Virtus Senior Floating Rate Fund
2Q 2016 COMMENTARY
BANK LOAN SECTOR ASSESSMENT
FUNDAMENTALS — Fundamentals are likely to deteriorate modestly but remain acceptable given the forecast for positive gross domestic product (GDP) growth, solid cash flow coverage, and still-positive corporate earnings.
TECHNICALS — The technical picture continues to improve modestly, with a slight increase in collateralized loan obligation (CLO) issuance, more balanced retail fund flows, modest net new issuance, and a muted forward calendar.
VALUATIONS — Valuations remain attractive relative to our forecast, which expects defaults to track toward long-term averages over the next year. Going forward, returns are more likely to come from coupon clipping, with more modest total return potential.
IMPORTANT DEVELOPMENTS THIS QUARTER
Overview: On June 23, the United Kingdom voted to end its 43-year membership in the European Union (EU), a historic event that shook markets around the globe. The “Brexit” outcome took markets by surprise as the “remain” campaign appeared to have the edge in the days leading up to the vote. In the immediate aftermath, the British pound plummeted to its lowest level versus the U.S. dollar in 30 years, stock markets tumbled, gold surged, and government bond yields dropped to record low levels. The Japanese yen and U.S. dollar rose as investors flocked to safe havens; oil prices fell on fears of global recession.
But as the quarter came to a close, relative calm returned to the markets. Most equity market indices retraced their losses, the dollar retreated, and oil recovered. The VIX measure of volatility, which spiked on June 24 (closing at 25.76), returned to its second-quarter range in the mid-teens, not quite reaching the sustained highs in the tumultuous first weeks of the year.
UK: The UK ended June in a state of political and economic malaise. Leadership in both major parties disintegrated. Rating agencies Standard & Poor’s and Fitch downgraded UK credit, both citing the deterioration in outlook and the possibility of future downgrades. The pound continued to slump, with expectations that the Bank of England will cut rates over the summer to avert recession. The pound-to-dollar exchange rate fell from the year’s high of nearly 1.50 on June 23 to end the quarter at 1.33.
Federal Reserve: Besides Brexit, investors dwelled on further tightening by the Federal Reserve. In mid-May, signs of strength in the U.S. economy prompted Chair Janet Yellen to state that a rate hike was “appropriate” in the coming months, increasing the probability for June or July. A weak non-farm payroll report on June 3, however, dashed those prospects and clouded the outlook. To no surprise, the June FOMC meeting left rates steady with the looming Brexit vote an additional deterrent. Though the 2016 median dot plot at the June meeting called for two rate increases this year (from an expectation in December 2015 of four), rate hikes are less likely for the rest of the year in the aftermath of Brexit.
U.S. Economy: The U.S. economy continues to be resilient against global headwinds, including the UK’s vote. Consumer spending data remain strong, as does the housing sector. Gross Domestic Product (GDP) grew at an annual rate of 1.1% in the first quarter, below the 1.4% growth recorded in the fourth quarter of 2015. Inflation remains below target but has accelerated modestly over the past 12 months. Core PCE (personal consumption expenditures ex food and energy) is 1.6% versus the Fed’s 2% goal. Future job growth, however, is key to reinforcing U.S. economic strength.
Treasuries: The yield on the U.S. 10-year Treasury ended the quarter at 1.47%, down from 1.77% at the end of March and 2.27% at year-end 2015. Foreign buyers have had a huge impact on the Treasury market as investors have sought not just safe havens but also yield in a global negative rate environment. In the wake of the UK referendum, Fitch Ratings reported that the global total of sovereign debt with negative yields rose to $11.7 trillion as of June 27.
U.S. Dollar: The U.S. dollar zigged and zagged throughout the quarter (Bloomberg Dollar Spot Index), ending at a level close to where it started but roughly 5% below the January high. The greenback has been on a downward path in 2016 though spiking in mid-May on anticipation of higher rates and in June on the Brexit outcome.
China: Fears of a sharp slowdown in China have faded but have not gone away. Recent economic data have been soft (e.g., fixed asset investment), and the International Monetary Fund (IMF) has warned that the country’s massive corporate debt burden is a “key fault line” in the economy. The People’s Bank of China intervened to devalue the renminbi against the surging U.S. dollar following Brexit. Though it was not to the extent expected, it did raise the specter of the sudden and disruptive devaluation in August of 2015.
Oil: Oil prices continued their upward trend. Brent Crude, the international benchmark, topped $50 per barrel in early June before ending the quarter at $48.21. Supply disruptions in Canada (wildfires) and Nigeria (militant activity on oil infrastructure) helped to boost prices, as did a decline in inventories and U.S. shale production.
GLOBAL FIXED INCOME PERFORMANCE SUMMARY
The broader U.S. bond market, as represented by the Barclays U.S. Aggregate Bond Index, returned 2.21% for the second quarter. Despite the volatility and uncertainty surrounding the Brexit vote, spread sectors outperformed U.S. Treasuries as spreads tightened.
High yield corporates was the best performing sector, posting its fifth consecutive month of positive returns since the sharp selloff in the early part of 2016. All of the industries within high yield ended the quarter with positive results, led once again by energy and metals & mining, which posted double-digit returns. On a quality basis, CCC-rated securities continued to be the best performers. Overall, the sector benefited from the rally in commodity prices, a more dovish Fed, major central bank easing, and favorable technicals.
The emerging markets sector also performed well. Emerging markets were relatively stable following the Brexit vote, suggesting that the event was less systemic to global financial markets than previous events in recent history. Though greater fallout may yet occur, the emerging markets stand to benefit from a continuation of low U.S. interest rates, easing on the part of major central banks, and their potential to generate income in a yield-starved environment.
Outperformance of longer duration assets contributed to the gains in investment grade corporates while dampening the performance of bank loans, which have inherently shorter durations.
LOAN MARKET PERFORMANCE SUMMARY
Leveraged loans, as measured by the S&P/LSTA Leveraged Loan Index, posted a gain of 2.92% in the second quarter of 2016. This exceeded the 1.55% gain in the first quarter, and was the best performance since the third quarter of 2012.
The loan market rebound that began in March – after a period of nine consecutive monthly losses that brought valuations into the high 80s – continued into the first two months of the second quarter before pausing in June on Brexit-related concerns. Improved risk sentiment in the loan market was driven by the recovery in commodity prices, more dovish central bank policy, moderately better U.S. economic data, and much-improved loan market technicals.
In a reversal of the prior quarters’ performance, areas that were heavily beaten up during the sell-off, such as lower quality paper and the commodity industries, led returns during the second quarter’s risk rally. Defaulted, CCC, and second lien paper were up 16.43%, 9.77%, and 8.45%, respectively. The safe havens of the past months underperformed, with BB paper lagging but up a still solid 1.73%. Energy and metals & mining led the rally with double-digit returns. Only about 12 of the 39 industry groups in the S&P/LSTA Index outperformed the overall index return during the quarter.
To put loan market performance into context, loans underperformed high yield (+6.35%) due to lower beta. They modestly underperformed investment grade bonds (+3.41%) and the 10-year Treasury (+3.03%) as a result of a lack of duration in a falling rate environment.
Loan market technicals continued to strengthen in the second quarter as institutional demand improved sequentially, with CLO issuance almost doubling from the first quarter, a continued high level of loan repayments, and diminished retail outflows.
For the quarter, net supply, as measured by loan index outstandings, increased by only $1 billion. The quarterly average had been $16 billion over the last two years. At the same time, visible demand rose to roughly $16 billion, resulting in a supply deficit of roughly $15 billion. Despite a pickup in issuance toward the end of the quarter, net supply was down as repayments were elevated.
Mergers and acquisitions (M&A) activity led to several large repayments including Jarden, Ntelos, Truven, and Staples (whose deal was blocked). Second quarter gross issuance totaled $86 billion, an increase of 112% from the first quarter, but mostly on opportunistic volume such as refinancings and repricings that did not add much net new supply to the market.
CLO issuance picked up during the quarter, with $17.5 billion pricing in the second quarter, up from the $8.2 billion that priced in the first quarter. The market for both senior and mezzanine CLO liabilities continues to improve alongside the recovery in loan market prices. This remains well below last year’s pace of about $24 billion per quarter, but is a positive sign. Future issuance over the next few quarters is likely to remain at lower levels due to new risk retention laws going into effect around year-end, as well as a lack of collateral stemming from light net new loan issuance.
Retail loan fund flows improved substantially in the second quarter, with a positive month in May and manageable outflows of only $700 million in the second quarter, down from the $8.2 billion outflow in the first quarter. The improving macroeconomic backdrop and technicals led to an increase of $1.69 points in the average price of the loan index to $93.20 at quarter-end.
Broad market fundamentals continued to deteriorate modestly, but remained acceptable as the S&P/LSTA index default rate by number increased to a five-year high of 2.22% at the end of June from 1.93% at the end of March. The five defaults during the quarter were up from the three defaults in the second quarter of 2015, but down from the 10 defaults in the first quarter of 2016. Defaults remain below the long-term average of 2.8% and are concentrated in the troubled energy and metals & mining sectors. It does not appear as though the default activity is spreading to other sectors, although stress looks to be increasing in the retail sector due to changing consumer preferences. Supportive fundamentals include adequate first quarter earnings, strong but slightly deteriorating cash flow coverage of interest, a diminished maturity wall, and expected positive U.S. GDP growth over the next few quarters.
HOW THE FUND PERFORMED
Solid credit selection in the energy industry contributed positively to returns.
Underweights to the underperforming retail, diversified media, and information technology industries were all additive to the Fund.
Our high yield allocation added value.
Remaining fully invested with the modest use of leverage contributed positively.
Our up-in-quality bias and underweight to higher beta credit detracted from performance as risk rallied during the first two months of the quarter.
An underweight to the metals & mining and energy industries contributed negatively to Fund returns.
Issue selection within the utility industry was a drag on performance.
CURRENT FUND STRATEGY
The Fund ended the second quarter of 2016 with 92.60% invested in senior secured first lien bank loans, 3.92% in non-first lien bank loans, and the majority of the remaining exposure in high yield bonds as part of our liquidity strategy.
Focus on quality but with a modest downward shift: During the second quarter, we made a modest pivot in the Fund’s risk position given the more attractive valuations after the sell-off early this year, improving technicals, and a better overall risk environment.
The Fund is still positioned with an overall up-in-quality bias, though we added to risk at the margin through several changes. First, we brought the Fund to a more invested position by adding a modest amount of leverage given our favorable view on technicals. Second, we added higher quality credits that were trading at a slight discount. Third, we closed our underweight to the energy sector. Finally, we revisited our investment thesis on credits we initially passed on, but which have become more attractive on a relative value basis given discounted levels after the recent sell-off. The net result for the quarter was about a 2% increase in the Fund’s exposure to the lower quality credit tiers, a slight increase in exposure to high yield, and a modest use of leverage.
We are comfortable with our liquidity position, cautiously monitoring it and considering it daily in managing the Fund. We see the current vintage of new loan transactions as aggressive, and are passing on a substantial number of new deals. We continue to have an underweight to the single B and below credit tiers in the aggregate, given our view that the market is in the later stages of the credit cycle, and our concerns about global growth.
Industry over/underweights: During the quarter, we increased our weightings to the utility, energy, and financial industries as we rotated some of our exposure out of the higher quality and overweight industries such as healthcare and gaming.
Some of the largest industry overweights in the Fund are to the housing, healthcare, and cable industries.
The largest industry underweights are to the information technology, diversified media, and retail industries. Retail and diversified media continued to be disrupted by new technology and changing consumer preferences regarding online retail.
We have moved to a market weight in the stressed energy sector due to the improvement in energy prices. Our slight underweight to the metals & mining sector at 0.7% reflects the stress in the commodity sector, including metals and coal.
The outlook for leveraged loans remains constructive based on several factors:
still-attractive valuations (even after the recent recovery with spreads just outside the long-term average),
acceptable fundamentals, and
the recent rally in rates that positions loans well in a yield-starved environment.
Valuations remain attractive relative to our forecast for defaults to track toward long-term averages over the next year. Going forward, returns are more likely to come from coupon clipping, with more modest total return potential.
The average index dollar price of $93.20 is somewhat deceiving due to bifurcation in the market. This is evident in the average index price by credit tier: BBs are at $98.80, Bs are at $94.80, and CCCs are at $77.40. Fundamentals are likely to deteriorate modestly but remain acceptable given the forecast for positive GDP growth, solid cash flow coverage, and still-positive corporate earnings.
The technical picture continues to improve modestly, with a slight increase in CLO issuance, more balanced retail fund flows, modest net new issuance, and a muted forward calendar. The main risk in the short term is a reversal of technical trends.
After adding credit risk at the margin to take advantage of cheap valuations earlier in the year, we are now taking a pause after the loan market rally that started in late February. The Fund’s current risk positioning has improved relative performance. Our bias remains to keep portfolios up in quality with adequate liquidity. Longer term, we remain focused on the aging credit cycle and the increasing trend of weaker and more levered capital structures. We have thus taken steps to upgrade the Fund.