US Credit Update – Will Leveraged Loans Shine in 2018?
The chart below highlights the dominance of high yield bonds over leveraged loans in the U.S. over the past year. High yield finished the year with a total return of +7.2% versus total returns just over 4% for the two leading U.S. leveraged loan indices from Credit Suisse and S&P LSTA. After the pullback late in the first quarter, high yield accelerated from its floating rate counterparts in the final 3 quarters.
1 Month and 3-Month Total Returns
Investment grade credits were the best performers in December. The broad Bloomberg Barclays U.S. Corporate index returned 0.53%, with industrials outperforming financials. Leveraged loans were next at +0.46% followed by U.S. high yield at +0.38%. For the fourth quarter, investment grade also turned in the best results at +1.31%, though financials outperformed industrials by 23 bps. Leveraged loans were next at +1.21%.
Higher volatility may favor leveraged loans in 2018
A client noticed an interesting shift in the performance of U.S. high yield and leveraged loan during Fed tightening cycles. While leveraged loans, bolstered by floating interest rates and shorter duration, had outperformed high yield during past Fed tightening cycles in the tightening cycles that began in 1994 and 1999, that reversed in the 2004 tightening campaign. The outperformance of high yield has been even more remarkable during this tightening cycle.
The chart below shows the spread between the Bloomberg Barclays U.S. High Yield and Credit Suisse U.S. Leveraged Loan total return indices during current and prior three tightening cycles. After falling behind leveraged loans by 8.8% and 4.2% in the 1994 and 1999 campaigns, the situation has now reversed. High yield beat leveraged loans by 5.5% during the 2004-2005 hiking cycle, absorbing some swings along the way. The current tightening campaign has seen a steady acceleration away from leveraged loans with high-yield now outperforming by a hefty 11.4%.
Is there reason to expect leveraged loans to have another moment in 2018? Leveraged loans tend too earn their keep in rising rate environments when their floating interest rates and shorter duration offer superior protection over fixed rate high yield bonds. This downside protection means leveraged loans will be less correlated with treasuries during periods where yields are rising.
The next chart shows this has been the case since 2010. The Credit Suisse and S&P LSTA leveraged loan total return indices (far left) have averaged slightly negative 6-month correlations since 2010. In this hedging context, leveraged loans have offered a slight advantage over high yield, which also has a near-zero correlation with treasury total returns.
The next chart highlights how leveraged loans have performed during periods of total return losses for U.S. Treasuries. The scatter plots show rolling 3-month total returns for the Bloomberg Barclays U.S. Treasury index on the x-axis and for the Credit Suisse Leveraged Loan total return index on the y-axis. Outside of a small part of 2015, leveraged loans have consistently delivered positive, if modest, total returns when treasuries were seeing total return losses.
However, the same chart for high yield returns looks very similar, as high yield bonds have also performed well during periods where treasury yields rose. The key question is when leveraged loans managed to outperform high yield. The answer appears to be when uncertainty about rising interest rates is rising.
The next chart shows 3-month changes in U.S. Treasury implied volatility (MOVE Index) on the x-axis and the spread between 3 month total returns spread between U.S. high yield and leveraged loans. Leveraged loans outperform, resulting in positive spreads in the charts below, as treasury implied volatility rises. This was especially true in 2013 and 2016 which saw steep rises in Treasury yields. We noted today in Newsclips that expectations for higher volatility might finally be realized in 2018. Rising yields and a burst of treasury volatility would favor leveraged loans.
All but utilities saw spreads tighten in December
Spreads for 4-6 year maturity issues tightened nearly across the board in December. Utilities were the only exception, as weakness in some electric integrated names pulled the average change in spread toward even. Energy, communications and technology were the top performers.
Pipelines among top performers in 2017 among energy related industrials
Pipelines, the largest component of the energy sector within the Bloomberg Barclays industrial index, was among the top performers in 2017. Pipeline issues were +2.6% on the year, on average, tied with oil refining and marketing. Both industry groups enjoy slightly less sensitivity to spot prices for crude oil, and were favorites throughout the year. We noted last week in Newsclips how recent news flow had once again turned positive with pipeline closures resolving and the political environment becoming more friendly.
No reward for holding duration in technology industrials
Big names in the technology sector of the Bloomberg Barclays industrials index won the day in 2017. The largest names in computers and applications software were able to issue medium to longer duration bonds at favorable yields. Investors saw little in the way of reward for holding these safer plays. Better returns were found in shorter duration, lesser known industry groups.
Banks lagged among financials in 2017
The flattening treasury curve weighed heavily on bank credits in 2017. The largest industry group in the Bloomberg Barclays financials index, banks turned in the worst performance, up only 1.8% on average for the year. Among the other larger industry groups within financials, better returns were found in insurance and REITs.