RidgeWorth Insights: Leveraged Loan and High Yield
- Returns in the leveraged finance market were strong throughout the year, but in the wake of the U.S. presidential election, investors flooded into risk assets in anticipation of pro-growth policies from the new administration.
- Issuance was robust for both leveraged loans and high yield bonds, but refinancing and repricing transactions accounted for much of that volume early on, resulting in relatively little net new supply. Demand, however, strengthened during the year, particularly after the November election, providing support for price increases.
- Continued volatility is likely in the coming year, particularly in certain sectors. Healthcare, for example, may be adversely affected by possible Trump administration policies, presenting possible opportunities. In addition, we anticipate the Energy sector will continue to benefit from relatively stable oil prices resulting from the recent Organization of the Petroleum Exporting Countries (OPEC) agreement to cut production.
The year-long rally in the leveraged loan and high yield markets was briefly interrupted in November by Donald Trump’s surprise victory in the U.S. presidential election. But after posting negative returns in November, both markets rebounded, as a risk-on mood took hold and risk assets in general outperformed safe havens.
The Bloomberg Barclays U.S. Aggregate Index fell 2.98% during the quarter while the Credit Suisse (CS) Leveraged Loan Index advanced by 2.25%. The Bloomberg Barclays U.S. Corporate High Yield Index advanced 1.75%. Performance was strongest among lower-quality issues.
The supply of new loans was healthy in the fourth quarter, with $195 billion coming to market. In fact, 2016 was the strongest year since 2010 and the secondbest on record, with $485.4 billion in institutional loan issuance, a 49% increase over 2015. But of 2016’s issuance, 65% took the form of repricing and refinancing transactions. Net of this, new supply slipped about 11% from 2015.1
Demand for loans soared during the fourth quarter. In addition to the election results and improving commodities markets, demand was driven by the rise in the 3-Month London Interbank Offered Rate (LIBOR). As we noted earlier this year, many holders of bank loans had already benefited as 3-Month LIBOR passed 0.75%, the LIBOR floor on many loans. LIBOR has been rising for months due to new regulations affecting prime money market funds. In December, 3-Month LIBOR nearly passed the 1% mark, which would have resulted in a reset of rates on loans with a LIBOR floor of 1%, boosting cash returns.
Demand from retail investors began picking up in the second half of the year but surged after the election. Flows into loan mutual funds hit a high for the year of $5.7 billion for the month of December, nearly doubling November’s $2.9 billion inflow1 (see Exhibit 1).
Exhibit 1: Flows into Leveraged Loan Mutual Funds Surged in December
Source: Lipper FMI as of 12/31/16.
Collateralized loan obligation issuance was robust at over $70 billon,2 despite new risk retention regulation established in December 2016, owing to increased institutional investor demand.
Fundamentals improved during the year as rising commodities prices eased the pressures in the Energy and Metals & Mining sectors. More than half of defaults in 2016 occurred in the first quarter, and companies in commodities sectors accounted for more than 80% of those.1 But the par-weighted default rate finished the year at just 1.49%, the lowest since March 2014, when it was 1.37%.
High yield bonds outperformed all other fixed income categories in 2016, posting a return of 18.91%.1 Performance was driven by improving fundamentals in the Commodities sectors and by anticipation of progrowth policies from the incoming Trump administration. Metals & Mining and Energy were the strongest sectors for the quarter and the year while Healthcare lagged in both. Lower quality issues outperformed higher quality.
Credit spreads tightened about 70 basis points (bps) during the quarter. The yield-to-worst for the Bloomberg Barclays U.S. Corporate High Yield Index declined only eight bps, so the bulk of the tightening resulted from a rise in Treasury rates. That was evident most acutely among BB-rated issues, which helps to explain their underperformance.
The relative trickle of net new supply also contributed to price gains. Much of the new issuance went to repricing and refinancing transactions as companies sought to take advantage of low rates ahead of the Federal Reserve Board’s anticipated December rate hike. For the year, these deals accounted for 65% of total issuance. Total issuance declined over the course of the year, shrinking from $104 billion in the second quarter to just $52 billion in the fourth. For the full year, issuance amounted to $286 billion, marking the third consecutive annual decline.
Demand for high yield bonds improved as mutual fund flows turned positive in 2016. Inflows totaled $6.9 billion for the year ($13.4 billion, including exchange-traded funds), up from an outflow of -$16.6 billion in 2015.1 But flows for the fourth quarter were negative despite a strong reversal in December.
Fundamentals improved during the quarter. Excluding Metals & Mining and Energy sectors, leverage declined and interest coverage rose. Earnings growth also began to benefit fundamentals, and at year end, the par-weighted default rate was just 3.32%.1
In leveraged loans, much of the market is now trading at par or better, so next year’s returns are unlikely to match those of 2016. But if the environment continues to be “risk on,” and Energy and Commodities prices remain strong, that will be supportive of the market. The baton may be passing to Retail and some subsectors of Healthcare. Overall, the rise in rates has helped the leveraged loan sector, and that continues to benefit pricing.
In the high yield market, spreads narrowed significantly, so in the coming year we anticipate more modest returns, probably in the mid-single digits. We expect some pockets of volatility related to the policies of the incoming Trump administration. In Healthcare, for example, some dislocation is occurring in parts of that sector, and we hope to take advantage of that. In other sectors, Energy continues to be revalued, and with the recent OPEC agreement to cut production, oil prices are likely to remain high, which will continue to be supportive of the sector. In addition, many companies in the sector have reduced their cost structures enough to enable them to survive in the event that prices fall.
1 JPMorgan Securities as of 12/31/16
2 Credit Suisse LLC as of 12/31/16
Bloomberg Barclays U.S. Aggregate Bond Index is an unmanaged index of U.S. bonds, which includes reinvestment of any earnings and is widely used to measure the overall performance of the U.S. bond market.
Bloomberg Barclays U.S. Corporate High Yield Bond Index is an unmanaged market value weighted index that covers the universe of fixed rate, non-investment grade debt.
Credit Suisse Leveraged Loan Index is a market-weighted index that tracks the performance of institutional leveraged loans.
Investors cannot invest directly in an index.
A Basis Point is equal to 0.01%.
Collateralized loan obligations are securities backed by a pool of debt, often lowrated corporate loans.
Credit Spreads are the difference between the yields of sector types and/or maturity ranges.
Credit Ratings noted herein are calculated based on S&P, Moody’s and Fitch ratings. Generally, ratings range from AAA, the highest quality rating, to D, the lowest, with BBB and above being called investment grade securities. BB and below are considered below investment grade securities. If the ratings from all three agencies are available, securities will be assigned the median rating based on the numerical equivalents. If the ratings are available from only two of the agencies, the more conservative of the ratings will be assigned to the security. If the rating is available from only one agency, then that rating will be used. Ratings do not apply to a fund or to a fund’s shares. Ratings are subject to change.
The London Interbank Offered Rate (LIBOR) is a benchmark rate that some of the world’s leading banks charge each other for short-term loans.
Bonds offer a relatively stable level of income, although bond prices will fluctuate providing the potential for principal gain or loss. Intermediate-term, higher-quality bonds generally offer less risk than longer-term bonds and a lower rate of return. Generally, a fund’s fixed income securities will decrease in value if interest rates rise and vice versa. Although a fund’s yield may be higher than that of fixed income funds that purchase higher-rated securities, the potentially higher yield is a function of the greater risk of that fund’s underlying securities. Floating rate loans are typically senior and secured, in contrast to other below-investment grade securities. However, there is no guarantee that the value of the collateral will not decline, causing a loan to be substantially unsecured. Loans generally are subject to restrictions on resale. The value of the collateral securing a floating rate loan can decline, be insufficient to meet the obligations of the borrower, or be difficult to liquidate. Participation in certain types of loans may limit the ability of a fund to enforce its rights and may involve assuming additional credit risks.
The views expressed by the funds’ managers are as of the quarter-end specified. This information is general in nature, provided as general guidance on the subject covered, and is not intended to be authoritative. It is subject to change without notice as market conditions change, and is not intended to predict the performance of any individual security, market sector, or RidgeWorth Fund. All information contained herein is believed to be correct, but accuracy cannot be guaranteed. Investors are advised to consult with their investment professional about their specific financial needs and goals before making any investment decision.
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