CIO's PERSPECTIVE: 1ST HALF 2021 Leveraged Credit Review & oUTLOOK
- Positive returns during the first half of 2021, led by lower-rated segment and sectors hardest hit last year by the pandemic-related mitigation efforts.
- Entering the second half of 2021, tight high yield spreads are being driven by expectations for significant improvement in issuer fundamentals and a very low default rate over next 12-18 months.
- In the current environment, security selection is paramount, as issuers that do not meet current market expectations will likely experience material declines in the price of their bonds.
1ST HALF 2021 REVIEW
The first half of 2021 saw a continuation and/or acceleration of many of the positive trends in both the broad economy and high yield bond market that began towards the end of 2020. First, after a rocky start, the distribution and administration of the COVID-19 vaccination quickly ramped up and is currently ahead of many of the most optimistic forecasts made six months ago (albeit the rollout appears to have somewhat plateaued more recently). As a result, the pace of reopening the economy has also surprised to the upside, which should strengthen the ongoing economic recovery. In March, President Biden signed into law an additional $1.9 trillion COVID-19 stimulus bill, and the U.S. Federal Reserve (“the Fed”) remained committed to accommodative monetary policy. In addition, after the high yield market set a record calendar year in 2020 for both gross new issuance and refinancing volume, the primary market remained very strong in the first half of 2021. More specifically, the first and second quarter represented the largest and third largest quarterly gross issuance on record, respectively, with refinancing accounting for approximately two-thirds of total gross issuance. Notably, the volume of bonds issued to take out and refinance loans with bonds through the first half of 2021 is already almost 90% of the prior calendar year record set in 2012.
Against this backdrop, the fundamental profile of many issuers in the high yield market saw meaningful improvements in the first quarter of 2021, the most recent quarterly data available, a trend that I believe should continue throughout the remainder of the year. In aggregate, high yield market issuers experienced growing revenues as well as EBITDA in the first quarter of 2021, and according to JP Morgan estimates, aggregate EBITDA and revenues in the first quarter for the high yield market as a whole are now above levels generated during the first quarter of 2019 (pre-pandemic). However, leverage for the high yield market in the aggregate remains well above its pre-pandemic level (see Exhibit 3 on page 6 for a chart on leverage), as aggregate outstanding debt is higher than it was before the pandemic while aggregate EBITDA over the trailing twelve-month period includes the sharp declines experienced during 2020. As discussed in more detail below, anticipated EBITDA growth should cause leverage levels to improve significantly by year-end.
From a technical perspective, through the first half of 2021, high yield bond mutual funds experienced consecutive monthly outflows, though such outflows did not approach the level of inflows experienced during the same period last year. Conversely, leveraged loan mutual funds reported six consecutive monthly inflows over the period following over two years of straight outflows that ended in December 2020. In addition, while leveraged loan new issuance in calendar year 2020 did not match the record pace of the high yield bond market, loan issuance has been strong this year with the first quarter representing the second highest quarterly issuance on record.
Furthermore, CLO issuance, which similar to leveraged loan issuance did not bounce back in 2020 as remarkably as high yield issuance, has also been very strong this year. More specifically, the four highest monthly gross CLO issuance totals on record occurred in the first half of 2021. An active CLO market is critical for the leveraged loan market as CLOs are the largest investors in leveraged loans, holding over half of all loans outstanding and serving in the aggregate as the primary buyer in the new issue market.
Finally, over the first half of 2021, investors expressed concern that the accelerating pace of inflation was not simply temporary in nature as the Fed had publicly stated. Moreover, because the Fed was not taking proactive measures to contain inflation, investors feared that more drastic measures would be needed in the future, including aggressive rate hikes that could derail the economic recovery. Largely as a result of these concerns, intermediate-to-longer term interest rates in the U.S. increased meaningfully over the period, particularly during the first quarter.
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