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Andrew R. Jessop, Elizabeth (Beth) MacLean
This article originally appeared on institutionalinvestor.com on 7 February 2014.
Leveraged credit investments had a strong year in 2013, with bank loans returning 6.2% and high yield bonds returning 7.4% (according to the Credit Suisse Leveraged Loan Index and the Bank of America Merrill Lynch U.S. High Yield Index, respectively), even as many other fixed income asset classes were negatively affected by interest rate volatility.
The significant rise in Treasury yields from their lows in mid-2012 substantiated leveraged credit’s ability to deliver positive annualized returns in a rising rate environment – in fact, both loans and high yield bonds have done so consistently for almost 20 years (see Figure 1). High yield did have a mid-course correction in mid-2013, when spreads broke the typical negative correlation with Treasury yields, but recovered to provide positive returns in the last quarter of 2013 as correlations reverted to normal patterns. Meanwhile, loans continued delivering stable returns, only pausing briefly in June 2013.
Based on our observations, the two components (bank loans and high yield) of the broader leveraged finance sector share a close relationship, with the majority of companies that issue one also issuing the other. From a portfolio standpoint, however, investors may look to bank loans versus high yield with nuanced objectives in mind – for example, investors with low tolerance for volatility and more interest rate sensitivity may emphasize loans given the attractive relative value potential and downside hedging from their position in the capital structure, while investors with greater risk tolerance and a more benign outlook for rates may emphasize high yield (or “medium yield” in today’s environment – see PIMCO Viewpoint, “High Yield in 2014: Where Can You Look for Upside in a ‘Medium Yield’ Market?”).
A few broad themes dominate the outlook for leveraged finance markets in 2014. Consistent with our own views, industry forecasts call for low (1%–3%) defaults, based on low levels of principal maturities in the next year (source: BofA Merrill Lynch). Issuance may ease back from record highs last year, but should remain healthy. We also expect continued slow but steady growth in the U.S. economy to offer further stability to these companies.
Fundamentals: Calm conditions persist Slow, steady U.S. GDP growth, together with stability in corporate profits and a lack of corporate debt maturities over the near term, should result in a continued low default environment for leveraged finance, in our view. Less than 10% of the combined high yield and loan market matures between 2014 and 2016. This is a five-year low for the three-year principal maturity schedules (see Figure 2), and lends support to our outlook for low defaults through 2014 and into 2015. We expect there will be a few notable exceptions, including some overleveraged 2006 leveraged buyouts (LBOs) that will likely default in 2014, but these are largely anticipated and priced into the market. In general, we expect calm credit conditions for leveraged finance in 2014.
Given these strong underlying credit fundamentals, look for the technical side to be the primary driver of shifts in the loan and high yield bond markets in 2014. In 2013, high demand not only supported refinancing and maturity extensions (positive for the underlying credit), but also enabled a return of more issuer-friendly structures, with covenant-lite becoming the norm in the loan market, payment-in-kind (PIK) toggle returning to the high yield bond market and an increase in loans and bonds used to fund dividends or share repurchases. In 2014, we expect these issuer-friendly features to continue unless there is an unexpected drop in demand for high yield credit. That said, our base case is for continued strength in demand.
Demand: The pace of flows may slow, but should remain healthy After record retail flows of $62.4 billion into loan mutual funds (source: J.P. Morgan) and robust collateralized loan obligation (CLO) issuance in 2013, we expect the pace of flows into the loan market to slow in 2014 but remain positive, as we think that basic themes driving those flows remain intact. On the CLO front, pending regulatory headwinds will likely lead to a pull-forward effect, with many CLO managers trying to print deals ahead of new federal risk retention rules currently being formulated, particularly the smaller managers who may be less able to meet the new requirements. Steady retail demand, a strong early push from CLO issuers and increasing institutional appetite for loans should drive demand into 2014.
High yield saw overall outflows of $3.9 billion in 2013; high yield ETFs were up $0.9 billion while actively managed funds lost $4.8 billion (source: EPFR Global data through 25 December 2013). In 2014, overall demand for high yield is expected to be influenced by rate volatility as credit fundamentals remain supportive.
Supply: Issuance may decrease in 2014, but supply should remain robust Responding to investor interest, leveraged credit issuance accelerated in 2013 to a combined $1.07 trillion in loans and high yield, with record high levels in both markets (though the bank loan market saw more dramatic growth). However, 75% of new loan issuance and 54% of high yield issuance was related to refinancing or repricing of existing debt (all data from J.P. Morgan), underscoring corporations’ focus on strengthening their balance sheets.
We expect to see a reduction in overall issuance in 2014, but activity should remain healthy. Industry forecasts range from approximately $285 billion to $335 billion in high yield bonds and from approximately $350 billion to $420 billion in loans, based on sell-side research from Morgan Stanley, Barclays, Credit Suisse and J.P. Morgan. After addressing near-term maturities, we believe issuers will set their sights on maturities from 2017 to 2019, pushing maturities further out as long as the markets remain receptive.
Mergers and acquisitions (M&A) activity disappointed in 2013, when a few bellwether deals for H.J. Heinz and Dell gave rise to expectations for more robust activity that never materialized. With an improving outlook for the economy, we could begin to see corporate issuers more willing to spend their cash in 2014. We may see more organic new issuance to finance mergers or capital spending programs, which have thus far lagged as companies focused more on extending their debt maturities (see Figure 3). Therefore, we expect investment grade issuers to continue to offer a higher share of new supply in the market. In 2013, $128.5 billion in new high yield supply came from “fallen angels” (companies being downgraded by rating agencies from investment grade to high yield), representing a higher proportion of new issuance than in previous years, according to BofA Merrill Lynch (through November).
While we could see more organic new issuance, we also expect transactions to fund dividends to continue as the exit strategy for many private-equity-funded deals remains unclear. And as noted above, more friendly structures like covenant-lite and PIK toggle will likely persist as long as fundamentals hold steady and demand remains strong. We also expect to see lower-rated issuers aggressively tapping the market, a trend that also began to grow in 2013.
Implications of the leveraged finance outlook As we enter 2014, we move further into what has become a prolonged credit cycle. Fundamentals remain supportive, with few maturities helping to drive a low default environment that is “supportive of stability in the speculative-grade credit markets,” as a recent Moody’s report phrased it. However, we continue to see erosion in structural protections, and are closely monitoring an overall increase in leverage as more aggressive transactions test the depth of the market.
As a result, careful credit selection and close monitoring of both individual credits and sector trends are imperative for leveraged finance investing in 2014. Liquidity will also be an important theme; in our view, portfolios should be positioned to withstand shocks from rate volatility or flow reversals in the actively managed or ETF universe.
With careful attention to individual credit and market liquidity risks, we believe leveraged credit offers many opportunities for attractive return potential in the coming year.
Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to certain risks, including market, interest rate, issuer, credit and inflation risk. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Bank loans are often less liquid than other types of debt instruments and general market and financial conditions may affect the prepayment of bank loans, as such the prepayments cannot be predicted with accuracy. There is no assurance that the liquidation of any collateral from a secured bank loan would satisfy the borrower’s obligation, or that such collateral could be liquidated. Collateralized Loan Obligations (CLOs) may involve a high degree of risk and are intended for sale to qualified investors only. Investors may lose some or all of the investment and there may be periods where no cash flow distributions are received. CLOs are exposed to risks such as credit, default, liquidity, management, volatility, interest rate and credit risk. Corporate debt securities are subject to the risk of the issuer’s inability to meet principal and interest payments on the obligation and may also be subject to price volatility due to factors such as interest rate sensitivity, market perception of the creditworthiness of the issuer and general market liquidity. Investments in companies engaged in mergers, reorganizations or liquidations may involve special risks as pending deals may not be completed on time or on favorable terms. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Investors should consult their investment professional prior to making an investment decision.
The issuers referenced are examples of issuers PIMCO considers to be well known and that may fall into the stated sectors. References to specific issuers are not intended and should not be interpreted as recommendations to purchase, sell or hold securities of those issuers. PIMCO products and strategies may or may not include the securities of the issuers referenced and, if such securities are included, no representation is being made that such securities will continue to be included.
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