Leveraged Finance Outlook

Transcription

1 Fixed Income Research Leveraged Finance Outlook Research Analysts Jonathan Blau Managing Director Daniel Sweeney Director Karen Friedlander Associate Outlook for Western European High Yield and Leveraged Loans Our total return projection for 2013 for Western European high yield is 6%. Our default forecast for European high yield is 1% to 2% in 2013 and 1% to 3% in Our total return projection for 2013 for Western European leveraged loans is 5%. Our default forecast for European loans is 2% to 4% in 2013 and 2% to 6% in The Euro Area and U.K. economies have been in mild recession for most of 2012, with a clear downward trend in PMIs and other leading indicators for the past two years. These indicators have stabilized recently and show signs of improvement. Credit Suisse Economics Research expects GDP growth to be 1.8% in the Euro Area and 2% in the U.K. by the end of The Credit Suisse Western European High Yield Index spread is currently 540 bp, 97 bp tighter than the long-term average. Spreads have tightened during the current Euro Area recession for two reasons. First, most original issue high yield is located in the core countries, which have been less affected thus far. Second, as fallen angels enter the market from the peripheral countries, they enter as BBs with relatively low spreads, tightening the average. Currently, bonds with a BB from at least one ratings agency comprise 64% of the high yield index, a sharp increase from 26% at the end of BB financials now comprise 15% of the overall index, up from 0% in This shift in composition has added volatility to high yield spreads and makes relative value comparisons based on historical relationships more difficult. At 655 bp, the Credit Suisse Western European Leveraged Loan Index discount margin is still well above its long-term average of 508 bp. This large excess spread has cushioned investors against default losses, which is evidenced by the strong total return year to date of 9.76%. The outstanding 2006/2007 vintage loans that are in distress will continue to restructure, causing default rates to remain above average. For 2013, we project 75 billion of new European high yield issuance and 20 billion of European institutional leveraged loan issuance. Exhibit 1: Projected 2013 Returns, Defaults and Issuance 2013 Projections Performance Default Rate Issuance W. European High Yield (Hedged in ) 6% 1% - 2% 75 Bln W. European Lev. Loans (Hedged in ) 5% 2% - 4% 20 Bln Visit our website at: ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES ARE IN THE DISCLOSURE APPENDIX. FOR OTHER IMPORTANT DISCLOSURES, PLEASE REFER TO CREDIT SUISSE SECURITIES RESEARCH & ANALYTICS BEYOND INFORMATION Client-Driven Solutions, Insights, and Access

2 The Euro Area and U.K. economies have been in mild recession for most of 2012, with a clear downward trend in PMIs and other leading indicators for the past two years. However, these indicators have stabilized recently and show signs of improvement. Credit Suisse Economics Research expects the euro area economy to pull out of recession early in the new year, though it is likely to be a slow, U-shaped recovery because there is little scope for the inventory-driven bounce in output that was seen in early Exhibit 2: Euro and UK PMIs European PMI UK Services PMI UK Manufacturing PMI Eurozone Services PMI Eurozone Manufacturing PMI /31/2006 6/30/2006 9/30/ /31/2006 3/31/2007 6/30/2007 9/30/ /31/2007 3/31/2008 6/30/2008 9/30/ /31/2008 3/31/2009 6/30/2009 9/30/ /31/2009 3/31/2010 6/30/2010 9/30/ /31/2010 3/31/2011 6/30/2011 9/30/ /31/2011 3/31/2012 6/30/2012 9/30/2012, the BLOOMBERG PROFESSIONAL service This low growth scenario should limit the spread tightening in the high yield market, though this wasn t the case in Peripheral sovereign risk was the more important driver in 2012 for European high yield, with the average five-year yield of Italy, Spain and Portugal tightening 400 bp. This decline in peripheral sovereign yields can t be repeated to the same extent in 2013, though CS Interest Rates Strategy expects 2009 levels to be tested during the year, meaning that there could still be bp more tightening of peripheral sovereigns in This could continue to exert some downward pressure on yields, though we expect the economic outlook to dominate performance as 2013 progresses. Exhibit 3: 5-Year Peripheral Sovereign Yield (Italy, Spain, Portugal) versus Credit Suisse Western European High Yield Index Yield 12.00% 10.00% 8.00% Yield 6.00% 4.00% 2.00% Western European HY Yield-to-Worst Peripheral Sovereign 0.00% 12/31/2009 2/28/2010 4/30/2010 6/30/2010 8/31/ /31/ /31/2010 2/28/2011 4/30/2011 6/30/2011 8/31/ /31/ /31/2011 2/29/2012 4/30/2012 6/30/2012 8/31/ /31/2012, the BLOOMBERG PROFESSIONAL service Leveraged Finance Outlook 2

3 Our total return projection for 2013 for Western European high yield is 6%. When we examine the most likely scenarios for stronger or weaker growth, we forecast a range of 5% to 7%. The Credit Suisse Western European High Yield Index spread is currently 540 bp, 97 bp tighter than the long-term average. Spreads have tightened during the current Euro Area recession for two reasons. First, most original issue high yield is located in the core countries, which have been less affected thus far. Second, as fallen angels enter the market from the peripheral countries, they enter as BBs with relatively low spreads, tightening the average. Exhibit 4: Credit Suisse Western European High Yield Index Spread Spread to Worst 1800bps 1600bps 1400bps 1200bps 1000bps 800bps 600bps 400bps 200bps 0bps Average STW: 637 bp 353 bp 9/30/ bp 9/28/ /31/ bp 219 bp 5/31/2007 2/28/ bp 540 bp 12/6/2012 These shifts are shown in Exhibit 5. Currently, bonds with a BB from at least one ratings agency comprise 64% of the Credit Suisse Western European High Yield Index, a sharp increase from 26% at the end of This occurred in two stages. The composition of original issue high yield shifted towards BBs in as several companies were upgraded from B. Beginning in 2009, fallen angel financials entered the BB segment. BB financials now comprise 15% of the overall index, up from 0% in Exhibit 5: Market Weights by Rating and Industry of the Credit Suisse Western European High Yield Index 100% 90% 26% % of WE HY Index 80% 70% 60% 50% 40% 30% 20% 74% 49% 49% 15% 49% 34% BB, ex-financials BB Financials B and below, ex-financials 10% 0% B and below Financials Leveraged Finance Outlook 3

4 These ongoing shifts have added more volatility to high yield spreads, as financials were dramatically wider than non-financials last year but now are tighter. Exhibit 6: Western European High Yield Spreads, Industrials vs. Financials 2300 bp Spread-to-Worst 1800 bp 1300 bp 800 bp 300 bp 1256 bp 860 bp 552 bp 485 bp 1/1/2009 3/1/2009 5/1/2009 7/1/2009 9/1/ /1/2009 1/1/2010 3/1/2010 5/1/2010 7/1/2010 9/1/ /1/2010 1/1/2011 3/1/2011 5/1/2011 7/1/2011 9/1/ /1/2011 1/1/2012 3/1/2012 5/1/2012 7/1/2012 9/1/ /1/2012 Financials WE HY Index Ex-Financials These shifts in composition are also evident in the relationship between core and peripheral spreads. About half of the year-to-date spread tightening in the periphery has been caused by the addition of fallen angels into the periphery segment, the majority of which are BB-rated banks that trade tighter than the index. The average spread of the peripheral fallen angels added to the index in 2012 is 539 bp, a significant source of the peripheral tightening. Exhibit 7: Western European High Yield Spreads, Core vs. Periphery 1400 bp 1200 bp Spread-to-Worst 1000 bp 800 bp 600 bp 400 bp 608 bp 540 bp 516 bp Periphery CS WE Index Core 200 bp 12/31/2010 1/31/2011 2/28/2011 3/31/2011 4/30/2011 5/31/2011 6/30/2011 7/31/2011 8/31/2011 9/30/ /31/ /30/ /31/2011 1/31/2012 2/29/2012 3/31/2012 4/30/2012 5/31/2012 6/30/2012 7/31/2012 8/31/2012 9/30/ /31/ /30/2012 Though the difference between peripheral and core spreads has tightened remarkably year to date as a result of the shift in composition, the total returns have been very similar. Exhibit 8: Core versus Periphery: Spread Differential and YTD Total Returns Peripheral-Core Spread Difference 600 bp 500 bp 400 bp 300 bp 200 bp 100 bp 109 bp Peripheral-Core Spread Difference 9/23/ bp 12/30/ bp 12/6/12 92 bp Cumulative Total Return YTD 25% 20% 15% 10% 5% 23.09% 21.50% 20.95% Periphery CS WE Index Core 0 bp 0% Leveraged Finance Outlook 4

5 The rapidly changing composition of the market presents several challenges. First of all, relative value comparisons are more difficult. For example, it appears that peripheral spreads are far too tight relative to core spreads, but much of this depends on the fate of the downgraded banks. Additionally, building forecasts based on historical relationships is more challenging. We build our return projections model based on the correlation of spreads to GDP growth over a long baseline. Since the ratings composition has changed so dramatically in the last six years, we must examine this relationship for each ratings category and assemble the results into an overall market projection. Comparing BB spreads to GDP growth shows that the BB segment of the market is tighter than current GDP growth implies, but is roughly in line with expectations for the end of Exhibit 9: W. Euro. High Yield BB Spread vs. Next Quarter Real Euro GDP 6.0% 0 bp Next Qtr YoY Real GDP %Chng 4.0% 2.0% 0.0% -2.0% -4.0% -6.0% -8.0% -10.0% Correlation =.75 YoY% CS Economic Forecasts 200 bp 400 bp 600 bp 800 bp 1000 bp 1200 bp BB Spread to Worst Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Next Qtr Real Euro GDP YoY %Chng CS Econ Forecast YoY% BB Spread-to-Worst, the BLOOMBERG PROFESSIONAL service This is also true if we compare GDP growth against the spreads of other rating categories. Weighting all of the ratings segments produces an implied spread of 535 bp for 2013, 5 bp tighter than current spread of 540 bp. We are using the CS Economics team s Euro Area GDP growth forecast of 1.8%. Exhibit 10: Western European High Yield Index Spread Projections Historical Spread at 1.8% GDP growth % of Index Spread Contribution at 1.8% GDP growth Split BBB 285 bp 8.01% 23 bp BB 400 bp 45.07% 180 bp Split BB 487 bp 11.90% 58 bp B 614 bp 21.64% 133 bp Split B 907 bp 5.59% 51 bp CCC/Split CCC 1351 bp 5.80% 78 bp Not Rated 580 bp 1.99% 12 bp Total % 535 bp Leveraged Finance Outlook 5

6 We believe that there is modest room for more spread tightening in 2012, given improving economic conditions. Our total return projection for Western European high yield for 2013 is 6%. When we examine the most likely scenarios for stronger or weaker growth, we forecast a range of 5% to 7%. Exhibit 11: CS Western European High Yield Return Projections Detail 12/6/2013 Growth of 1.8% 535 bp Spread as of 12/6/ bp Spread Change Bund Widening Total Yield Change -5 bp 28 bp 23 bp Yield-to-Worst as of 12/6/ % Future Yield-to-Worst 5.97% Price as of 12/6/ Future Price (Implied by Yield) Principal Return -0.78% Interest Return 6.88% Total Return for % Methodology notes: The base GDP growth of 1.8% is the quarter-over-quarter projection of our economics team. The spread associated with this economic outcome is from the historical correlation of GDP with high yield spreads as seen in Exhibit 10. The Bund widening is based on the projection of our interest rates team. The interest return is the current yield (average coupon / average price). European high yield spreads are currently 23 bp tighter than U.S. spreads. The year started with European spreads 172 bp wider, a swing of 195 bp during This tightening is the source of the 8% outperformance by European high yield relative to U.S. this year. The historical tights of this relationship are about 70 bp tighter, but given the lower coupon and higher average rating of European high yield, it will be much more difficult for European high yield to outperform U.S. high yield in Exhibit 12: Western European versus U.S. High Yield Spread-to-Worst West. Euro - U.S. Spread Basis 400 bp 350 bp 331 bp 300 bp 257 bp 250 bp 200 bp 172 bp 150 bp 100 bp 50 bp 0 bp -50 bp -100 bp -150 bp -111 bp -92 bp Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec bp West. Euro. Spread - U.S. Spread Leveraged Finance Outlook 6

7 Looking at the maturity schedule for financials versus non-financials shows that the plurality of near-term default risk stems from the financials. Spreads for financials maturing 2013 through 2015 are 424 bp, compared to the remainder of the market at 362 bp. To an increasing extent, default projections are tied to the fate of the peripheral banks, which is inherently political. Exhibit 13: W. Euro. High Yield Maturities: Financials vs. Non-Financials Billions Financials Non-Financials Default rates have remained low despite the recession and are currently at 0.98%. Our default forecast is 1% to 2% in 2013 and 1% to 3% in There is a modest allowance for peripheral bank defaults in this analysis. Exhibit 14: Default Rates and Projections 20% 18% 16% 17.28% 33.91% Default Rate 14% 12% 10% 8% 6% 12.43% 6.56% 4% 2% 0% 2.35% 2.60% 1.20% 1.97% 0.97% 1.00% 1.60% 0.53% 1.06% 3.20% 0.98% 1%-2%1%-3% LTM 2013 Nov 12 (est.) European High Yield Default Rate 2014 (est.) Leveraged Finance Outlook 7

8 The market issued a record of 52.5 billion of new issuance so far in We expect 2013 to set another record. Exhibit 15: Western European High Yield New Issuance Proceeds ( Bln Equiv.) Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Total YTD at 12/ We project 75 billion of new European high yield issuance in We base this projection on two analyses. In both of these analyses, we are excluding the effects of fallen angels since they are usually non-callable and less likely to be refinanced. Fallen angels in the European high yield market have grown to 37% of the market size, versus 16% two years ago. Our first analysis of 2013 issuance is based on the refinancing supply. As shown in Exhibit 16, there is 21 billion face value trading to a call in 2013 and another 18 billion maturing and trading above par, which implies 39 billion in refinancing activity. Assuming refinancing activity accounts for 55% of issuance as it did in 2012, M&A and general corporate issuance will add an additional 31 billion of new money to the market. Adding these estimates, this analysis suggests 70 billion in new issuance in Exhibit 16: W. Euro. High Yield New Issuance used for refinancing New Issuance for Refinancing ( billions) Projected billion currently trading to 2013 call 18 billion maturing in 2013 & trading above par Leveraged Finance Outlook 8

9 Our second analysis of 2013 issuance is based on the fact that when the yield falls significantly below the coupon, there is a wave of refinancing in the high yield market. Currently, the yield is 175 bp below the coupon, the largest difference since This is driving record new issuance and will continue to do so in Exhibit 17: Yield-to-Worst versus Coupon of CS Western European HY Index, excluding Fallen Angels 22.00% 20.00% 18.00% 16.00% 14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 9/30/ % 9/30/ % coupon-yield = 142 bps 2/28/ % 2/28/ % coupon-yield= 250 bps 2/28/ % 2/28/ % coupon - yield= 136 bps 0.00% Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11 coupon - yield= 175 bps 7.86% 6.11% Yields below coupon are equivalent to prices above par. There is a coincident relationship between average price and issuance, as seen in Exhibit 18. Since the absolute volume of issuance has grown with the outstanding market size, we used a relative measure, the issuance volume as a percentage of the outstanding market. This relationship suggests issuance over the next year to average 3.5% per month of the 205 billion of original issue high yield currently outstanding, which equates to 85 billion issuance for Exhibit 18: Western European High Yield Price vs. New Issuance as a % of Total Outstanding (3-Month Rolling Average, Excludes Fallen Angels) Average Price (Excl. Defaults & FAs) 115% 105% 95% 85% 75% 65% 55% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% Issuance % of Outstanding Avg Px (ex Defaults & FAs) Issuance % of Outstanding (3-Month Rolling Average) Taking each of these analyses into account, 70 billion from the first and 85 billion from the second, we weighted them towards the more conservative estimate. We project 75 billion of new European high yield issuance in Leveraged Finance Outlook 9

10 Western European Leveraged Loans Our total return projection for 2013 for Western European leveraged loans is 5%. When we examine the most likely scenarios for stronger or weaker growth, we forecast a range of 4% to 6%. Our default forecast is 2% to 4% in 2013 and 2% to 6% in At 655 bp, the Credit Suisse Western European Leveraged Loan Index discount margin is still well above its long-term average of 508 bp. This elevated level is adequate to compensate for risk, though the discount margin has tightened by 181 bp year to date. This is also borne out by the strong total return year to date of 9.76%, as compared to the negative total return of -0.65% experienced in 2011 when discount margins began the year too low and weren t adequately compensating investors for risk. Exhibit 19: Credit Suisse Western European Leveraged Loan Index 3-Year Discount Margin 2000bps 12/31/ bp 1600bps Discount Margin 1200bps 800bps 400bps 0bps 531 bp 12/31/2001 Average 3 yr Discount Margin: 508 bp 238 bp 4/30/ bp 12/6/2012 3yr Discount Margin (assumes 3yr refin) Series1 This is illustrated by comparing the discount margin to the default loss rate. The large excess spread in the market has cushioned investors against default losses, which are approaching 2009 levels. The current difference between the discount margin and default loss rate has tightened as default losses have increased and discount margins have tightened, and it is now much closer to the pre-2009 average difference of 364 bp. Exhibit 20: Western European Leveraged Loan Discount Margin vs. Default Loss Default Loss Rate 20.0% 18.0% 16.0% 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% Correlation: 0.90 Average Difference : 364 bp 1973 bp 4.59% Average Difference : 634 bp 11/30/ bp 3.22% 2000 bp 1800 bp 1600 bp 1400 bp 1200 bp 1000 bp 800 bp 600 bp 400 bp 200 bp 0 bp 3-Year Discount Margin Loan Default Loss Rate (8 Months Later) West. Euro. Loan Discount Margin (3 years) Leveraged Finance Outlook 10

11 The default rate for European loans for the trailing 12 months ending November 2012 is 5.44%. The outstanding 2006/2007 vintage loans that are in distress will continue to restructure, causing default rates to be above average. However, this segment of the market is priced for this outcome. There are 8 billion of loans maturing in the next two years that currently have discount margins to maturity greater than 1000bp. Exhibit 21: W. Euro. Leveraged Loan Maturities by Discount Margin Billions WE Leveraged Loans Discount Margin (to Maturity) >= 1000 bp Maturing by Year (As of 11/30/12) WE Leveraged Loans Discount Margin (to Maturity) < 1000 bp Maturing by Year (As of 11/30/12) We project the European loan default rate decreases from 5.44% currently to 2% to 4% in Since there are a number of distressed loans maturing in 2015 which will likely have some sort of restructuring or default event in 2014 (if not earlier), we project 2% to 6% defaults in Exhibit 22: Western European Loan Default Rates Western Europe Loan Default Rate 20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% 1.43% 16.05% 47.00% 1.07% 2.32% 0.83% 1.81% 0.09% 2.15% 6.79% 4.57% 0.95% 5.44% LTM Nov 12 Defaulted loans defined as missed coupon, filed for bankruptcy, entered administration, distressed exchange, or cross-defaults. *Institutional includes TL-b, TL-c, TL-d, delayed-draw and other tranches generally held by institutional investors Leveraged Finance Outlook 11

12 Exhibit 23 compares the Euro Area manufacturing PMI (inverted scale) to the leveraged loan discount margin. These have been fairly well correlated over the recent past. If the PMI breaks through 50 next year, the loan discount margin could tighten below 600 bp. Exhibit 23: Euro Area PMI versus W. Euro. Leveraged Loan Discount Margin Discount Margin 2000 bp 1800 bp 1600 bp 1400 bp 1200 bp 1000 bp 800 bp 600 bp 400 bp 200 bp Discount Margin (3-year life) Eurozone Manufacturing PMI Eurozone PMI (Inverted) 0 bp Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar The size of the Western European loan market continued to decrease in 2012, though at a slower rate than in prior years. New issuance and prepayments were nearly equal, so bond-for-loan refinancings and bankruptcy resolutions were the primary source of the 9.5bn decline in the market size year to date. Approximately 10% of the market was extended as issuers continue to buy time to grow into their capital structure. Exhibit 24: Western European Leveraged Loan Events Inst'l Loan Events ( Bln Equiv.) * New Issuance Issued in Extension Issued in Exchange Additions: Prepaid w/ Bonds Prepaid w/ Equity Prepaid w/ Loans/Cash Extended Bankruptcy Resolution Rising Star Illiquid/Unknown/FX Adjustments Deletions: Net Change: Beginning Size Ending Size *As of Nov 30, 2012 Leveraged Finance Outlook 12

13 Institutional issuance has been 20.4 billion year to date, which is about 13% of the December 2011 market size. This rate is too slow to refinance the market as older loans approach maturity. There was only one new CLO issued in Europe this year, and the lack of a CLO market makes refinancing more challenging than in the U.S. The U.S. market is refinancing at about a third of the overall loan market size each year. Exhibit 25: Percentage of Facilities Outstanding Issued Prior to 2009 % Loan Facilities Issued Prior to % 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Dec 6, % 14.5% Western European Leveraged Loans US Leveraged Loans Nevertheless, given the weakness in the European banking system, we do not forecast a change in this dynamic for We project 20 billion European institutional loan issuance for Exhibit 26: W. Euro. Institutional Leveraged Loan Issuance Institutional New Issue Volume ( Billions) /31/ /31/ Leveraged Finance Outlook 13

14 The 124 bp differential between loan and bond yields is wider than the average of 95 bp since We expect this differential to tighten throughout 2013 as the strengthening economy tightens loan discount margins, but rising Bund yields pressure high yield bond yields. Exhibit 27: W. Euro. Leveraged Loan Yield (3yr life) vs. High Yield Yield-to- Worst 22.00% 20.00% Correlation : 0.65 Correlation : % 16.00% Yield 14.00% 12.00% 10.00% 12/6/ % 6.00% 4.00% 6.99% Loans 5.75% HY Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 CS West Euro. HY YTW CS West Euro. Leveraged Loan Index Yield (3-year life) Based on the relationship in yields between European high yield and European loans, our total return projection for 2013 for European leveraged loans is 5%. When we examine scenarios for stronger or weaker growth, we forecast a range of 4%-6%. In the table below, we derive the future loan yield by assuming that the difference between loan yields and bond yields will be 80 bp at the end of The interest return is the current yield (average coupon / average price). Exhibit 28: Western European Leveraged Loan Return Projections Detail 12/6/2013 Loan Yield as of 12/6/ % Future Loan Yield (80 bp wide of HY) 6.77% Current Price Future Price (Implied by Yield) Principal Return 0.63% Interest Return 4.36% Total Return 4.99% Leveraged Finance Outlook 14

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17 Global Leveraged Finance Strategy Jonathan Blau - Head of Global Leveraged Finance Strategy Jonathan Blau Managing Director (212) Daniel Sweeney Director (212) Karen Friedlander Associate (212)