Masterclass: TCW Exclusive Credit Outlook - December 2020

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  • 54 mins 03 secs
Four fixed income experts share their outlooks for 2021 focusing on investment grade, high yield and bank loans. They discuss the overall corporate credit landscape, evaluate the impact of COVID-19 on credit, and share some of the sectors they find most compelling.

  • Drew Sweeney, Senior Loan Trader, TCW
  • Jerry Cudzil, Head of Credit Trading, TCW
  • Steve Purdy, Head of Credit Research, TCW
  • Tammy Karp, Senior Credit Trader, TCW

TRANSCRIPT:     Masterclass: TCW Exclusive Credit Outlook - December 2020


Jenna Dagenhart:  Welcome to Asset TV. You're watching an exclusive TCW Masterclass. We're here for a fixed income discussion focused on credit as we close out what's been a very volatile year with COVID-19. We'll cover all aspects of credit markets, investment grade, high yield and loans with four senior members of TCW's credit team. Jerry Cudzil, Head of Credit Trading. Steve Purdy, Head of Credit Research. Tammy Karp, Senior Credit Trader. And Drew Sweeney, Senior Loan Trader.Jerry let's start with how TCW views the overall corporate credit landscape right now, and how you think about portfolio construction. Where does the best relative value lie between investment grade, high yield and leverage loans? Where does an investor go for yield today?

Jerry Cudzil:   That's a great question, and as we look at the market today, we take a step back. And as often it happens in risk markets, prices tend to lead the fundamentals. That's exactly the situation we find ourselves in today. The prices are leading fundamentals. They've led fundamentals early in March and April when we saw significant spread widening. We have seen significant remediation throughout the summer and the fall. We find ourselves almost back to pre-COVID levels. When we think about the market, we always ask ourselves, what's priced into the market today? What risks are we being paid to assume? I think it's a really interesting time in the marketplace. Because what we've seen is prices remediate. We've seen fundamentals deteriorate at the same time. Ultimately, our base cases, we expect a recovery as we enter 2021, but we think prices may have come too far too fast. What we've seen is a significant fundamental recovery in certain sectors, healthcare and hospitals and pharma, and we expect to see cyclical follow-through as well as we enter next year. But it's not to say that all sectors will be immune and we expect the bifurcation and the K-recovery as we like to call it to continue. There will be disproportionate winners and there'll be disproportionate losers. As we think about the market, we think about portfolio construction, we'd recognize two things.One is that spreads have remediated significantly and quickly. Two is that central banks are extremely accommodative and we expect them to remain so for quite some time. Always we have to ask ourselves, what are the prospective returns, and the prospective returns will be informed by the spreads by the starting investment spreads. As we think about it today, we can't do that blindly because we understand that the feds will be supporting the markets. There'll be holding rates low. That should remove volatility. Ultimately, what we are doing currently is reducing exposure in our portfolios and trying to get ourselves into more defensive posture.

Jenna Dagenhart:  I'm glad you mentioned monetary policy, Steve. How do you think about technicals created by central bank policy versus fundamentals of companies grappling with the COVID impact?

Steve Purdy: It's just a fascinating time in the markets. Because we've never seen a more significant collapse in GDP, which is having tremendous impacts on the fundamental of companies, but that's being offset by something else we haven't seen, which is the sheer scope and size of the policy response, both in terms of low rates, acid purchases, and even on the legislative side, when it comes to fiscal stimulus. These two factors are very significant and you have to be cognizant of how they impact each other. As rates go to zero and investors start to reach for yield, which means they're willing to accept a low return for more risk. That is a positive from the corporate side of the balance sheet, where companies have to finance themselves at lower rates, and that frees up cash flow to deploy into the business and to assist the recovery. Ultimately, the fed is trying to bridge these corporations to a better time when we get a vaccine and the health virus receipts, or the pandemic receipts, and we think ultimately the majority of companies will get there. But the landscape will look very different at that period of time. Because while liquidity is plentiful now, structural changes are occurring in each of these industries, which will leave some companies in a positive position when we come out of the pandemic, and others in a highly-leveraged and more limited capacity position going into 2022.

Jenna Dagenhart:   The market has remediated in spectacular fashion, Jerry. What's your view on the current valuations in the outlook for perspective returns?

Jerry Cudzil: The market has remediated very quickly and maybe what we should do, just to put some numbers around it so we can understand how quickly the market's remediated is just do a quick review of where we were and where we've come. As we think about, as we entered 2020, we had investment grade spreads at plus 90, and we had high yield spreads at approximately 300. As we moved into late March and early April, we had investment grade spreads touch 340 basis points and we had high yield spreads trade out to 1,000. Quickly as we move through April and May and as we saw Central Bank step in with accommodative policy and government step in with fiscal support, what we saw is access to capital re-open. We saw companies raise a significant amount of liquidity and we saw the capital markets re-open and we saw spreads begin to remediate.

Jerry Cudzil: That happened very quickly. As we sit here today, we find ourselves with corporations that are more highly levered, but we also find ourselves with spreads that look very similar to where they did when we entered the year in 2020. As we think about prospective returns, we try to answer that question, have we come too far too quickly, what we would say is the capital markets are open and they've remained open for corporations. That's good news. If the capital markets have bridged this liquidity gap for companies. What we would also say, we recognize is that leverage is higher. The risks in the marketplace are higher. And what we would say is we think prospective returns will be challenged as we enter 2021. We find ourselves now with investment grade spreads and plus 95 in an investment grade yields at sub 2%. As you sit here today, the high yield index is yielding about 4.3%.

Jerry Cudzil: Prospective returns are always informed by, and a lot of times constrained by your initial yield and your initial spread. It will be very difficult in our opinion, to get any significant nominal return in credit as we look at 2021. Having said that, we're in a world where $17 trillion of debt is yield below zero. As you think about returns, you have to think about returns in the context of the world we find ourselves in today, and 2% returns for investment grade debt and four and a half percent returns for high yield might not look so bad in a world where it's very difficult to find returns that are above zero.

Jenna Dagenhart:  That's a great point. Steve, what sectors are most compelling right now? And what about most concerning? For example, how do you evaluate theaters, cruise lines and other sectors hit especially hard by COVID.

Steve Purdy:  COVID has been an utterly unique recession. In most recessions, all companies are negatively impacted. It's only a matter of scale. But in the COVID recession, some companies have actually been very positively impacted, and it creates this world of the haves and the have nots, where we have people benefiting and then other companies suffering. We certainly bifurcate the investing universe in that way, and then we go a step further to ask ourselves for the haves and the have nots, which of these are benefiting on a temporary basis and which are being more impacted by structural trends that we think will continue to accelerate after the virus has receded.The things that we're focused on really are E-commerce. It's been around for a long time but it's accelerated dramatically as the older cohort has shunned going to purchase goods in person. That favors packaging and logistics businesses, and really hurts retail, particularly small box retail, mall and other commercial real estate assets. We think we've all been surprised by how effective work from home has been.

Steve Purdy:  That's a positive for technology and telecommunications companies that provide solutions for work from home. And it's a negative for commercial real estate, restaurants, other things that we purchase on our way to work, let's say groceries or gasoline. It's also a big negative for the outlook of business travel, which has an impact in a number of different sectors. Lastly, we believe that at-home entertainment will continue to be positively impacted. Streaming, telecom, cable, media businesses that fit that niche will be benefited, while there are certainly be some cohorts are more reticent to fly, more reticent to go to concerts and things of that nature. 

Steve Purdy:  To your question about the COVID impacted sectors, nobody knows what the path of the virus is and how willing people will be to take health risks as they consider spending their money in purchasing goods. The best we can do is just do a number of scenario analysis, where we look at these sectors individual companies and outline an upside case, a base case, a downside case, where we're literally modeling out different trajectory of recoveries. Then once we've done that, we look at the impact of the securities in terms of leverage or a free cashflow available for the debt, the creditors, and those things really guide us to figuring out what's good risk and reward. We really try to avoid companies that we think will default or run out of cash in those more aggressively downside scenarios. Hopefully by doing that scenario analysis, we can select securities with appropriate risk reward for our portfolios.

Jenna Dagenhart:  How would you say the pandemic has affected corporate fundamentals, Tammy. What's been the impact on the overall quality of the investment grade index, so this is the high yield index?

Tammy Karp:  I would say for IG credit, the pandemic has definitely had a negative impact on fundamentals. Firstly, the recession triggered by the pandemic has definitely had a negative impact on earnings. We've seen EBITDA fall on the one hand, and at the same time we've seen companies issue record amounts of debt. When you put those things together, we've seen net leverage actually increase our estimations anywhere from 0.3 turns to half a turn. Clearly, the fundamentals have been worsened by the pandemic, and keep in mind that it's worth noting that this comes at a time when heading into this year, heading into the pandemic, corporate was already at peak levels. Instead of using the last 10 years to deliver the balance sheets, companies have actually levered up, and that's partially the result of a very accommodative central bank system around the world that has enabled companies to borrow on the cheap. 

Tammy Karp: Just to put some numbers around it, 450 billion of the IG index, of the debt and the IG index was downgraded just this year alone. That's 6% of the market. 1 trillion of debt in the credit index is now low triple-B. That's 13% of the IG credit market, so these are very big numbers. Then of that 1,300 billion or 30% of low triple-B debt is on negative outlook by at least one rating agencies. Again, these are pretty amazing statistics in my opinion, but the bottom line is that the index today is lower rated, it's higher lever. It's also a lot longer than it was. When you put all these things together, the market, when you quality adjust it, the spreads are actually much closer to the all-time types than they are even to the cycle types.

Steve Purdy:  On the high yield side. Obviously leverage has increased because EBITDA has contracted. But what investors need to consider is that the makeup of the index has actually changed a lot because we had such a one high default cycle, and a number of the worst companies fell out, particularly in the energy space. We also had a number of fallen angels, which actually increased the quality of the index because they were bringing better balance sheets from their investment grade history. It really is important for investors to focus on what companies are in the index, and it's not easy to compare what an index looked like a year ago in the high yield side, given the change in the makeup.

Jenna Dagenhart: Investment grade corporations have raised record amounts of debt and also build up large amounts of liquidity. How do you think companies will deploy that cash in 2021?

Tammy Karp: Well, that's the million-dollar question. We've had record supply as we noted. So far this year, investment grade corporations have issued 1.8 trillion in debt, which dwarfs the previous record, I think, which was in 2017. Yes, they've issued a lot of debt. The good news is that if you look at corporate cash balances, they're at record highs.I think they're over 2 trillion in cash on their balance sheets, which is up, I think, around 25% versus last year. That's definitely a positive. The question is now, what will companies do with all that cash? If you look at history, is any indication, over the last 10 years when the economy was relatively sanguine, companies did not use all the cash and all the free cash flow to deliver. In fact, we saw just the opposite. Leverage kept increasing, going into this pandemic as companies took advantage of historically low rates to fund M and A, to buy back shares, to pay for dividends. 

Tammy Karp: I really I'm not sure how companies are going to use that cash going forward, and it'll be interesting to see if they use that cash to deliver. But at the end of the day, I think also investors will have to hold their feet to the fire. If investors are complacent and they don't demand that companies use that cash to deliver, then I'm not sure there's much of an incentive for those companies to do that. I think a lot of it will also depend on the investment community, and how much they penalize companies for not delivering. 

Jenna Dagenhart:  We saw a record number of fallen angels in 2020, but most occurred in the second quarter. Steve, what's your outlook for further downgrades to high yield?

Steve Purdy:  No, we've been focused on that triple-B minus part of the market for years now, because it has ballooned in size. We quite frankly thought there would be a large amount of fallen angels. What we did not expect was the pace and the catalyst that the pandemic provided to create such an enormous downgrade wave that occurred in the second quarter. I would say surprisingly, we found a number of fantastic opportunities given the technical dislocation when certain investors are forced to sell those securities as they transitioned to the high yield market. It really provided great opportunities for investors on a return perspective, for sure. I think a lot of that downgrading was pulled forward, if you will, because of the severity of the sell off, and the immediacy with which the federal reserve stepped in to demonstrate its desire and capability to assist companies and individuals get through this very tumultuous time. 

Steve Purdy:  It would not surprise offs as we get a bit of a holiday, if you will, in terms of the downgrades. But as we emerge into the 2021 economy, I think it will become clear that certain companies will not be able to achieve the de-leveraging that they're hoping to, and that will lead to a bit of an echo boom, if you will, in downgrades as we go into the second half of '21.

Tammy Karp: I could just put some numbers around it. There've been 190 billions of fallen angels this year. Debt that's fallen out of the IG index into the high yield index, which is about 2.3% of the market. Obviously that's a record number, a huge number. I don't think anyone thinks next year will be as big. But Steve Purdy noted, when you have 300 billions of low triple-B debt, that's on negative outlook in the index, certainly we could see another big year of fallen angels. 

Jenna Dagenhart:  Does it surprise you that spreads have tightened so much while virus cases are spiking? How do you think new lockdowns will impact businesses?

Steve Purdy: We've been made pretty clear for the fed that they want to be supportive and to quote, bridge companies through the health crisis. Now that we have a vaccine on the horizon, I definitely think that investors believe that we now have a pillow on the healthcare side that can give us some optimism of the long-term. Definitively, the rise in cases is having an impact on businesses. We're hearing in real time from airlines that near-to-home bookings have actually decelerated quite rapidly. 

Steve Purdy:  As governments implement new regimes and orders to withstand or contain the spread of the virus, this just adds more uncertainty for businesses when they think about how to invest for the future of their companies. But from an investor standpoint, if they believe that companies have enough liquidity to make it through safely to the second half of 2021, they can now rest a little bit easier that we will get past the worst of the health part of this.It might be in the second quarter of next year or maybe even after, but beyond that, we should get back to a more normalized environments. The balance sheets that can withstand that amount of time should be reasonable investments in terms of returning principal. 

Jerry Cudzil: I would make one comment about that, and I would just say that the reality is that the fed liquified the financial system and the fed put a support, put a floor, if you will, into risk assets. I would say we're not surprised about the remediation and a high quality credit. That makes a lot of sense to us. I'd say where we maybe are a little bit surprised is the market's willingness to continue to provide liquidity to maybe some sectors that are directly impacted by COVID. Clearly the vaccine has helped a lot, and so the market is, there's this tug of war going on in the marketplace right now between the fundamentals as they exist today, and maybe the uncertainty around how we exit or how we reenter, and as we think about the prospective fundamentals of credit. Really, when you think about the back end of the credit markets, they've begun to outperform in a really significant way as we move through October and November, and that to us is a bit surprising.

Jenna Dagenhart:  What about ESG? What have we learned about the resilience of ESG during the pandemic?

Steve Purdy: There's no doubt that if anything, the pandemic has actually increased the focus on ESG. There are some who have used the term 2020 being a green swan event. I think that's probably taking it a little bit far. But if anything, the pandemic has revealed how important ESG issues can be. I would also say, particularly United States, the S has really come into focus. Normally people focus on the environmental and the governance issues, but social issues have become a very real dialogue in this company, and that has worked its way into every corporation. It's also worked its way further into the hearts and minds of investors, particularly of a younger cohort, just getting more involved in investing, and over time will be a larger part of in the investing universe. 

Steve Purdy: This has been met by management teams, we're happy to say, who have been a lot more forthcoming about their views, and even given a lot more statistics about ESG metrics that we focus on, than they ever have in the past. All of this means that ESG will continue to be a large part of all investing, and for us at TCW, it always has been. It's just been nice to see a lot of reciprocation from markets and from management teams as they help us work our analysis into our value investment philosophy.

Jenna Dagenhart: What policy issues do you think will be important for investors in 2021?

Steve Purdy: I think the elephant in the room clearly is, the government just spent a lot of money, for good reason in the form of stimulus. But ultimately, we're in a new leverage regime and we need to figure out what the policy solution to that is going to be. That might not be a 2021 debate, but that really extraction from markets by the fed and finding a way to generate revenues to bring down that overall leverage on our government balance sheet is going to be the number one focus for the next four years, at least.Smaller ticket items or sectors, we didn't get the blue wave that some in the market were predicting you're going to get, but we do have a democratic president. We have a mixed legislator and we'll see what happens in Georgia. Then we have a more conservative court. All of which makes a pretty interesting environment from a policy standpoint. 

Steve Purdy: From a sector focus, healthcare will continue to be in the lens because of drug pricing, potential appeals of ACA, and then just support for hospitals and CARES Act type programs going forward. Technology is also likely to be in the cross hairs as we contemplate various regulations, which has quite frankly, bipartisan support. Those are two sectors we focus on. Then there's some other broader issues that are not going to go away. China, how we think about tariffs, intellectual property and global trade will stay on the forefront. Then taxation is going to be a critical focus item for both individuals and at the corporate level.

Jenna Dagenhart:  Like most risk assets Jerry, high yield bonds have tightened significantly from March and April and are approaching pre-COVID levels as you mentioned earlier. Given the high levels of default and economic uncertainty, do you think the investors being compensated appropriately to invest in high yield bonds?

Jerry Cudzil: That's always the question we ask ourselves, are we being compensated appropriately? Jenna, you referenced the default rate in the high yield market. We've had proximately six and a half percent default rate in the high yield market on a year-to-day basis. But I think the part of that doesn't probably get spoken about enough is just how low recoveries have been. Recoveries in this cycle had been about 15 cents on the dollar and unsecured high yield bonds. If you think historically over time, recoveries have been approximately 40. Clearly what you're doing is just introducing more loss into the marketplace. Six and a half percent default rate implies potentially a much higher default rate if you were to think about introducing higher loss.

Jerry Cudzil: The question then ultimately is what are your expectations as you move forward, as we move forward in this environment of uncertainty and tighter spreads and lower yield, do we think we're being compensated to invest it in the marketplace and what are our expectations really for volatility or default? I say from a default perspective, right now as we look at the marketplace, we talked about it, the central banks are being extremely accommodative. Only about 1% of the high yield market trades below 70, a little bit less than that actually at a market value basis trades below 70, and it's approximately about 2% on a market value basis trading below 70. 

Jerry Cudzil: Thinking about prospective defaults, we look at securities trading below 70 cents on the dollar of trade outside of 1,000 on a spread basis, to think to companies that might be vulnerable to default and what the marketplace is anticipating might be more vulnerable to a default. We're looking at a really small cohort. That 2% number was 25% back in March and April, so there's been significant remediation in the marketplace or expectations for default in 2021 are significantly lower than they were in 2020 in the base case. Clearly there are plenty of scenarios that could play out that could increase that number.

Jerry Cudzil: As we think about the second piece of that, which is higher volatility, clearly with tighter spreads and significant lower yields is 4.3% yield on the high yield index, you don't have the ability to absorb a lot of volatility. I think what we've learned is even though central banks are accommodated, we've seen plenty of scenarios where accommodative with central banks don't necessarily preclude spread widening. What we would think is spreads may remediate faster. Ultimately, spreads may not go back to the wides that we saw in April of this year, the end of March of this year. But we don't think you're being paid to absorb a lot of volatility either. What we are doing is shifting our portfolio to a more defensive posture to reflect some of the lack of ability to absorb volatility and loss as we move into next year.

Jenna Dagenhart: Given this volatility, the recovery rates and default expectations, everything we just talked about, how are you approaching the high yield bonds market today?

Jerry Cudzil: Well, I'd say there's a few things. What we would say is we recognize and appreciate the central bank support. And we recognize how powerful that can be and what that can mean for prices. What we would also say is our portfolios always are supposed to be informed by prospective returns. When you look at yield and you look at spread at the index level, it's very difficult to get excited about moving out the risk spectrum in the high yield marketplace today.

Jerry Cudzil: What we are seeing though, what I would say is we are seeing a handful of organic idiosyncratic opportunities in the marketplace. Even though we've seen significant remediation, we've seen significant spread tightening, there certainly are still a number of scenarios, either indirectly impacted by COVID, or dealing with their own idiosyncratic liquidity situations or otherwise, where we have found opportunities in the marketplace. As an active manager, that's exciting. You get to gravitate toward areas of dislocation, underwrite that situation and say, are we being compensated appropriately for that? And that's fun. 

Jerry Cudzil: I would say what we also have to do is recognize that in a world with lower yields and tighter spreads, and knowing that we cannot afford to absorb as much loss as we could investing back in March and April, we were supposed to be more defensive. That does begin to push us into a more defensive posture. We do slightly favored bank loans today in the portfolio than we did. Rates are we think as low as they're going to go.

Jerry Cudzil: And so ultimately, we think bank loans would benefit in that scenario. They are first lien or top of the capital structure. Honestly the whole market is dealing with a weak covenant issues. That's not just a bank loan issue, that's a bank loan in a high yield market issue. From a relative value standpoint, we think bank loans represent a little value. Then as we think about the marketplace from a sector standpoint, we're beginning to move back to some of the non-cyclical sectors, and that's going to bring us toward areas that Steve mentioned earlier, which are technology, communications, it's going to move us back into subscription-based recurring cashflow companies, and that's going to move toward paper packaging and the like. 

Drew Sweeney: Just to follow up on the idiosyncratic opportunities, in the loan universe, there's a much larger buyer base that is rating sensitive. We've seen a lot of that where back in March and April were rating agencies, prospectively downgraded loans with the expectation that certain businesses would do poorly. Then interestingly, some of those businesses didn't do poorly.It could be a fast-food restaurant whose EBITDA march has improved dramatically because now all of a sudden they were just working at a to-go window as opposed to indoor cafeteria area as well. When we've seen that improvement, the agencies haven't actually been very active about upgrading those loans. 

Drew Sweeney: When you have a demand base that's largely sensitive to ratings, and as loans got downgraded to something like a triple-C where they're no longer available to much of the buyer base, then those are provided real opportunities for those who are a little bit more indifferent about the actual rating.

Steve Purdy: On high yield from a credit research perspective, I think our approach really hasn't changed. It comes down to, are we going to get paid back our principal and interest? And in high yield, that risk is always really much higher than other asset classes. We've been very focused on cash flows and in a timeframe when prices were very low, as Jerry mentioned, you're getting compensated for taking a more risky cashflow stream. Obviously now, the market has rallied back significantly, but there are certain businesses that still have very risky cash flows. If you're in the cruise industry, the theater industry, there are a number of the leisure industries or the airplane industry, you still have no free cash flow. Although securities prices have run, we've stayed focused on underlying free cash flow and the ability to get repaid, and that is leading us to take our portfolios more up in quality as we're just simply not being compensated for some of these more risky sectors.

Jenna Dagenhart: 2020 saw record high yield bond issuance. Any conclusions to draw from that. What are your expectations for 2021?

Jerry Cudzil:  We saw record credit issuance in 2020. We saw record investment grade issuance of over 1.8 trillion, as Tammy mentioned earlier. Then we saw over $400 billions of gross issuance in the high yield market dwarfing any other time in history, and now over $160 billion in net issuance in the high yield market as well. What can we conclude from that? Well, I think the first thing we can conclude is that clearly the capital markets were open and providing capital for high yield companies. 

Jerry Cudzil:  Second is if you look at where that insurance came from, what we think is companies did the right thing. Companies needed liquidity, they're determining out their debt opportunistically, but they also raise cash and they brought some cash onto the balance sheet. The question we always ask ourselves, and Steve mentioned it earlier is, we're always looking at liquidity in the high yield market. The high yield market is, companies are vulnerable to the capital markets closing in a much more significant way than the investment grade companies are. So we have to be mindful of the quiddity, especially in times of volatility. We spend a lot of time in March and April and May asking ourselves about our leverage finance portfolios. 

Jerry Cudzil:  The first question we would always ask around any of these companies is what is the liquidity profile? How long can this company deal with a hit to their revenue? How long can a company deal with zero revenue in the case of maybe the airline industry or the cruise industry. The capital markets were open, companies put cash onto the balance sheet, they extended out their liquidity. Then ultimately, now the question is, well, what are companies going to do with that cash? To the extent that we have a vaccine, to the extent that there's an economic recovery, and to the extent that earnings recover, well companies have a higher amount of liquidity, and our expectations for 2021 in our base case is that the economy will recover. Is that earnings will recover as well, and companies will begin to use this cash in a number of different ways. 

Jerry Cudzil:  I think Tammy said it best. If history is any guide, what you will see is companies use that cash toward dividends, toward buybacks, toward merger and acquisition activity. What we would say is in the high yield market, we would expect higher merger and acquisition activity. We would expect those companies to be a little bit more aggressive with that cash. Maybe the right way to think about the high yield market as we look at leverage, because clearly there's two different metrics when you think about how much debt a company is carrying. Is that gross number, but it's that net number if you take away that cash. The reality is we think the companies are going to spend that cash, and maybe the right way to think about leverage on these corporate balance sheets is to think about a gross number, which probably doesn't look half as attractive. But we don't think companies are vulnerable. We think the capital markets clearly are open and we expect companies to be a little bit more aggressive with their cash in 2021.

Jenna Dagenhart: Looking to 2021, what are your thoughts on high yield bonds returns and defaults?

Jerry Cudzil:  Well, we started talking about this a little bit. When you look at the high yield market and 2% trading below, 2% of the market trading below 70, clearly the market is telling you there's not as much stress as when 25% of the market was trading below 70 cents on the dollar back in March and April. It's funny because it's a lot easier to invest in the market when 25% of the market trades below 70.There's two ways to de-risk your portfolio. One is to upgrade, go higher in quality or reduce your exposure. But they say the second way is to buy bonds and lower dollar prices. That's one way to de-risk a situation. You could invest at lower dollar prices because you can only lose as much as you invest. Our expectations as we move in 2021 are significantly lower default. Six and a half percent defaults in the high yield market this year. 4% default in loan market this year. We would expect those numbers to be probably on the magnitude of about half. 

Jerry Cudzil: We don't know, we don't spend our time forecasting default, but what we would say is the markets remained open, corporations have bridged the liquidity gap, the economy most likely will recover, and we think that that bodes well as we move into '21, forecasting a lower default rate. As we think about returns, well, we've said this a number of times and we'll continue to emphasize, that prospective returns are a function of starting investment spreads and starting investment yields.When you're entering investments in the high yield market at four and a half percent, it's going to be really difficult to out earn that yield in 2021 in the high yield market. What we would imagine is that in 2021, your base case return for high yield is somewhere between four and 5%. But I think the reality is that you're probably looking at a 4% return for high yield. Again, we don't spend our time forecasting, but we would just say that informed by our starting prices and yields, that's how we think about the market today. 

Steve Purdy:   I would say one of our core themes going into 2021 is that the economy we're going to see next year is going to look very different than the economy we experience in 2019. One of the real big shifts that we're seeing is that larger national companies, which have greater scale have taken tremendous amounts of market share as a lot of their smaller competitors have gone out of business. But high yield market is home, not surprisingly to the smallest companies that are in the public traded bond space. We do believe that dispersion at the issuer level will continue, and we're most concerned and focus on those smaller businesses, which are seeing market share a road, and while they might have runway from a liquidity standpoint, it might become clear they cannot grow into their capital structures as we get into the latter stages of 2021. That's where the vulnerability is really light from the credit research standpoint.

Jenna Dagenhart: Drew, returning to you, is the recovery in bank loan process sustainable? 

Drew Sweeney:  Yeah. I would start out by saying it very much is sustainable, but there are a lot of assumptions embedded in that. First of all, you have to consider the fact that bank loans have run up. We've had two of the best or two of the top 10 quarterly returns in the history of the bank loan market. We've had price appreciation, considerable price appreciation in the back half of the year already. Then second of all, along the lines of what all the other speakers touched upon, there are fundamentals and then there are valuations. If you think about valuations, in the loan market just like the other risk markets, they're looking through. Investors are looking through the pandemic. They're saying this is largely transitory. When we get to the other side, something will be there.

Drew Sweeney:  It's interesting, valuations are looking through it. When you walk down the street, obviously on main street and anywhere else, you can see that businesses are closed. You could say on one hand, the market's priced to perfection. But on the other hand, then you can look around and say, how much room is there to run it. Jerry touched and Steve touched on high yield quite a bit.If I think about bank loan, valuations and I say, loan yields are all in five and a half percent and the three-year discount margin is 522 basis points and the high yield OAS is 400 basis points, you think on a relative basis, bank loans still have a lot to go. 

Drew Sweeney:  Then finally, if I think about loan prices, the average price is still below 95 and prices are pretty good indication of health of the loan market because bank loans or refinance bullet par at any point. When they're trading below par just means there's a disruption of some sort. So when I think about it and I think, okay, below 95, 65% of the time since 1992, bank loans have traded above 95, I think you're saying that there's room for... There's certainly room for run and there's certainly room for these levels to hold.

Jenna Dagenhart: What's your opinion on the credit quality in the bank loan market?

Drew Sweeney:   It's an interesting question because there's a variety of ways you can look at this. First I would say, a lot of people look at covenants. The bank loan market 15 years ago is largely dominated by maintenance financial covenants. Today that's largely transitioned to more high yield bond style covenants, incurrence covenants. That's generally a weaker form of covenant. Second, you look at leverage and you say, leverage, well, it's pretty close to the all-time high so that's clearly a negative as well. Then generally, the credit agreements are also weaker. You look at those three things and you'd say, okay, there are some weak points about the bank loan market. But I think I'd be remiss if I didn't highlight the fact that when you look at the bank loan index today, there are over 400 borrowers with a billion dollar term loan. These businesses are much larger than they were 20 years ago.

Drew Sweeney:  In fact, when I would finance a business in the early 2000s, I was often looking at a commodity-driven business or a metal forger, or a tier three auto supplier without a leading market share. The businesses that come to the loan market today, they often have large market shares, they have billion dollar UBITs, nearly a third of them have a billion dollar traunch. All in all, I'd say these businesses are bigger and better than they were than the peers in previous years. Then there are of course weaknesses within the covenants. Then finally, one thing to address within the leverage itself, the composition of the index has changed dramatically over the last 20 years.

Drew Sweeney:  When you think about technology now represents 13 to 20% of the bank loan index, depending on which one you're looking at, and these businesses sometimes are trading at 20 times multiple. A private equity group will come in and buy them out for 20 times. We're seeing these businesses leverage seven times, which seems a lot by a historic metric. But the private equity groups are putting in 13 times of equity cushion below us.On a relative basis, I think you have to adjust what that leverage means when you think about, well, this technology company has recurring revenue. It has 40% EBIT down margins. Plenty of free cash flow to service their debt, versus maybe something I looked at 20 years ago that was four and a half times levered, but worth five or six times. I think my point is, is really, I think the bank loan universe today is much improved from what we saw decades ago.

Steve Purdy: In terms of credit quality in the bank loan space. I would echo the fact that these businesses are much larger. And we found that that gives them a far superior access to capital than they ever had in the past. The growth of private credit and other opportunistic pools of capital has really give optionality to these businesses that is far greater than we've ever seen, and is particularly germane during a pandemic period like we're seeing now.

Steve Purdy: Where companies might have a couple of very difficult quarters as they adjust the realities of COVID. But as long as they can get access to capital to bridge that period, investors stand not to lose all their principal through a default or a one-time quote knockout of the option. That's been a huge benefit that we've to the loan market over the last three or four years.

Jenna Dagenhart:  How are issuers evaluating the loan market versus the high yield market?

Drew Sweeney:  I think from an issuer point of view, it's an interesting question. Because if I'm an issuer, it's usually a CFO, a treasurer, or it could be the private equity group, that's driving the process, and they're going to look at a few different things. They're going to one, look at cost of capital. Then two, they're going to say, what are our real business needs? 

Drew Sweeney: If you look at cost of capital and you're a strategic business that thinks rates are very low today, and you want to lock in a 10-year rate, then you're probably going to talk a little bit to the high yield market. If you're a private equity group and you're buying a platform M and A which you plan to do other acquisitions with, and may refinance the deal over the next three years as well.And/or you may look to take cashflow and pay down debt regularly because bank loans are callable after the first six months at any time are. If you need flexibility within that balance sheet, then you're probably going to toggle over to the bank loan market. It really is driven by both cost of capital and business needs. Then some of this was touched upon, but I think it's also interesting if you're an investor looking at the two markets.

Drew Sweeney: You go through the bond math and you say, okay, loans are have a three-year discount margin of 522 basis points. Do they have room to run, which is a more interesting space to invest in. But I think people need to understand the difference between the two indices as well. Back in 2012, there was a 70% overlap between bank loans and high yield. To all the points that were brought up earlier, we've seen a lot of fallen angels, we've had a large default rate within the high yield index this year, calling off maybe some of the weakest participants. It also has a large percentage of energy borrowers within the space. 

Drew Sweeney: That's very different than where the loan index is, where it has very few energy borrowers within the space. Then there's been an increase of loan-only deals. This will happen in two forms. One you'll either see an increase on a stretch first lien bank loan, or you'll see a first lien and second lien, and that really removes the need to have that high yield bond piece too. When you're looking at the index and when you're looking at investing in either index, it's important to look at, yeah, what do you think the return profiles are? But it's also important to say, what are the real constituents of these two markets and where do I want to be involved? 

Jerry Cudzil:  I would add One further point, which I think is probably worth noting, is that over the last 18 months, we've seen significant outflows out of the loan market. Part of what's moved companies from the leveraged loan market to the high yield bond market potentially is the demand component. What we could potentially see with inflation expectations increasing as we move into an economic recovery and supportive Central Bank, we could see money flow back into loans for the first time in a couple of years. 

Jerry Cudzil: You don't need to look back very far, 2013, '14 and '15, when you saw significant inflows into the leverage loan market. Where you saw leveraged finance companies toggle between the high yield bond market and issue in the leverage loan market. They would opt to not issue a secure high yield bond but they would issue a leverage loan.We've seen the exact opposite take place over the last two years, where companies have not issued a leveraged loan but they've issued a secured high yield bond. That's as much probably a function of the demand as anything as well. What we would say is inflows into the leveraged loan market might cause issues also to reconsider, because to Drew's point, it really is just a cost of capital question for an issuer. 

Jerry Cudzil: If that cost of capital is more attractive than the leveraged loan market, and that company has more flexibility to pay that debt down at any point in time, well then you might find more issues opportunistically issued in the loan market.

Drew Sweeney: Interesting to Jerry's point, November was the first month that we saw inflows to the retail inflows to the leverage loan market in 2020 and actually we'll be on that.

Jenna Dagenhart: As we wrap up this panel discussion, Drew, what's your outlook for bank loans in 2021 and what are your expectations for default and recovery rates? I know we touched on it a little.

Drew Sweeney: Right. I'll start in reverse with the default rate. The last 12 month default rate for bank loans is 3.9%. There's usually a shadow default rate that we can track. We do see in the near term over the next couple of months, you'll see default rates go a little bit higher over the next few months. But by the time you get to the end of 2021, the expectation is that you'll see a much lower bank loan default rate. As Jerry highlighted earlier on, the six and a half percent high-yield default rate, and as that remediates, because bank loans didn't have as big a purge of the lower quality issuers in 2020 that high yield did, you could actually see the two default rates right on top of each other. You could see something where bank loans are declining from current levels, but not declining at the same rate that high yield default rates are declining. 

Drew Sweeney: Then in terms of recovery rates for defaults, I think if you have inflows into the retail loan market, and you have an expectation that bank loan defaults are declining, and there's just a ton of capital chasing these restructured opportunities, I think my expectation would be to see recoveries higher than they have been for the last 12 months where they've been very low. For bank loans, the historical bank loan recovery is around 68 cents on the dollar. This year in the last 12 months, it's been 47 cents on the dollar. I would expect those recovery rates to improve, but because of some of the weaknesses within the credit agreements, I don't see them returning back to 68 cents on the dollar.

Drew Sweeney: How that flows through to bank loan returns for this year, I think I always start out with coupon, and then where do we go from here? Coupon at 4% and rates at zero. Essentially, the federal funds rate at zero and were 22 basis points. And yields around five and a half percent. If we continue to see inflows into the market because of some of these items that we've talked about previously, I think you'll end up looking at a yield plus type year, a five and a half to 6% return for the year.

Jenna Dagenhart: Steve, moving forward, any final thoughts on your end from a credit research perspective?

Steve Purdy: It's been such a volatile year where we've seen terrifying wides and now quite confident tights. I think 2021 will obviously have more in store for us from a dispersion standpoint. And that credit fundamentals and volatility will remain. And focusing on bottom up credit selection continues to be what we think is the best path forward in a market like witnessing now where we have such wide dispersion in terms of fundamentals.

Jenna Dagenhart: Well everyone, thank you so much for sharing your time and your insights. Really great to have you.

Drew Sweeney: Thank you so much.

Jerry Cudzil:  Thank you, Jenna.

Jenna Dagenhart: And thank you for watching this exclusive TCW masterclass. I was joined by Jerry Cudzil, Head of Credit Trading, Steve Purdy, Head of Credit Research, Tammy Karp, Senior Credit Trader, and Drew Sweeney, Senior Loan Trader. I'm, Jenna Degenhart with Asset TV.


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