Virtus Senior Floating Rate Fund
3Q 2016 COMMENTARY
- FUNDAMENTALS — Despite modest deterioration, fundamentals remain acceptable given the forecast for positive gross domestic product (GDP) growth, solid cash flow coverage, and still-positive corporate earnings. We continue to have an up-in-quality bias given the later stages of the credit cycle.
- TECHNICALS — The technical picture continues to improve, with a slight increase in collateralized loan obligation (CLO) issuance, the return to positive retail fund flows, modest net new issuance, and a muted forward calendar.
- VALUATIONS — Valuations remain attractive even with this year’s rally. Loan yields are competitive with other fixed income classes and well positioned to produce solid risk-adjusted returns should rates rise.
IMPORTANT DEVELOPMENTS THIS QUARTER
Overview: The third quarter was unusually calm, though it began with fallout from the U.K.’s decision to leave the European Union (EU) and ended with a bout of volatility as investors questioned the efficacy of central bank policy.
Brexit: Bond yields in the U.S., Japan, and across Europe fell to historic lows in early July as investors fled to the safety of bonds based on global growth concerns fueled by the Brexit decision. On July 5, the yield on the U.S. 10-year Treasury closed at a record low of 1.37%.
Markets recovered rather quickly from the initial shock of the Brexit vote, though the British pound continued to slump. Versus the U.S. dollar, the pound fluctuated below 1.34 for the quarter, reaching a low of 1.29 in mid-August. Downward growth estimates led the Bank of England (BOE) to cut its key interest rate for the first time in seven years to a record-low level of 0.25%. The BOE also announced a stimulus program of gilts, corporate bonds, and a bank lending program. Despite encouraging economic releases in August, the U.K.’s future remains uncertain as the disentanglement process from the EU has yet to begin. Filling the political vacuum in Brexit’s wake, Theresa May, the new Conservative party leader, will chart the course.
Global Central Banks: September brought heightened concerns about the ability and willingness of central banks to fight chronic low inflation and weak growth. The decision by the European Central Bank (ECB) to leave interest rates and its stimulus program unchanged was a precipitating factor in a widespread market sell-off, reinforced by fears that the Bank of Japan (BOJ) had run out of quantitative easing tools. Hawkish signals from the U.S. Federal Reserve added to the volatility. The BOJ subsequently decided not to change rates but to shift its focus to stabilizing the long end of the yield curve. This bolstered market sentiment, as did the Fed’s eventual decision to stand pat. The VIX measure of volatility, which spiked on worries over the central banks, returned to its ultra-low levels of 11 to 14, from a high of 28 in February.
Federal Reserve: While the FOMC kept the benchmark rate at 0.25%-0.50% at its September meeting, three dissenters favored a hike. Chair Janet Yellen stated that the case for an increase had strengthened, but the policymaking body was willing “to wait for further evidence of continued progress toward its objectives.” September saw a flattening of the dot plot of the Fed’s medium- and longer-term expectations, which include a single quarter-point rate hike this year and two in 2017. Absent disappointing economic data or negative global developments, the probability of a December rate hike currently hovers around 57%.
U.S. Economy: The U.S. economy was reasonably sound during the third quarter. Gross domestic product (GDP) grew at a greater-than-expected annual rate of 1.4% in the second quarter. Despite stalling in August, consumer spending continues to be the primary driver of growth in the economy. The housing sector remains stable. Non-farm payroll numbers have been solid, though they were soft in August after two strong months. The unemployment rate at quarter-end was 4.9%. Inflation remains below target but has accelerated modestly over the past 12 months. Core PCE (personal consumption expenditures ex food and energy) stands at 1.6% versus the Fed’s 2% goal.
Treasuries: The yield on the benchmark U.S. 10-year Treasury ended the quarter at 1.60%, up from 1.47% at the end of June. However, this is down from 2.27% at year-end 2015. Yields are lower across fixed income year-to-date as global central banks have maintained easy monetary policies. Relative yields in the U.S. are attractive, which has driven demand. Bloomberg reported that, as of September 30, negative-yielding bonds now account for almost $12 trillion. Japan represents roughly half of the total, with the bulk of the remainder from France, Germany, the Netherlands, Spain, and Italy.
Oil: Brent crude, the international benchmark, traded between $45 and $50 per barrel for much of the quarter before closing at $47.41. Off and on prospects of a production freeze by major producers and fears of a global supply glut drove volatility. In late September, OPEC leaders reached an agreement to curb output, but deferred finalization of the terms until their November 30 meeting. Regardless of the outcome, the International Energy Agency reported that the supply/demand imbalance will persist at least through the first half of 2017 given record levels of output by OPEC producers and slowing demand, particularly in China and India.
China: China remained out of the headlines for much of the quarter. Positive economic data releases in August, notably industrial production and retail sales, suggested that China may be on track to meet its full-year GDP growth target of 6.5% to 7.0%. As the quarter came to a close, the Chinese yuan was about to officially join the U.S. dollar, the euro, and the yen in the International Monetary Fund’s basket of reserve currencies.
GLOBAL FIXED INCOME PERFORMANCE
The broader fixed income market, as represented by the Bloomberg Barclays U.S. Aggregate Bond Index, returned 0.5% for the third quarter. Expectations of continued accommodative monetary policy and the global demand for yield resulted in strong performance for credit sectors. These sectors ably outperformed U.S. Treasuries as spreads tightened.
LOAN MARKET PERFORMANCE SUMMARY
Leveraged loans, as measured by the S&P/LSTA Leveraged Loan Index, posted a strong return of 3.08% in the third quarter. This return exceeded the 2.92% gain in the second quarter, and was the best performance since the third quarter of 2012. The third quarter 2016 result brought the year-to-date return to 7.72%.
The loan market rebound that began in March, after a period of 10 consecutive monthly losses that brought valuations into the high 80s, continued into the third quarter despite a brief pause in June on Brexit-related concerns. Drivers of improved risk sentiment in the loan market include the recovery in commodity prices, more dovish central bank policy, moderately better U.S. economic data, and much improved loan market technicals.
Lower quality paper and the commodity industries led performance as prices of loans in these sectors recovered after being heavily beaten down during last year’s sell-off. CCC, second lien, and defaulted paper were up 8.08%, 7.07%, and 6.61%, respectively. Higher quality credit underperformed, with BB paper lagging but up a still-solid 2.24%. Metals & mining and energy were outliers to the upside and led the rally with returns of 15.5% and 9.6%, respectively. 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 (5.57%) due to their lower beta and lower commodity exposure. They outperformed investment grade bonds (1.44%) and the 10-year Treasury (-0.74%) as Treasury yields rose during the quarter.
Loan market technicals continued to strengthen in the third quarter with the return to positive retail fund flows, negative net new issuance, and continued institutional demand that supported a modest sequential increase in CLO issuance.
For the quarter, net supply, as measured by loan index outstandings, decreased by roughly $5 billion (quarterly average increase of $9.5 billion over the last two years). Visible demand rose to roughly $23 billion, resulting in a supply deficit of about $28 billion. Third quarter gross loan issuance totaled $105 billion, an increase of 20% from the second quarter but mostly on opportunistic volume such as refinancings and repricings that did not add a lot of net new supply to the market.
Repayments from mergers and acquisitions (M&A) and bond-for-loan take-outs continued at an elevated level, limiting net supply. Gross M&A new issuance volume has remained fairly muted. We have observed a distinct trend of more aggressive issuance given the excess demand. Negative trends include higher levels of adjustments to cash flow and higher leverage on new issuance. This may result in poor performance down the road in terms of defaults and recoveries for the current vintage of issuance.
CLO issuance picked up during the quarter, with $19.9 billion pricing in the third quarter, up from the $17.5 billion priced in the second 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. The outlook for issuance is constructive for the fourth quarter as managers try to issue deals ahead of the deadline for new risk retention rules in December. Issuance may slow in early 2017 as market participants deal with the uncertainty over the implementation of the new rules.
Retail loan fund flows improved substantially during the third quarter, with nine consecutive weeks of inflows. It was the first quarter of positive flows since the first quarter of 2014. Flows have turned notably positive due to a combination of:
a rise in LIBOR rates due to new money market fund rules,
an increased probability of a December Fed rate hike, and
a backup in 10-year Treasury yields.
The improving macro backdrop and technicals led to an increase of $1.92 points in the average price of the loan index, to $95.12 at quarter-end.
Broad market fundamentals continued to deteriorate modestly but remain acceptable. The S&P/LSTA Index default rate (by number) remained relatively flat from the prior quarter-end at 2.23%. This was close to the five-and-a-half year high of 2.25% at the end of July. Quarterly defaults continued the downward trend, as only two issuers defaulted in the third quarter compared with five defaults during the second quarter and 10 defaults in the first quarter. The declining level of defaults is due to rising commodity prices and wide open capital markets. 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 appears to be increasing in the retail sector due to changing consumer preferences. Supportive fundamentals include adequate second 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, financials, gaming/leisure, and automotive industries contributed positively to returns.
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 hurt performance as risk continued to rally in the third quarter.
An underweight and negative credit selection in the metals/minerals and information technology industries also detracted from performance.
An overweight and selection in the housing industry detracted.
CURRENT FUND STRATEGY
The Fund ended the third quarter of 2016 with 90.6% invested in senior secured first lien bank loans, 3.6% in non-first lien bank loans, and the majority of the remaining exposure in high yield bonds as part of our liquidity strategy.
In the third quarter, we maintained an overall up-in-quality strategy, although we continued to add some risk at the margin. This was a reflection of the improvement in the commodity markets as well as continued healing in the capital markets.
We continue to scrutinize existing holdings to ensure the fundamental thesis is intact and to look for relative value opportunities given the large rally since February. We also continue to review the secondary market for discounted/total return opportunities, and have added several discounted loans to improve the convexity of the Fund.
We have also become more comfortable with oil supply/demand dynamics and certain energy credits in favorable basins with favorable cost structures. As a result, we have closed our underweight to the energy industry through the addition of some energy credits.
In the new issue market, underwriting standards progressively weakened throughout the third quarter. We have noted an increase in leverage, large adjustments to cash flow in marketing transactions, and several non-traditional agents bringing deals to get around Fed leverage guidelines. We see this vintage of new loan transactions as aggressive, so we are passing on a substantial number of new deals.
During the quarter, we increased our industry weightings to the cable, information technology, and food/tobacco industries while decreasing our exposure to the healthcare, services, and housing industries. Some of the largest industry overweights in the Fund are to the cable, housing, and chemicals industries. The largest industry underweights are to the diversified media, retail, and services industries.
The net result for the quarter was an increase by roughly 300 basis points in the Fund’s exposure to the lower quality credit tiers and, to a much lesser extent, high yield. The increase in exposure to single B credit contributed to the solid performance of the Fund in the third quarter. However, 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 balanced with wide open capital markets. We are comfortable with our liquidity position, cautiously monitoring and considering it daily in managing the Fund.
The outlook for leveraged loans remains constructive given a combination of:
still-attractive valuations, even after the recent recovery and with spreads just inside the long-term average,
acceptable fundamentals, and
the recent flattening of the yield curve, which 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. Loans also offer floating rates and much lower return volatility relative to high yield, which sets up the asset class to outperform in either a too hot or too cold economy.
Going forward, returns are more likely to come from coupon clipping with more modest total return potential. The average dollar price for the loan index ended the quarter at $95.12. However, the average price of the index remains somewhat deceiving as evidenced by the average index prices by credit tier:
BBs at $99.96
Bs at $96.75
CCCs at $81.72
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 with a slight increase in CLO issuance, the return to positive 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. We will continue to selectively add credit risk at the margin to take advantage of total return opportunities. The Fund’s current risk positioning has improved relative performance. However, our bias remains to keep the Fund up in quality with adequate liquidity given the later stages of the credit cycle and the weakening quality in new issuance trends.