Late Cycle Investing: How to Position and Protect Portfolios Within Leveraged Finance

Author:
Steven Oh, CFA
Global Head of Credit and Fixed Income
Los Angeles

25 July 2019

Concerns continue to grow that the economic cycle – now over a decade old – may finally be nearing its end. And concerns are particularly high for investors in the credit markets: Credit cycles are historically correlated with economic cycles, and any significant changes to the US economy’s current growth trajectory could serve as the catalyst for the next credit cycle downturn.

Yet we see reason to believe economic volatility could remain relatively low. One of the seminal shifts arising from the financial crisis is the emergence of more active central banks. Time and time again, they’ve shown their willingness to preemptively inject stimulus whenever recessionary risks appear to rise. This approach is a departure from prior cycles where central banks were more reactive in policy actions. For the US, the resulting impact is a smoothing effect on the economic cycle – and on the credit cycle.

In the low-growth, low-inflation environment we see ahead, corporate fundamentals should be well supported. High yield corporate credits, leveraged loans, and collateralized loan obligations (CLOs) broadly continue to offer attractive yields, even with spreads tightening year to date after the oversold conditions of fourth-quarter 2018. Further, with retail market demand shifting away from floating-rate assets due to the collapse of the yield curve, loans and CLO spreads have remained elevated and currently provide more attractive riskadjusted relative returns.

Volatility, however, has the potential to crop up for short-term periods as a result of industry-specific problems, mini-cycles, and geopolitical and headline risks. With current valuations largely reflecting benign expectations, investors may have limited cushion to protect their portfolios from adverse event outcomes. We think that taking a proactive approach to managing the challenges ahead may help many investors better position for success.

Leveraged finance fundamentals remain supportive, but take caution

So what might a slowing but still low-growth environment look like for leveraged finance assets? Although current spreads have continued to tighten year to date, they generally remain above relatively compressed averages of the past few years. This can offer attractive return potential for long-term investors looking to diversify their fixed income portfolios and strengthen yield curve positioning.

Similar to all risk assets, leveraged finance markets experienced sizable price convulsions with yield gyrations of 200-plus basis points during the sharp volatility of fourth-quarter 2018 and subsequent rebound in first-quarter 2019. However, these extreme movements were primarily the result of short-term volatility from investor fear, not an indication of any underlying broad segment weakness. Despite some growing concerns of excess in the markets, credit fundamentals remain strong and do not suggest any material increase in systemic risk.

  • Low defaults: Default rates continue to hover near post-crisis lows, and markets are anticipating continued low levels over the next two years. This should continue to be the case until either the economic outlook significantly changes or issuer fundamentals substantially worsen.
  • Higher interest coverage and manageable leverage: With lower absolute interest rates, debt service coverage ratios are near all-time highs. Additionally, overall leverage ratios have improved in the high yield market over the past few years and have remained manageable, if slightly up, for the leveraged loan market.
  • Overblown headline risk: A number of financial press headlines have pointed to deteriorating credit quality across leveraged finance segments, but this does not appear to match the broad reality of these markets. Many of these articles have cited individual facts that can easily be taken out of context, negatively affecting the market with inaccurate risk concerns. Long term, we tend to see these reports mostly as market noise, with any resulting price depression creating potential buying opportunities.

With these strong dynamics, we believe investors should be focusing primarily on idiosyncratic risks within the leverage finance markets, not systemic risk, at least until there is any meaningful change to overall market conditions. Nevertheless, valuations have become very full to a bit high in many parts of these markets. As a result, we are also advocating a slightly more defensive bias and caution in overall portfolio positioning.

High yield: Favor ‘B’ rated credits

The high yield bond market has gone through a sustained period of low primary issuance over the past five years, largely skewed away from generally riskier leveraged buyout debt and more toward standard corporate issuers with lower leverage, higher coverage, and greater alignment of interests between debt and equity holders.

Because of this, overall credit rating quality has improved, with BB-rated credits notably up to 46% of the overall market versus 36% at the end of 2006. The segment also went through a significant mini-cycle between 2015 and 2017, particularly within two of its riskier sectors – energy and retail – where many of the worst credits were cleaned out. This has all helped to reduce overall default risk in the market.

It is difficult to imagine default rates moving much lower at this point, but even if a downside-case macroeconomic scenario begins to unfold, we do not anticipate anything near the mid-double-digit peaks that occurred in the past two downturns, given improvements in overall issuance quality.

At current valuations, select upside remains but is more limited, in our opinion, with investors largely not being paid to take on anything above market risk in most sectors. We also are favoring B-rated credits, reflecting a marginally more cautious view, and with BB-/Ba-rated securities exhibiting more duration risk based on current yield curve expectations.


US High Yield Key Rate Durations: Ba- Versus B-Rated Credits
Ba-rated credits currently exhibit notably higher duration risk at longer maturities than B-rated securities.

US High Yield Key Rate Durations: Ba- Versus B-Rated Credits


Leveraged loans: Take advantage of relatively sluggish valuations

Leveraged loans did not trade off quite as much as high yield assets did in the fourth quarter but have also been slower in recovery, as investors have become less concerned about potential interest rate hikes.


Leveraged Loan and High Yield Cumulative Retail Fund Flows (Q4 2018 to Date)
A dramatic shift toward a more dovish Fed tone has led to more demand for fixed-rate products and waning demand for floating-rate products.

Leveraged Loan and High Yield Cumulative Retail Fund Flows (Q4 2018 to Date)


Loan retail fund flows have been negative for every week so far in 2019, though this has been partially offset by the consistent formation of new CLOs. In response to the lower overall demand, loan supply is also down 40% year to date, resulting in more balanced market conditions that limit a further rise in risk profiles.


Institutional Loan Volume Versus CLO Issuance (USD Billions)
Despite retail fund outflows, the bid for loans from CLOs remains strong and has kept loan prices relatively stable.

Institutional Loan Volume Versus CLO Issuance (USD Billions)


This rebound lag has resulted in a valuation advantage compared with most other fixed income segments to capitalize on the loan market’s potential diversification benefits and senior secured position in the capital structure. Significant new loan issuance post crisis has substantially grown the market to $1.1 trillion – up from $400 million in 2006 – much of which is in larger, liquid names.

Defaults have also continued to trend lower, although leverage has recently ticked higher in aggregate, with risk rising on the margin but still far from being highly elevated. Much of the segment’s leveraged buyout issuance growth has been in the technology and services sectors, where higher free cash flow generation and strong long-term growth prospects arguably make somewhat higher debt-to-enterprise values not unreasonable.

Another hot topic in the financial press is that most new issuance has come to market without maintenance covenants, though we do not see this necessarily as an area of concern with the generally larger syndicate credit profiles of many of today’s issuers. Ultimately, credit investing is not about selecting good covenants but about selecting strong credits.

We have been reducing exposure to cyclical industrial names given concerns about manufacturing weakness and favoring more defensive industries such as consumer staples, even as high valuations in these sectors have made us a bit selective with new additions.

CLOs: Take advantage of higher yields and potential entry points

CLOs are created by the securitization of leveraged loans, structured by selling 150 to 350 different loans into a special-purpose vehicle, with notes from the most senior tranches offering the strongest credit enhancements. These assets offer the potential for significant yield pickup, and the higher tranches tend to attract a conservative investor base.

Until recently, CLOs have also lagged other credit markets in recovery due to the combination of a strong level of new issuance and weaker demand. (The introduction of new risk retention regulation in Japan, while ultimately exempting CLOs, has softened demand among Japanese banks.) And as interest-rate expectations have declined, there has also been a shift among certain US investors away from floating-rate CLOs toward fixed-rate bonds.

The net result has been that spreads across the capital structure, particularly at the top and bottom of the CLO stack, have remained stubbornly wide.

CLO spreads currently offer a material yield advantage compared with similarly rated corporate bonds. This is partly a reflection of the segment’s complexity, as well as a general misunderstanding of the asset class. Higher-rated securities have generally outperformed of late and can make more sense for investors interested in de-risking or who have a preference for the investment grade space.

Finally, market dislocations may also offer opportunistic entry points into lower-rated B credits to add total return potential. For example, B-rated CLO spreads are currently around +975 basis points, providing a material premium to corporate bonds.


CLO Relative Value: US CLO Spreads Versus Corporate/High Yield LIBOR OAS
CLOs offer a material pickup in spreads compared with similarly rated corporate/high yield bonds.

CLO Relative Value: US CLO Spreads Versus Corporate/High Yield LIBOR OAS


Asset allocation outlook

In terms of relative valuations, our current view is that neither high yield nor lower-rated investment grade corporate securities are particularly appealing, but both are still a better place to be than government bonds or higher-quality investment grade credits overall.

The Fed’s shift toward a much more dovish stance should continue to provide support for higher risk assets. Hence, our general bias is supportive of credit risk toward the below-investment-grade segment at the moment, but that is shifting more to a neutral outlook given our marginally defensive stance. We also are being more cautious in cyclical sectors, particularly industrial capital goods.

Valuations in leveraged loans and CLO tranches appear to offer superior risk-adjusted return value right now. However, defaults could be higher in the leveraged loan segment versus the high yield bond market in the next broad default cycle due to the rise in loan-only capital structures.

Issuer overlap has declined to low levels below 40%, and the average corporate rating (not tranche rating) is now lower in the loan market than in the high yield market. Both of these trends point to the importance of conducting thorough research within these segments.

Keep in mind, though, that relative valuations can change frequently. Investors wishing to take advantage of these ongoing changes may want to group similar or adjacent asset classes in a more opportunistic manner rather than investing in discrete asset classes to take potential advantage of these price and risk/reward movements.

Strong opportunities for active management

We continue to find solid long-term investment potential in the leveraged finance segments. High yield corporate bonds, leveraged loans, and CLOs can all continue to deliver attractive relative performance in a slow-growth economic environment.

Overall fundamentals remain solid, and most of the fears around potential issuer excess appear largely unwarranted for the time being. This has translated into a generally constructive, if slightly more conservative, positioning outlook, given the current late stage of the economic and credit cycles.

In this climate of increasing dispersion, leveraged finance markets continue to provide active managers compelling areas to generate alpha. There can be wide variations in relative yield, valuations, and risk/reward characteristics, not only when comparing segments but also when evaluating individual credits within each segment.

Security selection and sector allocations can all be effectively used to construct beneficial portfolio biases based on issuance, cyclicality, and leverage and interest coverage trends to enhance overall risk/reward characteristics and strengthen outperformance potential.


Leveraged Loan Spreads by Sector (Last 12 Months)
Wide variations across sectors and individual credits create a compelling opportunity for active managers.

Leveraged Loan Spreads by Sector (Last 12 Months)


High Yield Issuer OAS Versus OAS Duration
Not all segments of the high yield market are equal – select issuers have positive dynamics and sector outlooks.

High Yield Issuer OAS Versus OAS Duration


Nevertheless, the fourth-quarter selloff in these assets offered a fire drill of what an extended market downturn may look like. While our overall fundamental outlook supports higher risk exposure, the current juncture is when investors tend to overreach.

Now is not the time to extend risk with only a modest carry pickup nor to go for the catalyst-driven situation where upside/downside risk are equally matched. Instead, emphasize business models that work in all parts of the cycle, not just under ideal conditions.

Disclosure:

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