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High Yield Bond and Senior Secured Bank Loan Outlook
KDP Asset Management, Inc. 24 Elm Street Montpelier, Vermont 802.223.0440 [email protected]
October 2015
KDP
This is an analytical piece and the asset classes discussed herein, and any other materials provided to you, are intended only for discussion purposes and are not intended as an offer or solicitation of an offer with respect to the purchase or sale of any security and should not be relied upon by you in evaluating the merits of investing in any securities. These materials are not intended for distribution to, or use by, any person or entity in any jurisdiction or country where such distribution or use is contrary to local law or regulation. Past performance is not indicative of future results. The asset classes discussed herein should not be perceived as investment recommendations and may no longer be in an account’s portfolio. It should not be assumed that investments in any asset class discussed was or will prove profitable. Characteristics, allocations and account quality ratings of any particular account may vary based on investment guidelines defined by the client. The views expressed herein represent the opinions of KDP Asset Management, Inc. and its affiliates and are not intended as a forecast or guarantee of future results. This material may not be reproduced or used in any form or medium without express written permission. Additional information on KDP, including fee schedules can be found in Form ADV Part II which is available upon request.
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The Case for High Yield Bonds
Macro: High Yield Sentiment at Low End of
Historical Range - Recommended Position Higher
Valuation: Spread on KDP Defensive High Yield
Composite is at 2-Year High
Technicals: BBs at Widest to BBBs Since 2011
Source: : KDP, U.S. Department of the Treasury as of 9/30/2015
Fundamentals: Default Environment Remains
Historically Low as Spreads Rise
Source: J.P.Morgan, Default Monitor 10/1/2015
Source: Morgan Stanley, Leveraged Finance Chartbook 9/28/2015
Source: Morgan Stanley, Leveraged Finance Insights 10/2/2015
KDP
High Yield Observations
Fundamentals
• Minimal near-term maturities
• Historically low default rate - excluding commodities - environment due to solid fundamentals and supportive US economy.
• KDP's credit analysts continue to see constructive current metrics outside of certain metal/mining sectors. • Broad refinancing at low rates has pushed interest rate coverage levels higher, further reducing default risk. • Rising leverage levels due to lackluster EBITDA growth and rising new issuance driven by M&A and capital
expenditures. Technicals
• Retail mutual fund flows have been negative for four consecutive months.
• Several large new issues priced at yields much higher than anticipated, causing a broader repricing of the secondary market for Telecoms, Cable and Chemicals.
• Fears of upcoming revolver redeterminations due to oil prices pressuring the Energy sector.
• In recent risk-off environment spreads have widened significantly across most sectors reflecting global growth concerns. • Spreads likely to tighten once volatility ebbs and given high yield’s negative correlation to interest rates.
Valuations
• Wide spreads compared to benign default environment
• High yield carry is very attractive relative to other fixed income asset classes. • Off-the-run credits will remain cheap due to rise in liquidity premiums. • Spreads more than sufficient to absorb anticipated increase in rates. • Short duration high yield outperforming during risk off.
Macro
• Exogenous market shocks and idiosyncratic headline events are the greatest risks for lower quality credits, with large relative spread widening given market illiquidity and low energy prices.
• High yield volatility expected to remain elevated in near-term due to sharp sell-off in oil prices, geo-political risks, global economic concerns, and interest rate uncertainty.
• Minimal inflationary pressures and accommodative monetary policies worldwide bode well for spread products. • Rising Treasury rates in the US remains most significant risk for other fixed income classes.
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The Case for Senior Secured Bank Loans
Technicals: No Maturity Wall
Valuation: Loan Spreads Rise Further in September -
Approach 2-Year Highs
Source: KDP 9/30/2015
Fundamentals: Low Default Rate for Foreseeable
Future
Macro: Loans Remain Top Pick of Respondents For
Risk Adjusted Returns Over Next 12 Months
Source: J.P.Morgan, Default Monitor 10/1/2015 Source: Credit Suisse, Leveraged Finance Strategy Monthly 10/6/2015
Source: BofA Merrill Lynch Credit Market Strategist 9/11/2015
KDP Loan Strategy Composite Adjusted spread to LIBOR - 3 yr. Discount Margin
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Senior Secured Bank Loan Observations
Fundamentals
• Historically low default rate environment due to solid fundamentals • No near term maturity concerns
• Strong balance sheets, as recent rise in leverage levels beginning to stabilize. • Interest coverage ratios remain at post-crisis highs.
Technicals
• Mutual fund flows remained negative for the 4th straight month in September.
• New issuance was $9.5 billion in September which was the lowest issuance since January 2012.
• Strong CLO volume in 2015 combined with subdued new loan issuance is providing a strong tailwind for the loan market. • Liquidity remains good reflecting two-way flow with active secondary trading volume.
Valuations
• Potential for principal appreciation opportunities with only 7.2% of loans trading above par. • Adjusted 3-year loan spreads at YTD high and above long term average.
• Loan volatility remains subdued as they are higher in cap structure and have floating rates.
• Global growth concerns causing energy / metal mining loans to significantly underperform the broader market. Macro
• Leveraged loans widely perceived to have best risk-adjusted return over next 12 months. • Rising Treasury rates remain the most significant risk for most fixed income asset classes. • Floating-rate nature of bank loans provides a natural hedge to an increase in interest rates. • Generally negative correlation to Treasuries and low correlation to other asset classes
