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Loan Market Update

Shedding light on the recent year-end volatility and early 2019 snap back. An opportunity.

-- Frank Ossino, Senior Managing Director and Senior Portfolio Manager, Newfleet Asset Management

In mid-December, there was a high correlation between retail loan fund flows and the U.S. 10-Year Treasury. Thoughts of a more dovish Federal Reserve, and other factors including prolonged trade talks, possible slower growth, and a significant drop in energy markets, resulted in accelerated outflows into year-end. Indeed, after posting $11 billion of inflows by the end of September, retail investors withdrew $14 billion in the fourth quarter, including a record $3.5 billion in the final week of the year resulting in full year outflows of approximately $3 billion.

Chart 1: Prime-Fund Flows (Weekly Reporters Only)

Prime-Fund Flows_Lipper

Source: LCD, an offering of S&P Global Market Intelligence

Chart 2: U.S. 10-Year Treasury Yield

Bloomberg _ U.S. 10-Year Treasury Yield

Past performance is no guarantee of future results.
Source: Bloomberg

Chart 3: WTI (West Texas Intermediate) Oil Price

Bloomberg _ WTI Oil Price

Past performance is no guarantee of future results.
Source: Bloomberg

While retail outflows were heavy, the loan market is now over $1 trillion in size. More importantly, more than half of the market is held by long term, non-mark-to-market institutional investors (collateralized loan obligations (CLOs), in particular) that are not forced sellers to meet redemptions. This creates a ballast for the market. In fact, institutional investors (CLOs) created $5.7 billion in loan demand in December and near $30 billion in demand in 4Q18. Year-to-date CLO demand was a record $129 billion.

Chart 4: Monthly CLO Volume

Bloomberg _ Monthly CLO Volume

Past performance is no guarantee of future results.
Source: LCD, an offering of S&P Global Market Intelligence

The evaporation of demand from the retail investor group negatively impacted prices, as funds violently sold loans to raise cash to meet redemptions.  This is evident in the return profile between BB-rated loans (down 3.50% in 4Q18) and B-rated loans, which were down 3.29% for the quarter.  For the year, BB risk returned -0.42%, while B risk posted a gain of 0.86%, driven largely by the higher incremental coupon relative to BBs.  Mutual funds tend to gravitate toward the larger, more liquid loans for liquidity management purposes and those loans tend to be of higher quality.  Regardless, the repricing of risk was rapid and widespread across all industries, rather than slow and concentrated as we experienced in 2015.  Risk markets, in general, sold off with high yield (HY) and equities both posting negative returns for the quarter (-4.63% and -13.52%, respectively) and the year (-2.26% and -4.38%, respectively).

 

Chart 5: S&P LCD Loan Index Price

Bloomberg _ S&P LCD Loan Index Price

Past performance is no guarantee of future results.
Source: Bloomberg

Chart 6: S&P/LSTA Leveraged Loan Index Quarterly Returns

S&P/LSTA Leveraged Loan Index Quarterly Returns

Past performance is no guarantee of future results.
Source: S&P /LSTA Leveraged Loan Index

In our view, the year-end dislocation was largely technically driven.  Fundamentally, the U.S. macro economy remains favorable and Friday’s jobs print only aids the narrative of a low default, recession-free 2019. Defaults are low (Note: EFH in the table denotes utility company TXU), cash flow is healthy, and balance sheets are in good shape with minimal debt due in the near and medium term.

Chart 7: Lagging 12-Month Leveraged Loan Default Rate (Forecasts Through December 2020)

In our view, the year-end dislocation was largely technically driven.  Fundamentally, the U.S. macro economy remains favorable and Friday’s jobs print only aids the narrative of a low default, recession-free 2019. Defaults are low (Note: EFH in the table

Source, LCD, an offering of S&P Global Market Intelligence

Chart 8: Quarterly EBITDA Growth

Quarterly EBITDA Growth

Past performance is no guarantee of future results.
Source: LCD, an offering of S&P Global Market Intelligence

Chart 9: U.S. Leveraged Loan Maturity Wall

U.S. Leveraged Loan Maturity Wall

Source: S&P/LSTA Leveraged Loan Index

Regarding valuations, we believe the loan market may have been oversold as retail unwound its bet on rising rates and positioned for a slower growth environment by selling risk in generalAt a $95 price (and given the steady increases in LIBOR over the last year), the loan market yield is over 7%. In our view, this represents an attractive dollar cost averaging entry opportunity for long term, strategic investors.  Not only is the floating rate income profile still attractive, but lower prices now introduce a total return element to the asset class that we have not seen since periods such as August 2011’s U.S. debt downgrade, the 2012 Greek crisis, and the 2015/16 oil market declines.  As an aside, with the HY market now yielding 8%, investors, namely pensions and insurance, are re-entering that market as they historically have been conditioned to view these levels as attractive long term. Similar to HY and even institutional loan investors, approaching the loan market as a credit/income asset class, rather than solely an interest rate hedge, could be valuable to retail investors.

Chart 10: Pricing: Quarterly Average All-In Spread of B+B Institutional Loans

Pricing: Quarterly Average All In Spread of B+/B Institutional Loans

Past performance is no guarantee of future results.
Source: S&P Global Market Intelligence

Chart 11: B Rated Loans: New Issue Spread and Yield-to-Maturity

B Rated Loans: New Issue Spread and Yield-to-Maturity

Past performance is no guarantee of future results. Source: LCD, an offering of S&P Global Market Intelligence

Indeed, the first week of January points to investors recognizing the opportunity, including Newfleet, through our multi-sector portfolios.  Scheduled amortization payments introduced much-needed demand back into the asset class as cash repayments are reinvested into loans.  The CLO market also used the opportunity to buy loans at cheap prices to fill out existing and new portfolios.  There is anecdotal evidence that institutional separately managed accounts are also being created at these levels.  Finally, retail fund flows appear to be stabilizing (fewer outflows).  The loan market is up 1.2% in 2019 so far, as retail selling has abated and the new issue primary market remains very light (effectively non-existent at the moment).  Friday (1/4/19), in particular, saw loan prices appreciate quickly, allowing the market to already retrace much of December’s losses with quality loans outperforming lower quality. 

IMPORTANT RISK CONSIDERATIONS: Credit & Interest: Debt securities are subject to various risks, the most prominent of which are credit and interest rate risk. The issuer of a debt security may fail to make interest and/or principal payments. Values of debt securities may rise or fall in response to changes in interest rates, and this risk may be enhanced with longer-term maturities. Bank Loans: Loans may be unsecured or not fully collateralized, may be subject to restrictions on resale and/or trade infrequently on the secondary market. Loans can carry significant credit and call risk, can be difficult to value and have longer settlement times than other investments, which can make loans relatively illiquid at times. High Yield-High Risk Fixed Income Securities: There is a greater level of credit risk and price volatility involved with high yield securities than investment grade securities. Leverage: When a fund leverages its portfolio, the value of its shares may be more volatile and all other risks may be compounded. Liquidity: Certain securities may be difficult to sell at a time and price beneficial to the fund.

 

Bloomberg Barclays U.S. Treasury Index measures U.S. dollar-denominated, fixed-rate, nominal debt issued by the U.S. Treasury. Treasury bills are excluded by the maturity constraint, but are part of a separate Short Treasury Index. STRIPS are excluded from the index because their inclusion would result in double-counting.

The S&P/LSTA Leveraged Loan Index is a daily total return index that uses LSTA/ LPC Mark-to-Market Pricing to calculate market value change. On a real-time basis, the index tracks the current outstanding balance and spread over LIBOR for fully funded term loans. The facilities included in the Index represent a broad cross section of leveraged loans syndicated in the United States, including dollar-denominated loans to overseas issuers.

West Texas Intermediate (WTI) is a crude stream produced in Texas and southern Oklahoma which serves as a reference or "marker" for pricing a number of other crude streams and which is traded in the domestic spot market at Cushing, Oklahoma.

The indexes are unmanaged, their returns do not reflect any fees, expenses, or sales charges and they are not available for direct investment.

Collateralized loan obligation (CLO) is a security consisting of a pool of loans organized by maturity and risk.

Earnings before interest, tax, depreciation and amortization (EBITDA) is a measure of a company's operating performance. 

LIBOR: London Interbank Offered Rate.

Yield spread is the difference between yields on differing debt instruments of varying maturities, credit ratings and risk, calculated by deducting the yield of one instrument from another.

This commentary is the opinion of Newfleet Asset Management. Newfleet provides this communication as a matter of general information. Portfolio managers at Newfleet make investment decisions in accordance with specific client guidelines and restrictions. As a result, client accounts may differ in strategy and composition from the information presented herein. Any facts and statistics quoted are from sources believed to be reliable, but they may be incomplete or condensed and we do not guarantee their accuracy. This communication is not an offer or solicitation to purchase or sell any security, and it is not a research report. Individuals should consult with a qualified financial professional before making any investment decisions.

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