high yield and bank loan outlook - october 2013

INVESTMENT PROFESSIONALS

B. SCOTT MINERD

Global Chief Investment Offi cer

MICHAEL P. DAMASO

Chairman, Corporate Credit Investment Committee

JEFFREY B. ABRAMS

Senior Managing Director, Portfolio Manager

KEVIN H. GUNDERSEN, CFA

Senior Managing Director, Portfolio Manager

THOMAS J. HAUSER

Managing Director, Portfolio Manager

KELECHI C. OGBUNAMIRI

Vice President, Investment Research

MARIA M. GIRALDO

Associate, Investment Research

OCTOBER 2013

High Yield and Bank Loan Outlook

Fundamental factors underlying the corporate sector continue to under-score our constructive stance on high yield bonds and bank loans. Although leverage ratios have ticked higher, strong interest coverage ratios and our expectations for continued low default rates help alleviate concerns arising from increased debt burdens in the near term. We believe credit risk should remain benign for the next few years.

Over the past year, the technical backdrop in the loan market has led to meaningful spread compression. Attractive relative value of bank loans and a renewed focus on interest-rate risk have resulted in positive performance driven by record-setting infl ows into loan funds and robust collateralized loan obligation (CLO) issuance. In contrast, fl ows into high yield bond funds have been extremely volatile, contributing to mixed monthly returns. As technical dynamics can quickly change, this may be an opportune time to consider the implications of the increased prominence of retail capital and its potential to exacerbate policy-driven volatility.

REPORT HIGHLIGHTS:

• The U.S. Federal Reserve (Fed) on September 18 announced it would not taper quantitative easing (QE) and reiterated that asset purchases are not on a preset course. This announcement is likely to keep volatility elevated as investors continue to speculate on when tapering might begin.

• Buoyed by $17 billion of infl ows in the third quarter, bank loans rose by 1.5 percent. Amid infl ows of $7.9 billion, the high yield sector posted a third quarter return of 2.4 percent, rebounding from over $10 billion of outfl ows and a negative return of 1.4 percent in the second quarter.

• Recent regulatory changes have caused CLO liability costs to rise by 25 basis points since April 2013. Over the same period, loan spreads tightened by 80 basis points, causing CLO asset-liability spreads to narrow. This reduced arbitrage has led to a slowdown in new CLO origination.

• Since 2008, the retail share of the loan market has grown to 24 percent from 3 percent. The decline in CLO activity may cause the primary loan market to become increasingly dependent on retail demand, a technical dynamic that may induce greater volatility in bank loans.

INSTITUTIONAL INVESTOR COMMENTARY MUNI • HY • ABS • CMBS • RMBS

HIGH YIELD AND BANK LOAN OUTLOOK | Q4 2013

CREDIT SUISSE HIGH YIELD INDEX RETURNS CREDIT SUISSE LEVERAGED LOAN INDEX RETURNS

SOURCE: CREDIT SUISSE. DATA AS OF SEPTEMBER 30, 2013.

■ Q2 2013 ■ Q3 2013 ■ Q2 2013 ■ Q3 2013

SOURCE: CREDIT SUISSE. EXCLUDES SPLIT B HIGH YIELD BONDS AND BANK LOANS.*DISCOUNT MARGIN TO MATURITY ASSUMES THREE-YEAR AVERAGE LIFE.

Leveraged Credit ScorecardAS OF MONTH END

HIGH YIELD BONDS

Dec-12 Jul-13 Aug-13 Sep-13Spread Yield Spread Yield Spread Yield Spread Yield

Credit Suisse High Yield Index 554 6.25% 495 6.18% 499 6.45% 503 6.28%

Split BBB 302 4.16% 277 4.24% 270 4.37% 287 4.28%

BB 376 4.58% 346 4.98% 354 5.28% 362 5.18%

Split BB 442 5.03% 408 5.31% 418 5.69% 429 5.63%

B 566 6.27% 513 6.17% 515 6.41% 518 6.21%

CCC / Split CCC 958 10.21% 797 9.04% 787 9.16% 792 9.02%

BANK LOANS

Dec-12 Jul-13 Aug-13 Sep-13DMM* Price DMM* Price DMM* Price DMM* Price

Credit Suisse Leveraged Loan Index 498 99.86 468 100.11 483 99.70 487 99.52

Split BBB 324 100.53 307 100.24 317 99.92 312 99.81

BB 403 100.38 360 100.48 371 100.11 382 99.84

Split BB 489 100.26 427 100.32 437 99.93 444 99.74

B 560 99.38 502 100.06 518 99.58 523 99.42

CCC / Split CCC 939 99.73 860 98.22 868 98.00 869 97.93

2.0%

0.5%

0.0%

2.5%

1.0%

1.5%

3.0%

Index Split BBB BB BSplit BB CCC / Split CCC

0.1% 0.1%

0.3%

1.5%

1.2%

1.5%

0.8%

2.6%

0.4%

0.2%

0.8%

1.4% 1%

0%

-1%

-2%

-3%

2%

3%

4%

5%

Index Split BBB BB BSplit BB CCC / Split CCC

-0.5%

2.6%

1.6%

2.4%

1.5%

-1.2%

-1.8% -2.1%

-1.4%

-2.0%

3.8%

1.9%


Macroeconomic OverviewFED SPEAK SPARKS INTEREST-RATE VOLATILITY

Speculation on the future of QE dominated fi nancial headlines this summer, causing increased

interest-rate volatility and driving investor demand for low-duration assets. The yield on the

10-year Treasury note hit a two-year high of 3 percent, over 100 basis points above lows seen in

May, before eventually ending the third quarter at 2.61 percent following the Fed’s September

18th announcement that it would not yet begin tapering its asset purchases. In the fi ve-month

period between the beginning of May and the end of September, investment-grade bonds,

Treasuries, and high yield corporate bonds recorded negative returns of 4.5 percent, 2.8

percent, and 0.8 percent, respectively. Bank loans recorded positive performance of 1.2 percent.

The Fed’s decision to not taper QE came amid a cautionary outlook on the U.S. economy,

based on high unemployment, rising mortgage rates, and restrictive fi scal policy. As the

majority of investors had priced in expectations of a modest taper, the Fed’s decision came as

a surprise and caused the 10-year Treasury yield to fall by 16 basis points between the Fed’s

announcement and market close.

The Fed stressed that asset purchases are not on a preset course and remain dependent on the

economic outlook. The Fed’s assertion that it will monitor data “until the outlook for the labor

market has improved substantially in a context of price stability,” lacks specifi city and will likely

keep market volatility elevated in the fourth quarter.

The recent rise in interest rates has been the most violent on record on a percentage basis

and we see evidence of the negative impact that rate volatility can have in the economy.

As rate volatility persists, we believe the next few months will be characterized by a period

of extreme uncertainty.

“As the world awakens to the realization that the damage to economic growth and the housing market caused by higher mortgage rates is more severe than anticipated, we may see interest rates decline further. If retail investors then decide to make withdrawals from fl oating-rate funds or simply stop allocating to them, spreads would have to widen to attract new marginal buyers. While I remain bullish on credit for the cycle, bank loans are becoming less attractive given market dynamics.”

– Scott Minerd, Global CIO

PERC

ENTA

GE

INCR

EASE

IN Y

IELD

FRO

M C

YCLI

CAL

TRO

UG

H T

O T

OP

0 200 400 600 800 1000 1200 1400 1600 1800

CURRENT CYCLE(JULY 2012-PRESENT)

0%

80%

120%

40%

60%

100%

20%

DAYS FROM CYCLICAL TROUGH TO TOP

Previous 16 Cycles

SOURCE: BLOOMBERG, GUGGENHEIM INVESTMENTS. DATA AS OF SEPTEMBER 30, 2013.

HISTORICAL PERCENTAGE INCREASE IN 10-YEAR TREASURY YIELDOver the past 50 years, 10-year Treasury yields have increased more than 20 percent over 200 days a total of 17 times. Studying these cycles, the increase of more than 115 percent since July 2012 is greater on a percentage basis than any other cyclical increase from trough to peak in the past 50 years.


A Fundamentally Stable Credit EnvironmentINTEREST COVERAGE, LEVERAGE RATIOS AND LOW DEFAULT RATES IN FOCUS

In the years following the 2008 fi nancial crisis, a combination of fundamental and technical

factors culminated in an incredible bull run for the below investment-grade market. Since

January 2009, high yield bonds have returned 18.3 percent on an annualized basis, and yields

set new record lows as investors sought income alternatives.

As we approach the latter stages of the credit cycle, investors may wonder whether it is time

to reduce exposure to leveraged credit. Despite the volatility experienced in the third quarter

of 2013, we maintain our constructive stance on corporate credit based on the underlying

fundamentals – primarily, healthy coverage ratios, low borrowing costs, and our expectation

for low default rates.

Leverage, as measured by net debt to EBITDA, declined steadily between 2008 and 2011,

amid the deleveraging cycle that followed the fi nancial crisis. In 2011, leverage in the high yield

sector fell as low as 3.1x, just off the 15-year historical low of 2.9x. Recently, the opportunistic

issuance of debt to lock in historically low borrowing costs has caused leverage to rise to 3.9x,

the same level observed during the peak of the fi nancial crisis.

During previous periods, an uptick in leverage was usually accompanied by a fall in interest

coverage ratios (EBITDA divided by interest expense), signaling a signifi cant deterioration in

credit. Prior to the 2001 recession, leverage among high yield issuers rose to 4.7x as coverage

ratios fell to 2.4x. Similarly, the 3.9x leverage at the peak of the 2008 fi nancial crisis was

accompanied by coverage ratios of 2.9x. While leverage has steadily climbed over the past

two years, interest coverage remains healthy. Today, coverage ratios stand at 3.5x, above the

pre-fi nancial crisis average of 3.2x.

HISTORICAL HIGH YIELD COVERAGE RATIOS

SOURCE: BANK OF AMERICA MERRILL LYNCH. DATA AS OF JUNE 30, 2013.

Although recent data indicate that leverage use continues to climb, the reduction in borrowing costs has allowed issuers on average to improve coverage ratios, which remain elevated from levels prior to the fi nancial crisis.

4.0x

2.4x

3.2x

2.0x

3.6x

2.2x

2.8x

3.8x

3.0x

3.4x

2.6x

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Last: 3.5x


Strong coverage ratios are largely a result of a wave of refi nancing. Over the past fi ve years,

refi nancing higher-coupon debt at historically low interest rates has represented over 55

percent of new issuance. Refi nancing activity has also extended the so-called maturity wall to

approximately six years, with roughly 75 percent of bonds in the Credit Suisse High Yield Bond

Index maturing between 2017 and 2021. (The maturity wall is important because if it coincides

with a lack of liquidity like that experienced in 2008, defaults can spike as issuers are unable to

pay down maturing debt.) A similar story occurs in bank loans, where the average maturity is

fi ve years and 85 percent of the loans in the Credit Suisse Institutional Leveraged Loan Index

mature between 2017 and 2020.

In addition to lower borrowing costs and an extension of the maturity wall, current Fed policy

supports our view that default rates will remain low for some time. Fed guidance has indicated

that the target for short-term rates will remain low at least until mid-2015. Our research shows

that, on average, default rates have remained low for approximately 20 months following the

fi rst Fed rate hike after a sustained period of monetary accommodation. As a result, we do not

expect any meaningful rise in defaults over the next three to fi ve years.

A Review of the Bank Loan Investor LandscapeUNDERSTANDING COLLATERALIZED LOAN OBLIGATIONS

Over the past year, bank loans benefi tted from numerous tailwinds. The combination of strong

fundamentals, attractive relative value and an increased focus on interest-rate risk was the

catalyst for positive momentum in the sector. Over the fi ve weeks between July 22 and August

23, loan fund infl ows set new records, reporting over $1.8 billion of weekly infl ows three times.

Signifi cant interest-rate volatility caused by market uncertainty over possible Fed tapering

helped ongoing positive infl ows into the bank loan sector, which recorded 67 consecutive

weeks of positive infl ows.

As demand for bank loans grew, the CLO market thrived. Over $50 billion has been issued in

the U.S. CLO market year-to-date, with almost $30 billion completed in the fi rst quarter alone.

This year’s total issuance already exceeds full year 2012 issuance. A robust CLO market is

important for loans, as CLOs have historically represented a more sustainable, long-term source

of demand. However, activity in the CLO market has recently begun to decline. We believe it is

important for investors to understand the factors causing this shift.

CLOs issue several classes of liabilities, or tranches, with each tranche varying in level

of seniority, risk and return. Senior tranches are well-insulated from losses due to

overcollateralization (value in the underlying pool of loans exceeding CLO liabilities), excess

spread (interest cash fl ow from the underlying loans greater than CLO liabilities debt service)

and diversion triggers (if loan performance deteriorates, CLO equity cash fl ows are redirected

to retire senior tranches). Owing to these structural protections and historical loan


performance through multiple credit cycles, senior CLO tranches carry investment-grade

ratings. Equity tranches, at the bottom of the capital structure, receive excess proceeds

once debt tranches have been paid off . While typically leveraged 8-12 times, equity investors

assume the most risk, but also enjoy the greatest potential for enhanced returns.

An important metric which equity investors monitor is the asset-liability spread, or the

diff erence between bank loan spreads and the spreads paid on CLO debt tranches. In order to

maintain the economic incentive to originate new CLOs, this arbitrage must exist for equity

investors. As this spread tightens, this diminishes the return potential for equity investors.

Below is a theoretical example outlining the economics behind CLOs.

A WALK-THROUGH OF CLO MECHANICS

1

CLO CASH INFLOW

2

CLO CASH OUTFLOW

3

EQUITY YIELD

CLO invests in $500mm of collateral value and earns 450 basis points income from the underlying loans (referred to as the asset spread).

CLO issues $50mm of equity, the riskiest tranche of the structure. Excess cash is delivered to the equity following financial and collateral tests. This excess cash serves as the basis for CLO arbitrage opportunities.

CLO issues $450mm in debt tranches, representing the CLO liabilities. Total interest paid on the debt tranches equals $15mm.

TOTAL CLO INCOME EXCESS CASH AFTER COSTS EQUITY YIELD

450 basis points x $500mm collateral value =

$22.5mm CLO income – $15mm CLO costs =

$7.5mm excess cash ÷ $50mm equity =

$22.5mm $7.5mm 15%ARBITRAGE OPPORTUNITY

Regulatory changes have caused CLO liability costs to rise this year. New FDIC insurance

assessment calculations treat CLOs similarly to bank loans, triggering punitive risk-based

capital charges for large banks who own even AAA-rated CLO tranches. The new FDIC

insurance assessment rule took eff ect on April 1, 2013, and has caused large banks to demand

higher spreads for CLO investments.

The highest rated AAA tranche often represents the majority of the CLO capital structure.

This year AAA tranches, on average, represent 60 percent of new CLO issuance. Since the

passage of the new FDIC assessment rule, CLO AAA spreads have widened by 25 basis points,

to 140 basis points, resulting in higher liability costs for CLO issuers.

On the asset side, strong demand for bank loans and refi nancings have caused spreads to

tighten. Since the FDIC rule change took eff ect in April, bank loan spreads have narrowed by

80 basis points. As liability costs rise while asset yields fall, the arbitrage in CLOs has quickly

dissipated. Consequently, we have seen a decline in CLO activity from the fi rst quarter of 2013,

when U.S. CLO origination approached $30 billion.


DECLINING CLO ASSET-LIABILITY SPREADS, AAA CLO SPREADS VS. LOANSRecent regulatory changes have led to an increase in CLO liability costs. Combined with spread tightening in the loan market, rising costs compromise the CLO’s ability to generate arbitrage opportunities.

SOURCE: JP MORGAN. DATA AS OF SEPTEMBER 30, 2013.

100 bps

500 bps

300 bps

400 bps

550 bps

200 bps

600 bps

150 bps

350 bps

450 bps

250 bps

100 bps

124 bps

154 bps

160 bps

106 bps

130 bps

Jan-12 Mar-12 May-12 Jul-12 Sep-12 Nov-12 Jan-13 Mar-13 May-13 Jul-13 Sep-13

Loan Spread to Maturity (LHS)Asset-Liability Spread (LHS)

AAA CLO Spread (RHS)

112 bps

118 bps

136 bps

142 bps

148 bps

Caution in the TechnicalsSHIFTING TECHNICALS MAY FORESHADOW INCREASED VOLATILITY IN LOANS

While positive fundamentals should help sustain the credit cycle in the near term, there are

several notable trends that investors should continue monitoring. Particularly, the growing

prominence of retail investors in the bank loan market can contribute to volatility, as we have

witnessed in the high yield sector.

HIGH YIELD BOND MARKET PERFORMANCE VS. HIGH YIELD MUTUAL FUND FLOWS When high yield bond funds recorded outfl ows of over $10 billion in June alone, the high yield bond sector posted a negative return of 2.6 percent, the worst monthly decline since September 2011.

SOURCE: BARCLAYS, CREDIT SUISSE. DATA AS OF SEPTEMBER 30, 2013.

-2.5%

1.5%

-0.5%

0.5%

2.0%

2.5%

-1.5%

-2.0%

0.0%

1.0%

-1.0%

$2Bn

$4Bn

$5Bn

$0Bn

$1Bn

$3Bn

($1Bn)

($2Bn)

($4Bn)

($3Bn)

($5Bn)

WEEKLY RETURN (LHS)

Flows (RHS)

Jan-13 Feb-13 Sept-13Aug-13Jun-13May-13Apr-13Mar-13


In 2011, high yield bonds benefi ted from $14.4 billion in net infl ows from mutual funds,

followed by $23.5 billion of infl ows in 2012. During these years, high yield bonds recorded

positive returns of 5.5 percent and 14.7 percent, respectively. This year, high yield bond funds

experienced volatile monthly fl ows, with the greatest volatility occurring in June, when outfl ows

exceeded $10 billion. In June, high yield bonds posted a negative return of 2.6 percent, the

worst monthly decline in the sector since September 2011.

Year-to-date infl ows of $52 billion into loan funds have increased the retail market’s share of

bank loans to 24 percent. As new CLO issuance slows, we anticipate that retail’s infl uence on

the bank loan market could increase. This has shaped our more cautious outlook on bank

loans as we enter the fourth quarter. We believe that further decline in interest rates may

cause retail investors to make withdrawals from loan funds or simply stop allocating to them,

causing spreads to widen in order to attract new marginal buyers.

PRIME FUNDS AS PERCENTAGE OF TOTAL LOANS OUTSTANDING / NEW ISSUE LOANSBank loan mutual funds, also referred to as prime funds, are becoming a larger portion of the overall bank loan market. In the context of declining CLO volume, we expect retail market share to continue to grow.

40%

0%

20%

30%

10%

35%

15%

25%

5%

$6Bn

$10Bn

$2Bn

$12Bn

$4Bn

$8Bn

$0Bn

PRIME FUNDS AS % OF TOTAL LOANS OUTSTANDING / NEW ISSUE LOANS

CLO / PRIME FUND FLOWS INTO LOAN MARKET

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Q3 2013

12%

15% 15%18%

15%17%

13%

6% 6%

11%

16% 15%

24%

% of Total Outstanding % of New Issue

CLO Prime Fund Flows

$4.8

$0.4

$6.2$6.9

$8.7

$1.8

$8.0$9.0

$2.9

$6.5

$5.0

$10.7

$7.2

$3.9

$6.7

$4.9 $5.0

$7.2$6.8

$8.9

$6.4

$8.9

$5.3

$6.2

Aug-12 Sep-12 Oct-12 Nov-12 Dec-12 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13

$3.4

9% 8% 8%

3%

9%

14% 14%

19%

33%

$0.8$1.7 $1.6

SOURCE: STANDARD & POORS LCD. DATA AS OF SEPTEMBER 30, 2013.


Lastly, in August 2013, Fitch highlighted the use of ETFs as a vehicle for investors to enter and

exit the market quickly during volatile periods. This trend may ultimately be increasing market

volatility. Average daily trading volume for the fi ve largest high yield ETFs rose to $1.5 billion

in June from $470 million in May. Meanwhile, broker dealers that generally provide liquidity in

leveraged credit markets are reducing inventories as they seek to reduce risk and meet new

regulatory requirements. Shrinking dealer inventories at a time of rising retail infl uence could

serve to exacerbate volatility in the leveraged credit market.

Investment ImplicationsWE REMAIN CONSTRUCTIVE ON LEVERAGED CREDIT BUT POSITIONED FOR VOLATILITY

Heading into the fourth quarter, we caution that volatility will likely remain elevated as investors

continue speculating on the future of QE. Investors should use market volatility to selectively

ease into positions that may have become oversold. This year, investors who have employed

this disciplined, opportunistic approach to credit investing have been rewarded. Amidst the

rate volatility that began in May, high yield bond spreads widened to 554 basis points and yields

rose to 7.0 percent in late June despite the fundamental environment for credit remaining largely

unchanged. As of the end of the third quarter, spreads narrowed to 503 basis points, and yields

fell to 6.3 percent. The decline in the 10-year Treasury yield has helped ease short-term interest-

rate concerns and reignited the search for yield in high yield bonds. This positive technical

catalyst may lead to additional spread tightening during the fourth quarter.

Increased opportunistic loan issuance in September has brought net new loan supply to $126

billion for the year, exceeding the aggregate $113 billion of demand from CLO origination

and mutual fund fl ows. If supply continues to exceed demand throughout the rest of the

year, this would represent a signifi cant reversal of the trend observed over the past six

months. Heavy supply weighing on the market would lead to spread widening in order to

attract the next marginal buyer. A continued slowdown in CLO issuance would place greater

importance on retail capital in the loan market. This dynamic would make the loan market

more susceptible to increased volatility given the ease with which retail investor sentiment

can change. Based on the views highlighted above, we believe that high yield bonds will

outperform bank loans in the fourth quarter. While we remain constructive on the sector as

a whole, we would advise leveraged credit investors to increase allocations to high yields bonds.

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high yield and bank loan outlook - october 2013

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