japan (BOJ) surprised markets by cutting its key interest rate to -10 basis points on Jan. 29. Negative rates are meant to encourage banks to lend to households and businesses rather than park cash in Japanese government bonds, which now offer negative yields on maturities out to 10 years. The BOJ is not the first central bank to move into negative rate territory, but this move was not welcomed by markets. In the first two weeks following the announcement of negative interest rates, the Nikkei fell 14.6 percent. Japanese stocks rebounded in the second half of the quarter along with risk assets globally, but the BOJ is now struggling to explain the move to commercial banks and investors in short-term investment funds, the latter of which typically invest in government bills for daily liquidity. Negative rates have pushed a considerable amount of Japanese savings into foreign markets, with Japanese investors’ net purchases of medium- and long-term foreign debt securities totaling nearly $80 billion since late January.
The influence of global factors on U.S. monetary policy has clearly grown. The Federal Reserve (Fed) kept rates unchanged at the January and March Federal Open Market Committee (FOMC) meetings, citing concerns about potential downside risks to the U.S. economy posed by weaker global growth and market volatility. Despite evidence of higher inflation and a stronger labor market, the median FOMC participant now projects two hikes in 2016, down from a forecast of four as recently as December 2015. The median participant continues to expect four rate hikes in 2017.
In an environment where global rates are moving lower and markets are already starved for yield, foreign investors are looking to the U.S. While we hear arguments to the contrary, we expect that U.S. Treasury yields will fall further as the gravitational pull of global yields gets stronger, and do not discount the possibility of 10-year U.S. Treasury yields declining to closer to 1 percent before the end of the year.
Q1 2016 Leveraged Credit Performance Recap – Anchored to Oil Prices
The front-month West Texas Intermediate (WTI) oil futures contract fell sharply in the early weeks of the year to a cycle low of $26 per barrel on Feb. 11. A weaker dollar and optimism about a production freeze agreed to by a group of major oil producing countries helped oil to rebound to as high as $40 per barrel before WTI closed the quarter at $38 per barrel. Mirroring the oil market, high-yield corporate bonds reversed a 3.2 percent year-to-date decline through the middle of February with the rebound pushing high-yield returns into positive territory for the quarter. The Credit Suisse High-Yield Bond index delivered a positive total return of 3.1 percent in Q1 2016.
Bank loan prices rose along with the high-yield bond market, but the rebound was less pronounced. The Credit Suisse Leveraged Loan index delivered a positive 1.3 percent return in Q1 2016. As we will discuss later in the report, loans have encountered weak technical conditions that may improve in the months ahead. They have performed as expected, however, and delivered steady returns with far less volatility than other fixed-income markets.
The rebound in risk assets, in conjunction with rising oil prices, supports our view that the decline in leveraged credit has been largely tied to the commodity bear market and a sentiment-driven spillover into credits tied to other industries. Our concern is that the rebound in oil prices is not yet supported by a turnaround in the dynamics that initially caused prices to fall. Our analysis of inventory trends and production levels suggests that the oil market will remain oversupplied until the second half of 2016. Leveraged credit must contend with two important headwinds between now and the second half of the year: a rise in credit defaults in the energy and metals sectors, and a likely wave of ratings downgrades in both markets.
Volatility on the Horizon for High Yield – Technical Headwinds May Drive Spring Volatility
In January 2016, Moody’s placed 120 oil and gas companies and 55 mining companies on review for a downgrade, reflecting expectations for persistently poor conditions in commodity markets and a weakening global growth outlook to weigh on commodity prices going forward. The potential for “fallen angels,” a term given to corporate bonds that are downgraded from investment grade to high yield, is a looming challenge for leveraged credit. The rating agencies are expected to re-classify billions of dollars of investment-grade corporate credit to below-investment grade, which may exert upward pressure on high-yield spreads.
Investors are one step ahead of the rating agencies, having already repriced the investment-grade corporate bond market for potential downgrades last year. As of the end of the first quarter, $260 billion of investment-grade corporate bonds (based on par value) in the Barclays Investment-Grade Corporate Bond index offered yields comparable to BB-rated corporate bonds, the majority in energy and basic materials. Of this $260 billion, only $106 billion carry a negative outlook by either Standard & Poor’s or Moody’s. A downgrade of all $260 billion to subinvestment grade would increase the overall high-yield corporate bond market size by 20 percent to $1.8 trillion. Energy would represent the largest sector of the market, rising from an 11 percent share as of Q1 2016 to 25 percent by our estimates. The high-yield market will have to weather negative headlines and forced selling from investors unable to hold below-investment-grade credit.
Our fundamental outlook for bank loans is more positive than for the high-yield corporate bond market. With only 4.4 percent exposure to energy and metals, the bank loan market is more insulated from the credit problems plaguing highyield corporate bonds. Indeed, the 12-month trailing default rate for institutional bank loans is 1.4 percent, just half of the 2.8 percent for high-yield bonds. However, the strong relationship between the two markets weakens our near-term technical outlook for loans.
As we highlighted in our Q1 report, bank loans trade in sympathy with the highyield corporate bond market, which poses a downside risk to loans given our expectation of more volatility ahead for high-yield bonds. As the following chart demonstrates, the beta between movements in bank loan spreads to high-yield spreads has increased since the financial crisis. Today, a 100-basis-point change in high-yield spreads translates into a 75-basis-point change in bank loan discount 1margins, on average, up from 48 basis points pre-crisis. Bank loan discount margins have also tended to be 35 basis points higher than they were prior to the financial crisis for a given level of high-yield spreads. While this higher-beta relationship dampens our near-term outlook for loans, we expect greater stability in the high-yield bond market in the second half of 2016 as oil market fundamentals improve.
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