Elissa Johnson, Portfolio Manager and secured loans specialist within the Secured Credit Team examines the level of dispersion in leveraged credit markets and questions whether average market spread levels are becoming increasingly meaningless.

 

Despite the news headlines being dominated by talk of macroeconomic recession and slowing growth, trade wars and, in the UK, Brexit, leveraged credit markets (high yield and loans markets in Europe and the US) continue to perform well.

In this review, we look at the level of dispersion in these markets and question if average market spread levels are becoming increasingly meaningless. Is there a hidden flight to quality, which is a sign of problems to come, or are markets offering significant value in certain investments?

The search for yield

Table 1 shows the total return for each of the four main leveraged credit markets (hedged to euros). Returns have surpassed expectations, especially in high yield with many markets posting significant positive capital returns year to date. The strong performance of interest rate-sensitive assets over floating rate loans reflects how the trajectory for rates and inflation expectations has fallen over the course of the year.

Table 1: total returns in leveraged credit markets

European loans European high yield US loans US high yield
Total return, % ytd 2019 4.2 8.4 3.3 9.0

Source: Janus Henderson Investors, Bloomberg, Credit Suisse, as at 30 September 2019.
Note: Loans: Credit Suisse Western European Leveraged Loan Index and US Leveraged Loan Index. High yield: ICE BofAML euro high yield and US high yield indices. Data in euro.

Past performance is not a guide to future performance.

The main drivers of the returns have been:

  • the search for yield — with over US$15 trillion of fixed income securities offering a negative yield, together with compression of spreads in peripheral government bonds and investment grade credit markets, investors have looked for yield elsewhere
  • weak returns generally in Q4 2018 created a springboard — especially for high yield and US loans, with a subsequent recovery in 2019 as investors became comfortable with the macro backdrop and central bank support
  • limited issuance in some markets (so far in 2019), as shown in table 2

Table 2: issuance levels in leveraged credit markets

YTD September 18 issuance, bn YTD September 19 issuance, bn % change
European loans €68.10 €52.70 -23%
European high yield €44.30 €35.20 -21%
US loans $318.50 $221.00 -31%
US high yield $134.40 $163.90 22%

Source: Janus Henderson Investors, Barclays Capital, as at 4 October 2019..

Index spreads — meaningful or not?

As credit markets delivered strong returns this year, focus also increased on the index spread (or yield) offered by credit markets, and just how meaningful that is. Investors, particularly in loan markets, cannot buy the index spread of the market, and we would actually question if you would want to at this point in the cycle.

Dispersion is a measure of how much of the market, by asset value, trades within a certain range around the average of the market. We have chosen to review the percentage of the market that is trading outside of +/- 100 basis points (bp) of the average spread of the market, using average spread to worst for high yield and median 4 year discount margin for loans.

The results make for interesting reading.

Chart 1: dispersion in leveraged credit spreads

Source: Janus Henderson Investors, JP Morgan, Credit Suisse, as at 30 September 2019.
Note: Loans: Credit Suisse Western European Leveraged Loan Index and US Leveraged Loan Index.
High yield: JP Morgan data for Europe and US
Average spread to worst for high yield, median 4 year discount margin for loans

Past performance is not a guide to future performance.

Chart 1 shows that all four markets (loans and high yield, in Europe and the US) point to a rise in dispersion over the past 18 months or so. This period has coincided with a weakening of investor protections through looser documentation standards in these markets and rising leverage for the average leveraged finance deal — not surprising given the search for yield and subsequent levels of demand.

Therefore, perhaps it is to be expected that some credits are starting to see mark to market losses as highly levered companies are clearly more sensitive to a slowdown in earnings. An underperformance of expectations on deleveraging, and rising risk due to fewer covenant protections, needs to be matched by a rise in the expected returns, which can only be met through falling prices.

Our economic adviser is optimistic that economic growth may be bottoming in Q3 Q4 2019 but signs of a turnaround remain elusive. While monetary signals suggest that a recovery in 2020 is possible, it is by no means guaranteed and we could continue to see weaker data for the time being. This suggests that corporate earnings may still be subject to negative pressure — including the services/consumer sectors, which to date have been buoyed by high levels of employment and reasonable wage growth (eg, in the US and Germany), potentially leading to a further rise in dispersion and distress ratios in credit markets.

Are credit markets showing signs of distress?

A high level of dispersion suggests a rising distress ratio and this is exactly what we see. Chart 2 shows the percentage of the market that is trading with a spread of more than 750bp. However, the level of distress remains reasonably benign today, although the trend is clear. Given the macroeconomic outlook, particularly with employment rates in key geographies beginning to fall, we expect this ratio to rise further across all markets, albeit not to anywhere near the levels seen in the Global Financial Crisis when almost the entire market was in distressed territory.

Chart 2: leveraged credits trading with spreads of over 750bp

Source: Janus Henderson Investors, JP Morgan, Credit Suisse, as at 30 September 2019.
Note: Loans: Credit Suisse Western European Leveraged Loan Index and US Leveraged Loan Index.
High yield: JP Morgan data for Europe and US.

Past performance is not a guide to future performance.

Is credit friend or foe?

So what does all this data tell us? In our mind, it underlines the case for active management. Rising dispersion and distress suggests that the ‘average’ tells investors less and less and that performance relative to the market as a whole will be increasingly driven by actual credit selection.

It also suggests that the risk appetite of investors may not be all it seems. Although some deals are well bid, many trade at significant discounts to face value (see chart 3). While these discounts persist, it raises the question of value. Is there value to be had or are these credits subject to significant impairment, with restructuring or bankruptcy on the horizon? In this situation there is no alternative to fundamental analysis, including an assessment of governance and loan or bond documentation.

Chart 3: examples of European loans not trading at par

Source: Janus Henderson Investors, Bloomberg, as at 30 September 2019

Past performance is not a guide to future performance.

However, we do not expect a substantial rise in default rates. Like Moody’s, who published their default rate outlook in September, we continue to believe that default rates will remain relatively low, although we expect recoveries to be on average lower than in past default cycles, given the weaker documentation protections for investors in both high yield and loans this time around.

What we do expect, however, is increasing risk of mark to market losses, as companies’ earnings underperform investor expectations and worries that highly levered companies are unable to grow into their balance sheets pervade the markets. In this scenario, selective investment is critical to ensuring delivery of returns over the medium and long term, even in a low default environment.

Chart 4: Moody’s sub investment grade default rates over time

Source: Moody’s, as at 30 September 2019.
Note: Issuer weighted annual default rates

Estimates are  not guaranteed.

Conclusion

With softer macroeconomic growth we have seen distress ratios and dispersion rates start to rise, albeit European loans have seen less to date than other levered credit markets. Complacency should not ensue however. In our view, investors need to be highly selective in their investments to ensure they can benefit from the attractive yields, which are available from leveraged credit investing, without losing returns through mark to market losses on underperforming names.

We continue to believe that a cautious but constructive approach to investing, in both high yield and loans, can continue to provide excess returns for investors and a reasonable level of absolute yield and income in today’s low yield world.