Leveraged Finance Asset Allocation Insights: An Eventual Tailwind for High Yield?

Fundamentals: For US loan issuers, fundamentals remain largely positive amid greater macro uncertainty. Most first-quarter earnings reported thus far have shown gains, but growth seems less broad-based than in previous quarters. Increased volatility in earnings is expected as issuers continue to face inflationary pressures affecting input and labor costs. Rising interest rates could become an issue for those credits with mostly floating-rate debt and limited free cash flow. While default rates (0.18% as of 30 April 2022) remain near all-time lows (0.15% as of June 2007), the number of stressed credits has increased, and the default rate is expected to rise in the near term.²

Valuations: The spread-to-maturity for the broad S&P/LSTA index widened roughly 61 basis points (bps) to L+466 between 18 April 2022 and 17 May 2022. The weighted-average bid for the market declined roughly 275 bps over the same period.³ New-issue spreads are coming at the wider end of price talk, and although spreads have widened over the last month, valuations seem fair given the increased market volatility. In the near term, sentiment and declining liquidity seem to be overwhelming technical and fundamental factors.

Technicals: Demand for loans has waned recently as new collateralized loan obligation (CLO) formation slowed and retail fund flows turned negative. On the supply side, issuance has slowed as well. Loan issuance through 12 May is on pace to make the second quarter the slowest since late 2020. The forward calendar remains light, and a large portion consists of a handful of transactions.

Fundamentals: We are bracing for earnings revisions after seeing notable weakness in financials, health care, utilities, and restaurants. Results are tracking trends in consumer strength/ sentiment (resulting in increased provisions for credit losses in financials), labor (resulting in margin pressure from staffing costs in health care and restaurants), and inflation (seen in rising energy costs for power generation and for food). Financial metrics remain solid, with leverage trending back to longer-term averages. We expect default rates to remain low in 2022, although risks may rise given tighter financial conditions and a volatile macro backdrop.

Valuations: While most of the rates move has been priced in, tightening financial conditions and high inflation continue to weigh on risk sentiment. Poor equity performance led to option-adjusted spreads (OAS) on the Bloomberg US Corporate High Yield Bond Index bleeding out to the mid-400s in mid-May. Fair-value OAS should be about 350 bps due to solid fundamentals and our 2% default rate forecast. We see value at 400 OAS despite few upside catalysts given the global macro backdrop. BAML said it best with “buy at 450 but prepare for 500+.”⁴ The market’s implied default rate is in the 4% area, and we calculate that attractive, high-single-digit next-12-month returns are coming. But it’s going to take equity stability and more clarity on how tight financial conditions must become for us to get there.

Technicals: April’s outflow was $5.9 billion, and outflows continued in May. Outflows year-to-date (YTD) for high yield (HY) now total $33.8 billion, with $15.3 billion coming out of exchange-traded funds (ETFs). The primary market, at just $57.4 billion YTD, continues to be very light. YTD issuance is down 74% from the $221.8 billion issued for the comparable 2021 period. Technicals continue to gap both ways but are negative on balance due to tightening financial conditions and negative equity prices. (Technicals based on JP Morgan data as of 13 May 2022.)

Fundamentals: Credit risks remain benign for US leveraged loans as loan default rates in the US stayed at 0.2%. Fundamentals for CLOs remain constructive despite market turbulence. Loans priced below 80 increased to 1.6% from 1.5% last month but remain well below the five-year average of 3.5%. Despite the sell-off in May and the projected increase in the US loan default rate to 1.0% and in HY to 0.7%, default rates should remain below historical averages in 2022. (Fundamentals based on S&P/LCD data as of 16 May 2022.)

Valuations: BBBs are at 400 to 700, BBs at 750 to 950, and single-Bs at 1,050 to 1,450. BBB rated CLOs are fair to cheap compared to HY OAS at 455 and BB rated leveraged loans at 390. BB rated CLOs are trading wide of single-B HY at 495 and leveraged loans at 565 on an OAS basis. The three-month cross-currency Japan yen/US dollar basis (now using three-month SOFR rather than three-month Libor⁵) is approximately -34 bps as of 18 May 2022, up about 3 bps over the month, where US dollar assets remain relatively expensive to hedge for Japanese investors. (Valuations based on JP Morgan and S&P/LCD data as of 16 May 2022.)

Technicals: Selling of investment-grade (IG) CLOs has remained elevated the past few weeks, as tracked by bids wanted in competition (BWIC) and the Trade Reporting and Compliance Engine (TRACE). When combined with a concerted push to price primary deals, the forward pipeline has declined amid volatile markets. We anticipate lower BWIC and primary volumes for the next few months until markets stabilize and spreads tighten. Because of the cheapness of CLO tranches relative to other credit across the capital stack, we anticipate an increase in investor bids in the secondary market.

Fundamentals: Recession in Europe this year, starting with the UK, is looking more likely. For now, the eurozone economy continues to be buoyed by demand recovery from fewer Covid restrictions. The crunch time is likely to come in the fourth quarter. So far, first-quarter earnings have been mixed, with inflation having a pronounced effect on consumer durables and the food and beverage sectors. Sufficient liquidity should keep default rates relatively low for the remainder of the year.

Valuations: The market appears to be constantly repricing credit risk in a volatile environment for risk assets. The general sentiment is increasingly negative, pointing to expectations of wider credit spreads.

Technicals: Loans have continuously drifted lower on low volumes. With widening CLO liabilities, most CLO rampers are mainly looking to the primary market for appropriately priced assets; hence the lack of support in the secondary market despite low loan issuance. So far there are no signs of forced selling from separately managed accounts or CLOs. Prices seem to be drifting lower on the back of certain dealers leaking inventory into the market.

Fundamentals: Recession in Europe this year, starting with the UK, is looking more likely. For now, the eurozone economy continues to be buoyed by demand recovery from fewer Covid restrictions. The crunch time is likely to come in the fourth quarter. So far, first-quarter earnings have been mixed, with inflation having a pronounced effect on consumer durables and the food and beverage sectors. Sufficient liquidity should keep default rates relatively low for the remainder of the year.

Valuations: European high yield spreads are wider than for European loans and US high yield, especially in the BB rated space. The wider spreads seem to be justified by the perceived heightening of geopolitical tensions in Europe, which faces challenges in sourcing energy.

Technicals: HY investors remain defensively positioned despite the lack of significant outflows over the past two months. Performance of the few recent new issues clearly demonstrates the bifurcation between high-quality issuers with a proven track record and the rest of the HY universe.

Fundamentals: European leveraged loan default rates declined to 0.6% from 0.8%, and the percentage of loans trading below 80 decreased to 0.8% in April from 1.1%.⁶ That said, the market sell-off in May has increased those percentages given the conflict in Ukraine and China’s zero-Covid policy. The probability of a recession in Europe continues to increase, and we see a commensurate increase in default rates as a result.

Valuations: BBBs are at 475 to 525, BBs at 700 to 900, and single-Bs at 1,100 to 1,300. BBB rated CLOs are cheap relative to BB HY at 375 and leveraged loans, while BB CLOs are cheap relative to European HY at 485 and leveraged loans. European CLOs benefit from a Euribor floor of zero, which adds between 3 bps and 45 bps to the spread of CLOs, depending on the weighted average life. (Valuations data based on JP Morgan and S&P/LCD data as of 16 May 2022.)

Technicals: While market sentiment has improved slightly in Europe, uncertainty given the Ukraine conflict and increased probability of recession still loom. The thin buying base for European mezzanine tranches is proving a headwind for below-IG tranches.

Fundamentals: Our conviction on HY moved slightly higher, in line with IG, given changes in credit trend distribution on the back of first-quarter results. We remain slightly bullish overall given that our total credit trend distribution is still skewed to the positive. Among the 56% of EM companies reporting first-quarter results, revenue was up 15% year-over-year (y/y) and EBITDA was up 20% y/y.⁷

Valuations: Over the last month, CEMBI BD spreads have widened 44 bps, with HY up 69 bps, underperforming IG, which was up 31 bps.⁸ The widening has been a broad risk-off move rather than country specific, as the higher-beta segments have generally underperformed, namely Latin America in IG and Asia and Turkey in HY. While spreads have traded more in range with other fixed-income markets over the last month, we still see value opportunities given the sovereign-driven risk events and strong corporate fundamentals and outlook.

Technicals: Our short-term technical outlook is more positive given the continued cash buildup, due to an absence of significant outflows combined with minimal supply. YTD issuance of $130 billion is down 45% y/y, mainly driven by lower HY issuance, down 79% y/y. YTD net issuance is down $58 billion and could go lower given May’s month-to-date issuance of $5 billion versus $34 billion of scheduled cash inflows. (Technicals based on JP Morgan data as of 16 May 2022.)