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JULY 2013
High Yield and Bank Loan Outlook investment professionals B. Scott Minerd Global Chief Investment Officer Anthony D. Minella, CFA Co-Head of Corporate Credit Michael P. Damaso Co-Head of Corporate Credit Jeffrey B. Abrams Senior Managing Director, Portfolio Manager Kevin H. Gundersen, CFA Senior Managing Director, Portfolio Manager Kelechi C. Ogbunamiri Senior Associate, Investment Research
Despite the parallels being drawn between current credit conditions and those of 2007, the chances of experiencing a sudden spike in near-term defaults, similar to what ensued following the end of the previous credit cycle, remain remote given the robust capital markets activity. While rapidly deteriorating credit quality and excessive market leverage were the chief culprits behind the abrupt end to the previous credit rally, neither factor is currently a significant concern in the leveraged credit market. Interest-rate risk, specifically the market’s uncertainty regarding future monetary policy, precipitated the recent market sell-off and will likely continue to shape the performance of high yield bonds and bank loans in the near term. Amid increased interest-rate volatility and a gradual softening in underwriting standards, investors should seek to safeguard portfolios by shortening interest-rate duration and improving credit quality. While we continue to view bank loans as the preferred investment vehicle to achieve these dual objectives, the backup in bond yields has created an attractive re-entry point to selectively increase allocations to high yield bonds. REPORT HIGHLIGHTS:
• The Federal Reserve’s (Fed) announcement of possible tapering as early as the end of 2013 has caused investors to re-price risk. With yields on the 10-year Treasury note 82 basis points higher since May, current market conditions necessitate a greater focus on optimal positioning on the yield curve. • Investors’ preference for bank loans over high yield bonds is likely to persist until interest-rate volatility subsides. During the second quarter, high yield bonds lost 1.4 percent while bank loans returned 0.3 percent. • Credit conditions remain relatively benign compared to the experiences of 2006 and 2007. Analyzing market leverage and the financing terms of leveraged buyouts (LBOs) from the respective periods helps illustrate this contrast.
Leveraged Credit Scorecard AS OF MONTH END high yield bonds Dec-12
Apr-13
May-13
Jun-13
Spread
Yield
Spread
Yield
Spread
Yield
Spread
Yield
Credit Suisse High Yield Index
554
6.25%
473
5.34%
489
5.80%
541
6.74%
Split BBB
302
4.16%
252
3.52%
276
4.01%
310
4.65%
BB
376
4.58%
339
4.17%
339
4.54%
380
5.38%
Split BB
442
5.03%
387
4.39%
400
4.86%
453
5.81%
B
566
6.27%
480
5.28%
504
5.79%
564
6.80%
CCC / Split CCC
958
10.21%
789
8.41%
807
8.83%
865
9.87%
DMM*
Price
DMM*
Price
DMM*
Price
DMM*
Price
498
99.86
453
100.63
459
100.23
491
99.44
bank loans Dec-12 Credit Suisse Leveraged Loan Index
Apr-13
May-13
Jun-13
Split BBB
324
100.53
298
100.79
304
100.36
321
99.84
BB
403
100.38
363
100.90
364
100.57
385
99.79
Split BB
489
100.26
427
100.88
426
100.58
453
99.49
B
560
99.38
494
100.42
499
100.07
527
99.41
CCC / Split CCC
939
99.73
853
101.45
769
98.71
885
97.59
Source: credit suisse. excludes split b HIGH YIELD BONDS AND BANK LOANS. *Discount Margin to Maturity assumes three-year average life.
Credit Suisse High Yield Index Returns
Credit Suisse Leveraged Loan Index Returns
■ Q1 2013 ■ Q2 2013
■ Q1 2013 ■ Q2 2013 6%
5.5%
3.9%
4.0%
5%
3.5%
4% 3%
4.5%
3.2%
2.9%
2%
1.7%
3.0% 2.5%
2.1%
2.2%
2.1%
2.0%
1.0%
1%
2.7%
1.6% 1.5%
0%
1.3%
1.0%
0.8%
-0.5%
-1% -2% Index
0.5%
-1.2%
-1.4% -2.1% Split BBB
-2.0% BB
B
CCC / Split CCC
Index
Source: Credit Suisse. Data as of 06/30/2013.
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0.1%
0.2%
0.4% 0.1%
0.0%
-1.8% Split BB
0.3%
high yield and bank loan outlook | Q3 2013
Split BBB
BB
Split BB
B
CCC / Split CCC
“Revised first quarter GDP data showed that the contribution from housing-related activities made up 69 percent of the economy’s 1.8 percent growth. With interest rates rising, however, home affordability is plummeting from its recent historic high. Even a flattening of housing activity would cause economic growth to slow materially. This decreases the likelihood that the Fed tapers its asset purchases in 2013.” – Scott Minerd, Global CIO
Macroeconomic Overview Concerns Over Imminent Fed Tapering Likely Overblown
Amid a rapid ascent in long-term interest rates beginning in May, high yield bonds dropped 3.2 percent to end the second quarter, the largest two-month decline since September 2011. The severe dislocation in credit markets is the result of investors’ surprise over the faster-thanexpected pace at which the Fed indicated plans to taper and eventually end quantitative easing (QE). Instead of waiting for the Fed to act, the markets have preemptively begun to re-price risk. This market reaction is analogous to the experiences of the bond market crash of 1994, when then-U.S. Fed Chairman Alan Greenspan unexpectedly increased the federal funds rate by 25 basis points in February of that year, the first rate increase in five years. In the subsequent bond-market rout – the worst since the Great Depression – investors immediately began re-pricing bonds to where they assumed rates would be at the end of the tightening cycle. Based on the Fed’s economic projections, which will be used to determine if conditions warrant a change in monetary accommodation, the hysteria regarding imminent tapering may be largely overblown. The Fed’s outlook on the unemployment rate by year end suggests a belief that economic activity will accelerate as we head into the summer. However, we are already beginning to see pressure on housing and the broader economy from higher interest rates. We believe there is a strong possibility that the Fed will shift the tone of its guidance from QE tapering back to QE expansion or extension before the end of 2013. Given the likelihood of sustained interest-rate volatility, investors should look to reduce interest-rate duration through bank loans. Additionally, improved bond market valuations have created opportunities to increase spread duration through select, lower-rated high yield bonds.
Housing-related activities have positively contributed to real GDP growth for five consecutive quarters. In the first quarter of 2013, housing-related activities contributed more than two-thirds of the growth in real GDP.
Measuring the Impact of the Housing Recovery on GDP 5% HOUSING-RELATED ACTIVITIES*
4%
OTHER SECTORS
REAL GDP GROWTH
3% 2% 1% 0% -1% -2% Mar-11
Sep-11
Mar-12
Sep-12
Mar-13
Source: Haver Analytics, Guggenheim Investments’ estimates. Data as of Q1 2013. * Housing-related activities defined as private residential investment, personal expenditures on household durable goods and utilities, as well as consumption wealth effect from home price appreciation.
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high yield and bank loan outlook | Q3 2013
This Time is Different Significant Differences Between Current and Previous Credit Cycles
It has often been said that the past is the best predictor of the future. Based on this notion, there have been numerous attempts to draw comparisons between the current credit cycle and the previous one in an effort to extrapolate what potentially lies ahead for high yield bonds and bank loans. However, after analyzing the credit conditions of the respective periods, it is apparent that current conditions remain far from the levels of excess that ultimately culminated in the credit crisis. The following table includes a comparison of credit metrics during 20062007 vs. 2012-2013. While current credit conditions appear materially more benign across virtually every measure, one metric that notably stands out is market leverage.
Investors should be hesitant to draw parallels between the current credit cycle and that of 2006-2007, which was characterized by a surge in mergers and acquisitions (M&A) and LBO financings and excessive market leverage.
Summary of Key Credit Cycle Drivers KEY CREDIT CYCLE DRIVERS
2006 – 2007
2012 – 2013
$667 Billion
$164 Billion
Purchase Price Multiple
9.2x
8.6x
Equity Contribution
31%
37%
$330 Billion
$50 Billion
10-12x
7-12x
Total Return Swap Line Volume
$250 Billion
<$100 Billion
Total Return Swap Line Leverage
8-10x
3-4x
Covenant-Lite as % of Total Loan Issuance
20%
45%
M&A / LBO as % of Total Issuance
60%
22%
Refinancings as % of Total Issuance
22%
60%
Leveraged Buyout (LBO) Volume
Leverage Bridge Loan Value CLO Leverage
Issuance
Source: Fitch Ratings, JP Morgan, S&P LCD. DATA AS OF 06/30/2013.
While fundamental factors, such as weak operating performance and heavy debt burdens, were the primary catalysts that set off the credit crisis in 2007, the velocity and magnitude of the descent was exacerbated by the excessive leverage in the credit markets. After peaking at $100.11 in February 2007, the Credit Suisse Leveraged Loan Index went into a freefall, declining nearly 40 percent by the end of 2008. In the years preceding this collapse, bank loan investors had grown increasingly more aggressive in seeking ways to augment their returns. Seemingly calm credit conditions encouraged investors to utilize leverage as a means to enhance bank loan returns. Similar to buying on margin, total return swaps (TRS) enabled institutional investors to participate in the ongoing credit rally on a leveraged basis, typically
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high yield and bank loan outlook | Q3 2013
obtaining 8-10x leverage on their equity. However, as bank loan prices reversed course and began to fall precipitously, TRS investors received margin calls. Forced to either post additional equity or sell bank loan holdings to raise cash, most investors chose the latter option, resulting in further price degradation. In addition to highly leveraged institutional investors, investment banks also became forced sellers in the bank loan market. During the LBO boom years of 2006 and 2007, investment banks routinely committed capital in the form of bridge loans to help secure lucrative underwriting mandates. Bridge loans are short-term bank loans that provide interim financing until more permanent funding is secured. During normal market conditions, these bridge loans are quickly repaid through syndicated financings from institutional investors. According to JP Morgan estimates, banksâ&#x20AC;&#x2122; total committed capital exceeded $330 billion at its peak. As investor demand for risk assets began to sour in late 2007, banks were unable to raise long-term financing to take out these bridge loans, the majority of which had been issued to highly leveraged companies. With risk exposures ballooning, banks acquiesced to mounting regulatory concerns and began selling these loans at significant discounts. This placed excess supply on the market at a time of shrinking demand, compounding the volatility and downward price spiral in the bank loan market. Comparing the deal metrics of H.J. Heinz and TXU, the largest LBOs of their respective periods, highlights the difference between current credit conditions and those of 2007.
Emblematic of the excesses of the leveraged credit market at the time, equity contribution represented a relatively small percentage of the total financing used to fund the buyout of TXU in 2007. Investment banks committed over $11 billion in bridge loans for this landmark transaction.
Leveraged Buyout Deal Comparison TXU Corp. Transaction Date
October 2007
February 2013
$44 Billion
$28 Billion
Equity Contribution, % of Deal
19%
58%
Debt Financing, % of Deal
81%
42%
Post-LBO Total Leverage
9.6x
8.5x
$11.25 Billion Senior Unsecured Bridge Loan
$2.1 Billion Second Lien Bridge Loan
26%
8%
Deal Size
Bridge Commitment Bridge Commitment, % of Deal
Source: Fitch Ratings, DATA AS OF 06/30/2013.
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H.J. Heinz Co.
(Currently Energy Future Holdings)
high yield and bank loan outlook | Q3 2013
Optimal Portfolio Positioning Bank Loans Remain Our Preferred Investment Vehicle
While far from the excesses of 2006-2007 from a credit underwriting and market leverage perspective, investors, nonetheless, need to be cognizant of the current dynamics that are likely to impact performance. While we are monitoring the slight deterioration in underwriting standards, we believe this is a secondary, longer-term concern. In the near term, defaults should remain muted, given the preponderance of refinancing activity over the last three years. We anticipate monetary policy, and its attendant implications on interest rates, will continue to be the primary driver of credit markets over the next several years. Our preferred investment vehicle to mitigate interest-rate risk continues to be bank loans. The floating-rate coupons of bank loans provide greater protection against movements in interest rates. Due to their seniority in the capital structure, maintenance covenants, and secured status, we consider single B-rated bank loans to be of comparable credit risk to BB-rated bonds. Since rates began moving higher in early May, interest-rate sensitive BB-rated bonds have declined 3.9 percent, while single B-rated bank loans were essentially flat.
The rate backup over the past two months has helped demonstrate the value of bank loans. While higher duration BB-rated bonds fell nearly 4 percent, the floating-rate coupons of bank loans left them fairly insulated from the interest-rate volatility.
Comparative Performance During Rate Backup
BB Bonds
-3.94%
CS High Yield Index
-3.16% -2.87%
B Bonds CCC Bonds
-2.69% -0.57%
CCC Loans B Loans
-0.30%
CS Leveraged Loan Index
-0.29%
BB Loans
-0.28% -4.5%
-4.0%
-3.5%
-3.0%
Source: Credit Suisse. DATA AS OF 06/30/2013.
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high yield and bank loan outlook | Q3 2013
-2.5%
-2.0%
-1.5%
-1.0%
-0.5%
0.0%
Despite covenant-lite loans representing 53 percent of 2013 year-to-date total loan issuance, we believe concerns over this apparent relaxation in underwriting are largely overstated. This trend is likely more symptomatic of shifting capital market dynamics and investor demand than worsening credit quality. Based on their default and recovery characteristics, covenant-lite bank loans are very similar to senior secured bonds. The strong retail demand for floating-rate assets and robust collateralized loan obligation (CLO) creation have incentivized issuers to raise debt financing through the bank loan market over the bond market. Bank loan issuance, currently totaling $395 billion year-to-date, is on track to exceed bond issuance for the first time since the financial crisis. The shorter call protection periods and smaller call premiums of bank loans have also influenced greater loan issuance. Our long-standing belief that the unprecedented monetary accommodation from global central banks would eventually give rise to increased market volatility has come to fruition. Now that volatility has finally arrived, this will likely increase the demand for bank loans. Our portfolios remain positioned accordingly, with an overweight bias in bank loans. While largely staying the course, we remain poised to take advantage of market pullbacks to selectively add exposure to fundamentally strong credits. The recent 140 basis point backup in bond yields over the past two months has helped create more favorable valuations, particularly in single B-rated bonds. As the market struggles to determine the appropriate risk premium during this period of interest-rate uncertainty, our focus remains on optimal investment allocation across the credit quality and yield curve.
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high yield and bank loan outlook | Q3 2013
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important notices and disclosures Past performance is not indicative of future results. There is neither representation nor warranty as to the current accuracy or, nor liability for, decisions based on such information. This article is distributed for informational purposes only and should not be considered as investment advice, a recommendation of any particular security, strategy or investment product or as an offer of solicitation with respect to the purchase or sale of any investment. This article should not be considered research nor is the article intended to provide a sufficient basis on which to make an investment decision. The article contains opinions of the author but not necessarily those of Guggenheim Partners, LLC its subsidiaries or its affiliates. The author’s opinions are subject to change without notice. Forward looking statements, estimates, and certain information contained herein are based upon proprietary and non-proprietary research and other sources. Information contained herein has been obtained from sources believed to be reliable but is not guaranteed as to accuracy. The value of any financial instruments or markets mentioned in the article can fall as well as rise. Securities mentioned are for illustrative purposes only and are neither a recommendation nor an endorsement. Individuals and institutions outside of the United States are subject to securities and tax regulations within their applicable jurisdictions and should consult with their advisors as appropriate. “ 1Guggenheim Partners’ assets under management figure is updated as of 3.31.2013 and includes consulting services for clients whose assets are valued at approximately $37 billion. 2
The total asset figure is as of 03.31.2013 and includes $11.129B of leverage for Assets Under Management and $0.331B of leverage for Serviced Assets. Total assets include assets from Security Investors, LLC, Guggenheim Partners Investment Management, LLC (“GPIM”, formerly known as Guggenheim Partners Asset Management, LLC; GPIM assets also include all assets from Guggenheim Investment Management, LLC which were transferred as of 06.30.2012), Guggenheim Funds Investment Advisors 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 (“GP”): 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. Guggenheim Partners Investment Management, LLC (GPIM) is a registered investment adviser and serves as the adviser to the Core Fixed Income Strategy. GPIM is included in the GIPS compliant firm, Guggenheim Investments Asset Management, and is also a part of Guggenheim Investments. This material is intended to inform you of services available through Guggenheim Investments’ affiliate businesses. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Guggenheim Partners, LLC. ©2013, Guggenheim Partners, LLC.