2015 Leveraged Finance Outlook and 2014 Annual Review

Transcription

1 Fixed Income Research Leveraged Finance Outlook and 2014 Annual Review Research Analysts Jonathan Blau James Esposito Amit Jain Table of Contents 2015 Leveraged Finance Outlook 3 U.S. High Yield Performance Review 49 U.S. Leveraged Loan Performance Review 77 Western European High Yield Performance Review 91 Western European Leveraged Loan Performance Review 107 Leveraged Equity Index Performance Review 121 Relative Value Review 123 U.S. High Yield Event Review 141 U.S. High Yield New Issue Review 147 U.S. Institutional Leveraged Loan New Issue Review 189 Western European High Yield New Issue Review 199 Western European Institutional Leveraged Loan New Issue Review 209 U.S. High Yield Default Review 217 U.S. Institutional Leveraged Loan Default Review 251 European High Yield Default Review 275 European Institutional Leveraged Loan Default Review 287 DISCLOSURE APPENDIX AT THE BACK OF THIS REPORT CONTAINS IMPORTANT DISCLOSURES AND ANALYST CERTIFICATIONS. CREDIT SUISSE SECURITIES RESEARCH & ANALYTICS BEYOND INFORMATION Client-Driven Solutions, Insights, and Access

2 2015 Leveraged Finance Outlook and 2014 Annual Review 2

3 2015 Leveraged Finance Outlook Our total return projection for 2015 for U.S. high yield is 5%, and we weight the risks to the upside, seeing more opportunities to outperform. We project default rates to remain low at 1%-3% in 2015 despite increased defaults in energy, and 1%-3% in 2016, raising our previous 2016 projection. We project high yield issuance of $240 billion in 2015, a decline both from our previous 2015 projection and from the $318 billion issued in Conditions will be far less accommodative for opportunistic refinancing of existing deals. Our total return projection for 2015 for U.S. leveraged loans is 4%. We project a 1%-2% default rate for loans for 2015 and 1%-3% for 2016, both increased from our previous projection. We project leveraged loan issuance of $340 billion in 2015, a decline from both our previous projection and from the $443 billion issued in Our total return projection for 2015 for European high yield is 5.5%, an increase from our previous projection. We project a very low 0%-1% default rate for European high yield in 2015, and a 0.5%-2% default rate for 2016, an increase over our previous 2016 projection. Credit concerns in Europe are growing, but most companies, even the ones which have significant problems, have sufficient liquidity to avoid default over this time horizon. We project European high yield issuance of 125 billion in Our total return projection for 2015 for European leveraged loans is 4%, which is also an increase from our previous projection. We project a 1%-3% default rate for European loans for both 2015 and The loan market is working through the remaining problems from the LBO boom. We project European leveraged loan issuance of 110 billion in Exhibit 1: Projected 2015 Returns, Defaults and Issuance 2015 Projections Performance Default Rate Issuance U.S. High Yield 5% 1% - 3% $240 billion U.S. Leveraged Loans 4% 1% - 2% $340 billion Western European High Yield 5.5% 0% - 1% 125 billion Western European Lev. Loans 4% 1% - 3% 110 billion Volatility is the theme for 2015, increasing uncertainty around projections. First, the price of oil has had a huge impact on the energy sector, which is 15% of the U.S. high yield market, though only 4% of the U.S. loan market, and nearly zero in the European high yield and loan markets. After losing 20 points during the fourth quarter of 2014, the U.S. high yield energy sector has seen a rally since December of more than 5 points. Second, the Credit Suisse Economics team expects the Fed to raise Fed Funds in the second half of Historically, high yield has delivered below-coupon returns while the Fed tightens, with weaker credits performing worse. This is because as the central bank drains liquidity from the financial system, the risk is refinancing risk, affecting the weakest companies the most. At the same time, the ECB has announced a sovereign asset purchase (QE) program of approximately 1.1 trillion. While this is a strong positive for risky assets, the cross-current of the two central banks simultaneously tightening and easing is unpredictable on credit. Third, the long list of potential exogenous events, such as Euro area surprises, mispricings in rates or FX markets, or geopolitical conflicts spilling over into financial markets, adds another layer of volatility Leveraged Finance Outlook and 2014 Annual Review 3

4 Total Return Total Return Nevertheless, the U.S. economy continues to improve, and U.S. high yield and loan yields have risen to levels last seen in the third quarter of We note that the shifts by rating during the fourth quarter of 2014 put the market in a much more conservative profile. This leads us to weight the risks to the upside in our U.S. return projections. Leveraged loans also have the potential to receive a boost late in the year as a result of yield pickup from rate hikes. In addition, the European economy has shown signs of improvement, with our Economics team forecasting that European GDP growth will reach 3% by the fourth quarter. After the European QE program was suggested in September 2014, Bund yields (particularly the front end of the curve) dropped substantially, and they are not expected to meaningfully appreciate in the near term. We also expect default risk to remain low in These factors support our rationale for increased European high yield and loan return projections. Exhibit 2: Return of CS High Yield and Lev Loan Indexes, Jan present 6.0% 8/29/ % 12/31/14 5.0% 4.0% 3.0% 9/3/ % 2/17/ % 3.25% CS HY Index CS Lev Loan Index 2.0% 2.06% 1.0% 1.86% 0.0% -1.0% 12/31/2013 2/28/2014 4/30/2014 6/30/2014 8/31/ /31/ /31/2014 Exhibit 3: Return of CS Western European High Yield and Leveraged Loan Indexes, Jan present 7.0% 6.0% 12/31/14 2/17/ % 5.0% 4.0% 3.0% 2.0% 4.31% 1.96% 2/12/ % CS West. Eur. HY Index CS West. Eur. Lev Loan Index 1.0% 0.0% 12/31/2013 3/31/2014 6/30/2014 9/30/ /31/ Leveraged Finance Outlook and 2014 Annual Review 4

5 Total Return Yield U.S. High Yield: 2014 Review Defying expectations coming into 2014, Treasuries performed strongly, buoying the U.S. high yield return for much of the year. The 5-year Treasury yield decreased by 9 bp in 2014 to 1.65%, while the CS High Yield Index yield increased by 133 bp to 7.10%. Exhibit 4: CS High Yield Index Yield vs. 5-Yr Treasury Yield 10.0% 9.0% 8.0% 7.0% 6.0% 6/25/ /31/ % 6.25% 6/20/ /31/ % 5.77% 12/31/ % HY Yield 1/30/ % 5-Year Treasury 5.0% 4.0% 3.0% 2.0% 1.0% 12/31/ % 9/5/ % 12/31/ % 12/31/ % 1/30/ % 0.0% 1/3/11 7/3/11 1/3/12 7/3/12 1/3/13 7/3/13 1/3/14 7/3/14 1/3/15, the BLOOMBERG PROFESSIONAL service U.S. high yield had a strong performance for the first half of Each month from January to June had a positive return, averaging 91 bp per month, for a total return of 5.55% on June 30. Spreads tightened by 33 bp in the first half. The volatility began in July. The total return from July through the end of 2014 was -3.50%, and spreads widened 160 bp. The 2014 total return was 1.86%. BB issues outperformed higher coupon Bs and CCCs through August on the back of strong rate performance. BB outperformance became more pronounced during the fall sell-off, which impacted the riskiest credits most, and has continued into The shifts by rating during the fourth quarter of 2014 put the market in a much more conservative profile. Exhibit 5: CS High Yield Index Performance by Rating 7.0% 12/31/14 6.0% 5.0% 4.82% 4.0% 3.0% 2.0% 1.13% 1.0% 0.0% -1.0% -2.0% -1.85% -3.0% -4.0% -5.0% 12/31/2013 2/28/2014 4/30/2014 6/30/2014 8/31/ /31/ /31/2014 2/17/ % 3.08% -0.79% BB B CCC 2015 Leveraged Finance Outlook and 2014 Annual Review 5

6 Spread-to-Worst Change The selloff in high yield was led by the energy and mining industries, which widened dramatically in the last few months of the year with the fall in oil prices. These sectors account for about 20% of the U.S. high yield market, and they are anchored by the oil price. Exhibit 6: CS High Yield Index Spread-to-Worst Widening (8/29/14-1/30/15) 600 bp 500 bp 400 bp 300 bp 200 bp 100 bp 54 bp 79 bp 92 bp 97 bp 105 bp 108 bp 114 bp 119 bp 119 bp 128 bp 128 bp 129 bp 134 bp 141 bp 148 bp 149 bp 382 bp 473 bp -100 bp -200 bp -133 bp Exhibit 7 illustrates 2014 return by a cross section of both rating and years to yield-toworst date. The impact of rates is apparent as BB rated bonds with yield-to-worst dates in 7 to 10 years returned 9.12%, the highest of any category. The riskiest issues, longer dated CCCs, had the worst performance in Exhibit 7: Return by Years to Yield-to-Worst Date and Rating Full-year 2014 Less than 2 years 2 to 4 years 4 to 7 years 7 to 10 years BB 2.42% 2.06% 4.48% 9.12% B 3.40% 3.02% 0.59% 1.51% CCC 3.06% 0.13% -3.63% -3.33% Impact of the Oil Selloff on U.S. High Yield From the beginning of 2014 through 2/17/15, the high yield energy sector returned -6.76%. Excluding energy, high yield returned 6.61%, 287 bp higher than the overall return of 3.74% Leveraged Finance Outlook and 2014 Annual Review 6

7 Spread to Worst Total Return Exhibit 8: CS High Yield Index Total Return 10% 5% 2/17/ % 3.74% 0% -5% -6.76% -10% -15% 12/31/2013 2/28/2014 4/30/2014 6/30/2014 8/31/ /31/ /31/2014 Index Energy & Coal Excluding Energy & Coal This result can be seen in high yield spreads as well, where energy has widened the overall index spread by 44 bp, based on the difference between the index spread of 527 bp and the index excluding energy spread of 483 bp. Exhibit 9: CS High Yield Index Spread 1900 bp 1700 bp 1500 bp 1300 bp 1100 bp 900 bp 700 bp 500 bp 2/17/15 785bp 527bp 483bp 300 bp 1/2/2008 1/2/2009 1/2/2010 1/2/2011 1/2/2012 1/2/2013 1/2/2014 1/2/2015 Index Energy Excluding Energy The size of the high yield energy sector has grown significantly since the recession, and briefly surpassed media/telecom, which has been the largest sector historically. As of January 2015, energy comprises 14.9% of the CS High Yield Index and media/telecom comprises 16.3% Leveraged Finance Outlook and 2014 Annual Review 7

8 New High Yield Volume ($Bln) CS High Yield Index Market Weight Exhibit 10: CS High Yield Index Market Weight 20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% 16.3% 14.9% Energy Media/Telecom U.S. High Yield: 2014 Issuance Review U.S. high yield issuance in 2014, $318 billion, was moderately lower than the record years of 2012 and 2013, ranking it the third largest in history. Exhibit 11: Historical High Yield Issuance $400 $ $300 $250 $200 $150 $100 $50 $ YTD * As of 1/30/ Leveraged Finance Outlook and 2014 Annual Review 8

9 Market Size ($ billions) The high yield market grew by $110 billion face value to $1,437 billion in Exhibit 12: Historical High Yield Issuance High Yield Market Size New Issue Volume New Issue Volume ($ billions) * As of 1/30/2015 Includes non-investment grade $US-denominated straight corporate debt. Floating-rate and convertible bonds and preferred This $110 billion increase in 2014 is the net after new issuance, refinancings, purchases, exchanges, maturities, bankruptcy resolutions, rising stars and fallen angels. For the most part, refinancings, purchases, exchanges and maturities are financed by new issuance, so they have a small net result on the market size. That leaves $27 billion of fallen angels added to the market, and $38 billion of rising stars and $16 billion of bankruptcy resolutions leaving the market, a net reduction of $27 billion. Exhibit 13: High Yield Events by Year Face Amount ($Bln) * New Issuance Issued in Exchange Fallen Angel Additions Call Tender Exchange Purchase Matured Bankruptcy Resolution Rising Star Deletions Net Change: Starting Size 1, , , , , ,435.7 Ending Size 1, , , , , ,451.4 * As of January 30, 2015 Retail mutual funds reported outflows in 2014, but there are multiple sources citing differing amounts. For example, ICI reported 2014 aggregate monthly outflows of $44.2 billion from high yield mutual funds and EPFR reported outflows of $31.4 billion. The net change in ETF flows over 2014 was very small. Finally, the market generated around $95 billion in cash coupon in We estimate that 75% of that was reinvested, or about $70 billion Leveraged Finance Outlook and 2014 Annual Review 9

10 If we net these sources, we estimate an inflow from institutional funds of about $100 billion. As we described above, we've made a number of assumptions in this estimate, so we consider it only an approximation. We don't have a direct method to verify it since most institutional investors don't report their allocations publicly. Exhibit 14: High Yield Fund Flows Estimate (billions) Amount Institutional Fund Flows $98.3 Retail Mutual Fund Flows -$31.4 Rising Stars/Fallen Angels/Bankruptcy Resolutions -$27.3 Coupon Reinvestment $70.0 Net Change in High Yield Market Size $109.6, EPFR 2015 Leveraged Finance Outlook and 2014 Annual Review 10

11 CS HY Index Yield-to-Worst U.S. High Yield: 2015 Outlook The expected mix of an improving economy, tightening Fed policy, the price of oil and macro volatility forms the basis of our 2015 high yield outlook. The Credit Suisse Economics team expects GDP growth in excess of 3% for CS interest rate strategists expect the 5-year Treasury to increase by over 100 bp by 4Q (We look at the 5-year since it is closest in duration to high yield.) In addition, the rates team expects the Fed to begin tightening in June, and they expect Fed Funds to reach about 1% by year-end. The expected tightening by the Fed has been telegraphed well in advance. Although a move of 1% is a modest start, we have no precedent since the modern high yield market began in the 1980s in which the Fed tightened after keeping rates so low for so long. We examine the effect to high yield of Fed policy over the past five years, and then we look at the history of Fed tightening on high yield. Since yields fell below 10% in the fourth quarter of 2009, the high yield market has experienced repeated selloff/recovery cycles. Exhibit 15 illustrates these cycles using the yield of the CS High Yield Index. Each recovery achieved a new low yield as the Fed pushed rates lower, bottoming at just above 5%. Each selloff was driven by a macro event, not a credit event from within the asset class. The selloffs have been very rapid, accelerated by the fact that dealers have reduced capital on their trading books dramatically since 2008 and are no longer the bid of last resort. Exhibit 15: CS High Yield Index Yield-to-Worst (4Q 2009 present) 10.0% 9.5% 9.0% 2/12/10 Rose 85 bp 6/10/10 Rose 132 bp 10/4/11 Rose 267 bp 11/25/11 Rose 85 bp 8.5% 8.0% 7.5% 7.0% 6.5% 6.0% 5.5% 5.0% 1/11/ % 4/30/10 Fell 127 bp 11/30/10 Rose 78 bp 6/28/11 Rose 90 bp 7/27/11 11/9/10 Fell Fell bp bp 5/16/11 Fell 111 bp 10/28/11 Fell 180 bp 6/5/12 Rose 99 bp 5/3/12 Fell 184 bp 9/14/12 Fell 173 bp 11/16/12 Rose 59 bp 5/8/13 Fell 178 bp 6/25/13 Rose 193 bp 8/1/14 Rose 98 bp 6/23/14 Fell 188 bp 2/17/ % Through this period GDP has been (mostly) positive, but weak and volatile. Companies cashflow has been adequate to reduce or postpone credit problems, but not sufficient to permit significant reduction in debt. Instead, companies have been taking advantage of abundant liquidity to refinance debt at lower interest cost, pushing out maturities and adding cash to balance sheets. Ultimately, stronger GDP and a steep yield curve should be positives for the high yield and leveraged loan markets. However, the period of Fed tightening has been a rough one for high yield historically. The reduction in liquidity has resulted in weak high yield returns, and weaker credits performed worse. There are two historical periods we can examine, the Fed tightening in 1994 following the 1990 recession, and the tightening during 2004 to 2006 following the 2001 recession Leveraged Finance Outlook and 2014 Annual Review 11

12 Total Return Total Return Following the 1990 recession, the Fed tightened from February 1994 to February 1995, with Fed Funds rising by 3.00%. The high yield market returned 0.52% in this period, with a coupon at the time of over 10.5%. The weaker the credit, the worse the performance: CCCs returned -10.6%, Bs 0.9% and BBs 2.9%. The overall spread widened by 50 bp, but CCCs widened 383 bp, while Bs widened only 30 bp and BBs actually tightened slightly by 11 bp. As the Fed neared the end of the cycle, the market began to recover, with positive returns overall in the final three months of tightening. CCCs turned positive in the final month. Exhibit 16: CS High Yield Index Performance by Rating: Feb 1994 Feb % 0.0% -5.0% 2/28/95 2.9% 0.9% BB B CCC -10.0% -10.6% -15.0% -20.0% Jan-94 Mar-94 May-94 Jul-94 Sep-94 Nov-94 Jan-95 Following the 2001 recession, the Fed began tightening in June 2004 and ended in June 2006, with Fed Funds rising by 4.25%. Most of the effect was felt in high yield in 2005, when 2% of the tightening occurred. During that year, the high yield market returned 2.3%, well below the coupon of 8.6%. CCCs returned -3.8% during the year, Bs 3.8% and BBs 2.3%. Exhibit 17: CS High Yield Index Performance by Rating: % 4.0% 2.0% 0.0% -2.0% -4.0% 12/31/05 3.8% 2.3% -3.8% B BB CCC -6.0% -8.0% Dec-04 Mar-05 Jun-05 Sep-05 Dec Leveraged Finance Outlook and 2014 Annual Review 12

13 Spread-to-Worst During 2005, the spread widened by 42 bp, led by CCCs which widened 151 bp. While the difference between BB and B widened slightly, beginning the year at 109 bp and ending the year at 121 bp, the difference between BB and CCC increased from 483 bp to 602 bp. Exhibit 18: CS High Yield Index Spread by Rating: bp 850 bp 845 bp 750 bp CCC 650 bp 694 bp 550 bp B 450 bp 350 bp 320 bp 364 bp BB 250 bp 211 bp 243 bp 150 bp Dec-04 Feb-05 Apr-05 Jun-05 Aug-05 Oct-05 Dec-05 Like the 1994 tightening cycle, returns turned positive near the end of 2005, with CCCs turning positive last. But unlike 1994, the effects were more muted. Even though the tightening began in 2004 and ended in 2006, nearly all of the effect to high yield was in The impact was less severe than 1994 since the pace was slower Leveraged Finance Outlook and 2014 Annual Review 13

14 Next Qtr YoY Real GDP %Chng U.S. High Yield: 2015 Return Projection We project 5% total return for U.S. high yield in 2015, unchanged from our previous projection. We weight the risks to the upside, seeing more opportunities to outperform. Our model for high yield return projections is illustrated in Exhibit 19. This is a singlefactor model relating the spread to real GDP. The high yield spread, inverted on the righthand scale, is fairly well correlated to year-over-year real GDP growth. In fact, the spread leads GDP by about a quarter. High yield, which is primarily the unsecured debt of levered companies, is most sensitive to cashflow, and the primary driver of cashflow is the economy. It isn't surprising that high yield leads a low-frequency indicator like GDP. The model implies a 2015 year-end spread of 517 bp, or 10 bp tighter than today. The Credit Suisse Economics team forecasts 3.2% real GDP growth by the end of For the purpose of this model, we also assumed that the spread of the high yield energy sector, 15% of the market, remains unchanged through the end of (We look at sensitivities to that assumption below.) Exhibit 19: Next Quarter Real GDP YoY% Change vs. CS HY Index Spread (1982 present) 10% 8% 6% 4% 2% 0% -2% -4% -6% -8% -10% Correlation =.73 YoY% CS Economic Forecasts 0 bp 200 bp 400 bp 600 bp 800 bp 1000 bp 1200 bp 1400 bp 1600 bp 1800 bp Spread to Worst Next Qtr YoY Real GDP %Chng HY Spread-to-Worst, the BLOOMBERG PROFESSIONAL service Combining a spread tightening of 10 bp and a rate rise of 94 bp, based on our rate strategists' 2015 year-end projections, leads to a yield rise of 84 bp, which translates to a price loss of 3.4 points for the remainder of the year. With a coupon near 7%, this model gives a total return projection of 4.5% for We incorporate other observations into our forecast. First, we note that the correlation of the real GDP model is good, at 0.73, but far from perfect, and it does not explain the intermittent volatility that high yield has experienced. Exhibit 20 illustrates this by magnifying the right-side of the model. The spread has diverged from the regression often: there is a reversion to the mean, which we saw with the spread widening over the past few months, but the timing is not predictable Leveraged Finance Outlook and 2014 Annual Review 14

15 Spread to Worst Next Qtr YoY Real GDP %Chng Exhibit 20: Next Quarter Real GDP YoY% Change vs. CS HY Index Spread (2008- present) 6% 3% 0% -3% Correlation =.85 Next Qtr YoY Real GDP %Chng 9/30/14 STW: 485 bp 12/30/14 GDP%: 2.5% (y/y) YoY% CS Economic Forecasts 200 bp 400 bp 600 bp 800 bp 1000 bp 1200 bp Spread to Worst -6% HY Spread-to-Worst 1400 bp 1600 bp -9% 1800 bp, the BLOOMBERG PROFESSIONAL service We also looked at similar models, substituting other economic and market indicators for real GDP. We tried nominal GDP, industrial production and market volatility. Like real GDP, most of these imply lower high yield spreads by the end of 2015 at 3%+ level of GDP growth. Second, with low defaults currently and forecast over the next two years (see below), we have "cushion" to absorb some of the projected rise in rates, particularly if a sharp rate rise scenario plays out in The CS High Yield Index spread is currently 527 bp, below the long-term average of 580 bp, but well wider than the all-time lows reached in Exhibit 21: CS High Yield Index Spread-to-Worst 2000bps 1816 bp 11/28/ bps 1200bps 800bps 400bps 0bps 1079 bp 12/31/90 Average: 580 bp 307 bp 2/28/ bp 10/31/ bp 2/28/ bp 5/31/07 10/4/ bp 2/8/ bp 12/31/ bp 527 bps 2/17/15 The current spread of 527 bp is 77 bp wider than the 2014 average of 450 bp. Even excluding energy, the current high yield spread is 463 bp, wider than the spread during most of Leveraged Finance Outlook and 2014 Annual Review 15

16 12/31/2013 1/14/2014 1/28/2014 2/11/2014 2/25/2014 3/11/2014 3/25/2014 4/8/2014 4/22/2014 5/6/2014 5/20/2014 6/3/2014 6/17/2014 7/1/2014 7/15/2014 7/29/2014 8/12/2014 8/26/2014 9/9/2014 9/23/ /7/ /21/ /4/ /18/ /2/ /16/ /30/2014 1/13/2015 1/27/2015 2/10/2015 CS HY Index Spread-to-Worst Exhibit 22: CS High Yield Index Spread-to-Worst 600 bp 550 bp 500 bp 450 bp 436 bp 2014 Average 450 bp 10/15/ bp 12/16/ bp 2/17/ bp 400 bp 350 bp Third, a sensitivity analysis for energy is a significant factor. The assumption in our base case is that the energy sector spread remains unchanged for the rest of the year, but it is certainly possible to imagine scenarios in which it widens or tightens 300 bp. A 300 bp yield change in energy would impact returns by about 2% (300 bp yield move x 14.8% weight x 4.5 year duration = 2% price move). Fourth, the Fed has been signaling a tightening cycle for some time, with more hawkish language recently. CS rates strategists expect the Fed to begin tightening in June, and they expect Fed Funds to reach a range about 1% by year-end. Another possibility is that the Fed moves more slowly, waiting to see how the economy responds. But actions by other central banks complicate this picture. The BoJ surprised markets by continuing its QE program, and the ECB is now engaging in a large-scale sovereign buying program of approximately 1.1 trillion. Over the past five years, QE programs have benefited risky assets, including high yield. We believe that the ECB and BoJ programs may have a more positive effect on leveraged finance assets than the negative effect of the start of a tightening cycle by the Fed. Although we think the 1994 and 2005 experience suggests that CCCs may widen, the overall spread may see some tightening momentum on the back of accommodative global policies and a strengthening of the U.S. economy. Fifth, we note that there is quite a bit of uncertainty in future treasury rates. The current market-implied 5-year Treasury for year-end 2015 is 1.93%, 42 bp wider than today, while our analysts forecast an increase in yield by about 94 bp. One path to our 5% total return projection is in Exhibit 23. Modestly tighter spreads combined with rising rates will lead to a yield rise of about 72 bp over the year. This translates to a price loss of about 3 points. With a coupon near 7%, that gives us total return projection of 5% for Leveraged Finance Outlook and 2014 Annual Review 16

17 Exhibit 23: Credit Suisse U.S. High Yield Return Projection Detail Return Estimate Methodology 2/17/15 Spread 527 bp Future Bond Spread on 12/31/ bp Spread Change Treasury Change Total Yield Change -10 bp 83 bp 72 bp 2/17/15 Yield-to-Worst 6.66% Future Yield-to-Worst on 12/31/ % 2/17/15 Price 99.3 Future Price on 12/31/ Principal Return -2.97% Interest Return 6.13% Total Return for rest of % YTD Total Return as of 2/17/ % Full Year Return 5.00% There are many upside scenarios. For example, if Treasury yields rise by the marketimplied amount of 42 bp, and spreads tighten by the amount implied by our model, 10 bp, total return would be 6.7%. In this scenario some of the return lost at the end of 2014 would be gained back in There are downside scenarios, of course. For example, if energy widens 150 bp, and all else is held constant, the overall yield rises about 95 bp, close to the highs reached in December 2014, and total return falls to 4.1%. After reviewing many scenarios, we believe that the macro environment is more favorable than not. We project 5% total return for U.S. high yield for 2015, and we judge that there is more upside than downside potential. Exhibit 24 shows the relationship between yield and the realized annualized return in the following five years. The latest data point on the chart is January 2010, before the current period of historically low yields. Yields on the low end of the range have shown a wide variance of return outcomes. Returns following low yields are either well above or well below the regression line because the following five years are split historically between low and high default cycles. The chart implies an annualized return between 0% and 6% over the next five years, depending on the timing of the next recession/default cycle Leveraged Finance Outlook and 2014 Annual Review 17

18 High Yield Default Rate Index Next 5-Year Annualized Returns Exhibit 24: HY Yield vs. Next 5-Year Total Return Jan 1986 Jan % 20% Yield as of 1/30/ % R² = % 10% 5% 0% -5% 5% 7% 9% 11% 13% 15% 17% 19% 21% Index Yield-to-Worst U.S. High Yield: 2015 Default Projection We project a 1%-3% default rate for high yield bonds in 2015 and 2016, raising our previous projection for This compares to the LTM January 2015 rate of 2.98%. We forecast high yield defaults using a bottom-up analysis, incorporating estimates of default probabilities on a name-by-name basis. The forecast is 1.9% for 2015 and 2.0% for We have increased the projection from our previous forecast, from November 2014, primarily due to rising default risk in the energy sector, and most of that increase falls in Nevertheless, we expect that defaults will remain below the long-term average through Most companies that are encountering problems do not have near-term triggers, such as maturities or liquidity issues, that will result in a default before Exhibit 25: Historical and Projected High Yield Default Rates 18% 16% 15.45% 14% 12% 10% 8% 6% 4% 2% 0% 2.89% 4.78% 1.59% 3.78% 8.80% 7.88% 3.34% 2.33% 1.83% 1.37% 1.38% 0.86% 0.90% 4.08% 4.54% 9.20% 4.32% 1.26% 2.64% 0.73% 0.49% 5.46% 9.37% 1.82% 2.98% 1.56% 1.72% 2.09% 1.9% 2.0% 0.91% A top-down approach also illustrates our default projection. Exhibit 25 shows the maturity schedule of the high yield market split by bonds trading over and under a spread of 1000 bp. Through 2016, only $6 billion is trading over 1000 bp, or about 0.4% of the total market. If we look out to 2017, this number increases to $21 billion, or 1.6% of the total market Leveraged Finance Outlook and 2014 Annual Review 18

19 $Billions Exhibit 26: High Yield Industry Spreads vs. Default Projections % 43 Maturities % $287 bln 84 18% % % % 12% High Yield Bonds Spread >= 1000 bp Maturing by Year (As of 12/31/14) High Yield Bonds Spread < 1000 bp Maturing by Year (As of 12/31/14) % 97 2% 2015 Leveraged Finance Outlook and 2014 Annual Review 19

20 Average Price (Excl. Defaults) Market Size ($ billions) U.S. High Yield: 2015 Issuance Projection We project high yield issuance of $240 billion in 2015, a decline both from our previous 2015 projection and from the 2014 issuance of $318 billion issuance was moderately lower than the record years of 2012 and The high yield market grew to a record size of $1,437 billion in issuance through 2/12 was $39.7 billion, as compared to $36.6 billion through the same period in Exhibit 27: High Yield Events by Year High Yield Market Size New Issue Volume New Issue Volume ($ billions) * As of 1/30/2015 Includes non-investment grade $US-denominated straight corporate debt. Floating-rate and convertible bonds and preferred There is a coincident relationship between average price and issuance as shown in Exhibit 28. This relationship was very weak during the LBO boom of the early 2000s, when many transactions occurred only in the loan market and high yield did not grow. However, the relationship has improved since the 2008 recession. Our return projection implies an average market price in 2015 of 97.7 for the remainder of the year. At this price, the model now suggests that issuance over the next year will average 1.6% of the high yield market size per month for the remainder of the year, or about $245 billion. Exhibit 28: High Yield Price vs. New Issuance as a Percentage of Total Outstanding (Three-Month Rolling Average) 120% 100% 80% 60% 40% 20% 0% R 2 = % 3.00% 2.50% 2.00% 1.50% 1.00% 0.50% 0.00% Issuance % of Outstanding (3-Month Rolling Average) CS HY Index Price (Excl. Defaults) Issuance % of Outstanding (3-Month Rolling Average) 2015 Leveraged Finance Outlook and 2014 Annual Review 20

21 Yield and Coupon We have a another indicator to get to a similar result: the difference between coupon and yield. When the coupon exceeds the yield by 150 bp or more, we have observed peaks in issuance, driven by issuers which have the incentive to refinance to lower their interest expense. The difference exceeded 150 bp for much of 2014, driving refi activity. But as of 2/17/15, the yield was only 29 bp below the coupon. Exhibit 29: Yield-to-Worst versus Coupon of CS HY Index 20% 18% 16% Coupon Yield-to-Worst 14% 12% 10% 8% 6% 4% 2% 0% 10.64% 1/31/ % Difference: 177 bp 8.73% 8.49% 12/31/ % Difference: 174 bp 4/29/ % Difference: 174 bp 2/17/ % 6.66% Difference: 29 bp Includes non-investment grade $US-denominated straight corporate debt. Floating-rate and convertible bonds and preferred Opportunistic refinancing in the high yield market was a quarter of issuance in 2014, about $80 billion of the $318 billion total issuance. (Refinancings composed about half of all issuance in 2014, but half of that was refinancing other debt, mostly in the loan market.) We estimate that there will be little opportunistic refinancing in 2015 because the difference between the yield and the coupon has collapsed. Assuming all else is equal, taking $80 billion from last year s total leaves about $240 billion, our projection for 2015 issuance Leveraged Finance Outlook and 2014 Annual Review 21

22 Total Return 12/31/2013 1/14/2014 1/28/2014 2/11/2014 2/25/2014 3/11/2014 3/25/2014 4/8/2014 4/22/2014 5/6/2014 5/20/2014 6/3/2014 6/17/2014 7/1/2014 7/15/2014 7/29/2014 8/12/2014 8/26/2014 9/9/2014 9/23/ /7/ /21/ /4/ /18/ /2/ /16/ /30/2014 1/13/2015 1/27/2015 CS LL Index Discount Margin (3-years) U.S. Leveraged Loans: 2014 Review The Credit Suisse Leveraged Loan Index discount margin, calculated to a three-year refinancing, was 558 bp at the end of 2014, 70 bp wider than 12/31/13. The discount margin reached a post-2009 low of 457 bp on 6/13/14. (Note that the 19 bp drop in late April was the one-off TXU default impact.) The tone of the market changed late summer, into the fall selloff, with the discount margin increasing 90 bp to a high of 588 bp on 12/17/14. Exhibit 30: CS Leveraged Loan Index Three-Year Discount Margin 600 bp 12/17/ bp 550 bp 10/16/ bp 12/31/ bp 2/17/ bp 500 bp 488 bp TXU Impact 19 bp decrease to 467 bp 6/13/ bp 450 bp CCCs outperformed with a return of 4.44% in CCCs are almost entirely 2 nd liens (and nearly every 2 nd lien is rated CCC). B and BB performed in line with coupon through the summer, and during the fall selloff uniformly underperformed. In contrast to high yield, there has been less of a risk-off signature in loans, as the higher-coupon lower-rated names have outperformed. Exhibit 31: Leveraged Loan Returns by Rating 7.0% 12/31/14 6.0% 5.0% 4.44% 2/17/ % CCC 4.0% 3.0% 2.06% 3.25% 3.18% 3.13% Index B BB 2.0% 1.0% 1.95% 1.61% 0.0% 12/31/2013 2/28/2014 4/30/2014 6/30/2014 8/31/ /31/ /31/ Leveraged Finance Outlook and 2014 Annual Review 22

23 Total Return LTM Return In 2014, the CS Leveraged Loan Index returned 2.06% and the CS High Yield Index returned 1.86%. With the credit selloff in late 2014, the risk-adjusted return of loans and bonds fell below that of many other assets in Exhibit 32 illustrates loans' and bonds' position below the capital market line. Exhibit 32: Risk and Return of Various Assets: % 25% U.S. LT Gvt 20% 15% Capital Market Line S&P % 5% Barcap AAA Corp ML Corp Barcap Agg Bd ML Mortgage U.S. IT Gvt JPM Emerging Markets ML ABS Master CS Leveraged Loan Index US Inflation CS High Yield Index 0% U.S. 30 Day TBill 0% 2% 4% 6% 8% 10% 12% LTM Volatility Impact of the Oil Selloff on U.S. Leveraged Loans Like high yield, the energy sector of loans experienced a strong selloff in late 2014, returning % from 12/31/13 to 1/30/15, vs. 2.32% for the overall CS Leveraged Loan Index. Exhibit 33: CS Leveraged Loan Index Total Return 6.00% 4.00% 2.00% 0.00% -2.00% -4.00% -6.00% -8.00% % % % 12/31/2013 3/31/2014 6/30/2014 9/30/ /31/2014 Index Energy Excluding Energy 1/30/ % 2.32% % The energy discount margin increased to 1,287 bp, widening the market s discount margin by 29 bp Leveraged Finance Outlook and 2014 Annual Review 23

24 CS High Yield Index Market Weight Discount Margin Exhibit 34: CS Leveraged Loan Index Discount Margin 1400 bp 1200 bp 1/30/ bp 1000 bp 800 bp 600 bp 400 bp 558 bp 528 bp 200 bp 0 bp 12/31/2013 3/31/2014 6/30/2014 9/30/ /31/2014 Index Energy Excluding Energy The impact of energy in loans is much smaller than it is in high yield because the weight of energy in the loan universe is lower. Energy now comprises 3.9% of the CS Leveraged Loan Index. Exhibit 35: CS Leveraged Loan Index Market Weight 5% 5% 4% 4% 3% 3% 2% 2% 1% 1% 0% 3.9% Energy U.S. Leveraged Loans: 2015 Return Projection We project 4% total return for U.S. leveraged loans in Exhibit 36 shows our baseline scenario. The relationship between bond and loan yields guides our projection, since they are highly correlated. Our high yield return projection is based on a yield rise of 70 bp, with the projected Treasury rate increase a significant driver. Since loans are less correlated to rates, we reduced the impact for loans. In our baseline scenario, we project that loan yields rise about 50 bp in 2015, which translates to a price loss of almost one point. Added to the coupon, this results in a total return of 4% Leveraged Finance Outlook and 2014 Annual Review 24

25 Coupon of Loan Index Exhibit 36: Credit Suisse U.S. Leveraged Loan Return Projection Detail Return Estimate Methodology 2/17/15 Loan Yield 5.98% Future Loan Yield on 12/31/ % Total Yield Change 0.53% 2/17/15 Price Future Price on 12/31/ Principal Return -1.45% Interest Return 4.28% Total Return for rest of % YTD Total Return as of 2/17/ % Full Year Return 4.00% Our projection implies that the difference between the yields of bonds and loans increases from 68 bp today to about 90 bp at the end of For the first time in years, loans are poised to see a small yield pickup from rate increases at the end of The Credit Suisse Economics team expects the Fed to hike rates to about 1% by the end of A LIBOR over 1% begins to overcome LIBOR floors to increase the average loan coupon. At a LIBOR of 1.25%, the coupon would increase from today s level by about 35 bp, to 5.1%. The rate impact on coupon, and more generally demand for loans by investors looking for protection from rising rates, provides upside potential to our 4% return projection. Exhibit 37: Impact of Rising LIBOR on Loan Index Coupon 10.0% 9.0% 8.0% 7.0% 6.0% 5.0% 12/31/17 12/31/16 LIBOR (implied) = 2.11% LIBOR (implied)=1.70% Coupon = 5.98% 12/31/15 Coupon = 5.57% LIBOR (implied)=.90% Coupon = 4.88% 4.0% 3.0% 12/31/14 LIBOR =.25% Coupon = 4.78% Note: LIBOR implied rates based on US Dollar Swap Bloomberg data as of 2/9/15 3-Month LIBOR Rate, the BLOOMBERG PROFESSIONAL service 2015 Leveraged Finance Outlook and 2014 Annual Review 25

26 Yield Difference HY Bond Yield - Loan Yield The total return of leveraged loans has outperformed the return of high yield bonds each time the yield of bonds has fallen to a level relatively close to the yield of loans. The loan outperformance lasts for a period of about two months, but eventually high yield overtakes loans again, given its higher coupon. At the end of January 2015, loan yields, calculated to a three-year refinancing, were 5.98%, 68 bp lower than high yield bond yields of 6.66%. The difference between these reached a low point in 2014 in late April at 11 bp. Exhibit 38: High Yield Bond Yield Less Leveraged Loan Yield 2.50% 2.00% HY Bond Yield - Loan Yield 1.50% 1.00% 0.50% 0.68% 0.00% -0.50% -1.00% -1.50% -2.00% 6/30/2008 6/30/2009 6/30/2010 6/30/2011 6/30/2012 6/30/2013 6/30/2014 In Exhibit 39 we compare only bonds and loans within the same capital structure, and this shows a mostly consistent relationship between bond yields and the loan yields. The average since June 2011 is 110 bp. Following the selloff of 2011 through late 2013, the difference was between 85 bp and 150 bp. However, the difference in yields tightened to a low of 36 bp in February 2014, and subsequently increased back to 108 bp as of yearend Exhibit 39: High Yield Senior Bond Yield vs. First Lien Leveraged Loan Yield (companies with both instruments in capital structure) 3.0% 2.5% Yield Difference: Unsec Bonds w/ 1st Lien Loans - 1st Lien Loans w/ Unsec Bonds 2.0% 1.5% 6/28/ % 1.0% 12/31/ % 0.5% 0.0% 4/30/ % 2/28/ % 2015 Leveraged Finance Outlook and 2014 Annual Review 26

27 $ Billions Loan Default Rate U.S. Institutional Leveraged Loans: 2015 Default Projection We project a 1%-2% default rate for institutional loans for 2015 and 1%-3% in 2016, both increased from our previous projection. The current LTM default rate, for January 2015, is 3.6%. Note that 2.2% of the current default rate comes from the TXU April 2014 default, and 0.6% comes from the Caesars January 2015 default. Other than these loans, originally issued before the recession, the environment has been benign, particularly given the rapid growth of the market during the past two years. However, default risk has increased over the past few months with the energy industry selloff. Exhibit 40: Leveraged Loans Default Rates: Historical and Projected 12% 10% 9.57% 8% 6% 5.29% 6.84% 8.10% 3.82% 4% 3.64% 2.91% 3.01% 2.50% 2.54% 1.32% 0.45% 0.55% 0.85% 1.01% 1.55% 1.87% 2% 1.45% 1.50% 2.00% 0.72% 0.37%0.23% 0% LTM Jan (est.) (est.) '15 Defaulted loans defined as missed coupon, filed chapter 11, distressed exchange, or cross-defaults. A top-down approach illustrates our default projection. Exhibit 41 shows that $53 billion face value of loans, or 5.7% of all loans outstanding, are trading with a discount margin to maturity of greater than 1000 bp. Of these, the face value of loans maturing by 2016 is $2.3 billion, or 0.3% of the total. We factor in a portion of distressed issuers maturing in the later years, as well as the January default of Caesars Entertainment, the only default in 2015 so far. Our mid-point estimate has increased to 1.5% in 2015 and 2% in Exhibit 41: Leveraged Loans Maturing by Year: Discount Margin to Maturity >1000 bp Maturities $203 bln 249 6% 249 3% % % 65 5% % 1 52% 12% 0 0% *Excludes revolvers, letters of credit, and delayed draw loans. Leveraged Loans Discount Margin to Maturity >= 1000 Maturing by Year (As of 1/30/15) Leveraged Loans Discount Margin to Maturity < 1000 Maturing by Year (As of 1/30/15) 2015 Leveraged Finance Outlook and 2014 Annual Review 27

28 Annualized Return Par Weight CS LL Index Nearly 70% of institutional loan issuance in 2014 was covenant lite, and the face value of covenant lite facilities in the CS Leveraged Loan Index has increased to 56.0%. This issuance is a consequence of low yields and plentiful liquidity, with investors willing to sacrifice some protections in exchange for extra yield. Exhibit 42: Covenant Lite Percentage: CS Leveraged Loan Index 60.00% 50.00% 2/12/ % 40.00% 30.00% 20.00% 7/31/ % 10.00% 0.00% 1/31/ % Covenant Lite We sorted the categories of covenant and seniority together, creating four baskets: full covenant 1 st lien, covenant lite 1 st lien, full covenant 2 nd lien and covenant lite 2 nd lien. Exhibit 43 shows that since January 2007 the risk-adjusted return of each basket is very similar. Covenant lite loans and second liens have outperformed with higher volatility. This is the tradeoff investors are making: somewhat higher returns for somewhat higher risk. Exhibit 43: Risk vs. Return, Covenant Lite versus CS Leveraged Loan Index: Jan 2007 Dec % 6.0% Full Cov - 2nd Lien Cov Lite - 2nd Lien 5.0% 4.0% Full Cov - 1st Lien Index Cov Lite - 1st Lien 3.0% 2.0% 1.0% 3-Month T-Bill 0.0% 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% Annualized Return Volatility 2015 Leveraged Finance Outlook and 2014 Annual Review 28

29 The set of covenant lite defaults is very thin. They are a relatively new structure in the loan market, with the first significant wave of covenant lite loans issued in Covenant lite has exhibited lower default rates and lower recovery rates compared to fully covenanted loans. Exhibit 44: Annual Leveraged Loan Default Rates by Covenant Package Default Rate by Covenant Recovery Rate by Covenant Cov-Lite Full Covenants Overall Cov-Lite Full Covenants Overall % 0.45% % % 1.32% % % 0.55% % % 0.85% % % 2.50% % % 5.29% % 56.75% % 6.84% % 57.09% % 8.10% % 62.59% % 3.83% 3.82% % 66.97% % 1.01% 1.01% % 83.41% % 1.56% 1.55% % 86.09% % 0.39% 0.37% % 66.08% % 0.27% 0.23% % 88.63% % 3.40% 2.91% % 54.44% 53.65% % 10.35% 9.57% % 43.74% 43.18% % 2.69% 2.54% % 54.28% 50.54% % 0.86% 0.72% % 55.44% % 1.78% 1.87% % 60.81% 56.78% % 1.94% 1.45% % 66.24% 64.67% % 5.88% 3.01% % 59.84% 57.91% Average: 1.08% 2.91% 2.75% Average: 41.35% 63.56% 65.17% 2015 Leveraged Finance Outlook and 2014 Annual Review 29

30 U.S. Institutional Leveraged Loans: 2015 Issuance Projection We project $340 billion for U.S. institutional leveraged loan issuance for 2015, a decrease from both our previous projection and from the $443 billion issued in The institutional loan market grew by $156 billion during 2014 to a market size of $906 billion, surpassing the previous peak from A key driver of 2014 issuance was corporate acquisition finance and LBO activity, both of which were higher than in (Note that we include loan repricings in our issuance total.) However, 2015 is off to a much slower start, with January issuance volume of $6.8 billion, down from $50.4 billion in January Exhibit 45: Institutional Leveraged Loan Events by Year Loan Events ($Bln) * 2015* New Issuance Issued in Extension Issued in Exchange Fallen Angel Additions: Prepaid w/ Bonds Prepaid w/ Equity Prepaid w/ Loans/Cash Extended Matured Bankruptcy Resolution Rising Star Illiquid/Unknown Deletions: Net Change: Starting Size Ending Size *As of January 31, Leveraged Finance Outlook and 2014 Annual Review 30

31 Monthly Issuance % of Outstanding (3-Month Average) U.S. CLO Issuance (in $bn) CLO issuance bolstered demand in the leveraged loan market in 2014, exceeding the previous peak from Exhibit 46: US CLO Issuance ( ) US CLO Issuance (in $bn) , S&P Capital IQ LCD There is a close relationship between the percentage of the loan market trading above par and issuance levels, as illustrated in Exhibit 47. The percentage of the market trading above par was 7.7% at the end of January With our projection that loan yields rise 30 bp and the average price decreases almost a point by the end of 2015, we expect the percent trading above par to remain low next year. However, the percent of the market trading above par is quite volatile. Historically, at the current level of price, yield and coupon it has varied between 5% and 40%. We estimate that the percent of the market trading above par will average 10%-20% for the rest of Using this model, that translates to issuance of about $340 billion, our projection for Exhibit 47: Monthly Issuance as Percent of Outstanding (lhs) vs. Percent of CS Leveraged Loan Index Trading Above Par (rhs) 16.00% 14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% R 2 = % 80.00% 70.00% 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% Percentage of Market Trading Over Par Issuance % of Outstanding (3-Month Avg) Percentage Trading Above Par (3-Month Avg) 2015 Leveraged Finance Outlook and 2014 Annual Review 31

32 Yield 12/31/2013 1/14/2014 1/28/2014 2/11/2014 2/25/2014 3/11/2014 3/25/2014 4/8/2014 4/22/2014 5/6/2014 5/20/2014 6/3/2014 6/17/2014 7/1/2014 7/15/2014 7/29/2014 8/12/2014 8/26/2014 9/9/2014 9/23/ /7/ /21/ /4/ /18/ /2/ /16/ /30/2014 1/13/2015 1/27/2015 CS WEHY Index Cumulative YTD Return Western European High Yield: 2014 Review For 2014, the Credit Suisse Western European High Yield Index (hedged, in Euro) returned 4.31%, below the coupon of 6.38%. There were two selloffs in the second part of 2014, and even though the market rebounded from those selloffs, it was not quite enough to reach an above-coupon return for the year. A number of sectors came under pressure, including energy, food, gaming and retail in the second half of Exhibit 48: Western European High Yield Index Total Return 7.0% 6.0% 8/27/ % 5.0% 4.0% 12/31/ % 1/30/ % 3.0% 2.0% 1.0% 10/16/ % 12/16/ % 0.0% Despite the strong performance of rates in 2014 the 5-year Bund yield dropped 90 bp the CS Western European High Yield Index yield increased 34 bp. Peripheral sovereign yields, using an average of Italy s, Spain s and Portugal s, decreased sharply in 2014, to 1.07% from 3.41%. Credit Suisse interest rate strategists forecast that the cyclical recovery will lead to a moderate rise in rates late in Exhibit 49: Western European Sovereign Yields versus HY Yields 6.00% 5.00% 4.00% 3.00% 4.85% 3.41% 12/31/ % 1/30/ % Western European HY Yield-to-Worst 2.00% 1.00% 0.00% -1.00% 0.92% 1.07% 0.02% 1.08% -0.05% 5-Year Peripheral Sovereign Yield (Italy, Spain, Portugal Average) German Bund 5 years, the BLOOMBERG PROFESSIONAL service 2015 Leveraged Finance Outlook and 2014 Annual Review 32