In 2014, the U.S. leveraged credit market featured a torrid pace in the first half of the year and an ugly second-half, the result of macroeconomic influences as opposed to changes specific to leveraged credit market issuers. Exiting 2014, many market experts have split into two schools of thought: one that considers the face of the second half of the year to be a “bad hair day” exception to a well-performing, favorably-positioned market, compared with the other group that believes the events of the past six months have permanently disfigured the market and represent the beginning of the end of the current credit cycle.
In our view, the coming year will resemble more the volatility of the second half of 2014 than the prolonged, virtually uni-directional (i.e., up!) market that leveraged credit investors have enjoyed over the past several years.
We expect that oil prices will be a key driver of leveraged credit market volatility this year. Oil prices have yet to stabilize and, until they do, we expect the high yield energy sector to remain volatile. As the market sorts out oil patch winners and losers, many other industry sectors and companies should benefit from increased consumer spending resulting from lower prices at the gas pump and a corresponding reduction in other energy-related expenses. Over the longer term, however, we anticipate that certain energy issuers like service providers and high-cost producers will face the prospects of credit defaults, which will likely push market yields higher and spreads wider.
We also view the potential actions of foreign governments and their central banks as likely contributors to leveraged credit market volatility in 2015.
Foreign economies that derive a significant portion of GDP from oil-related production may be faced with declining revenues. To the extent that a foreign sovereign has high debt service costs, like Venezuela, the risk that the sovereign defaults on its debt rises. Even if the market anticipates such an event, an actual default would likely add to investor angst and threaten market stability.
Secondly, in addition to chronic difficulties with European Union peripherals (e.g., Greece) and economic slowdowns occurring throughout the EU, China and Russia, we believe that governments/central banks will continue to take dramatic monetary and/or fiscal actions to stimulate their economies. These measures include quantitative easing in the EU, currency support by Russia, continued “Abenomics” in Japan, and so on. Actions such as these could have precarious and far-reaching consequences for investor sentiment and the U.S. capital markets.
Before the plunge in oil prices, investors’ expectations for a hike in interest rates were arguably the top concern for leveraged credit participants. Interestingly, the current macroeconomic condition of the U.S. economy, particularly the absence of inflationary pressures (partly due to falling oil prices), suggests that U.S. interest rates can continue to remain well below historical norms. While the Fed soothed markets in December with dovish rate guidance, its actions going forward, if unexpected, can greatly impact volatility.
Two structural factors also contributed to leveraged credit market volatility in the second half of 2014: mutual fund ownership and declining broker-dealer inventories. We believe these two market- specific factors will again contribute to higher-than-normal volatility in 2015.
When mutual funds face large redemptions, their managers are typically forced to sell positions to raise cash to meet fund withdrawals. These redemptions are often exacerbated by a “feedback loop” of negative sentiment caused, simply, by the market going down which, in turn, leads to more redemptions! Large and on-going forced selling can overwhelm existing market demand and, to the extent that the imbalance is significant, the pricing of thinly-traded debt instruments in particular can hit a proverbial “air pocket” and fall dramatically.
Sometimes, for example during the record outflows seen in July, significant redemptions from retail funds can be smoothly transitioned into portfolios for more stable institutional buyers that are waiting on the sidelines for a propitious time to invest. But as the retail migration out of credit increased during the second half of 2014, the market experienced a number of air pockets that lasted from a period of a few days to a week or more. Moreover, the resulting market volatility was exacerbated by a withdrawal of capital by broker-dealers. Based on our observations, this practice by broker dealers is becoming increasingly prevalent in the market.
Traditionally, broker dealers have served as market intermediaries by using their own capital to facilitate trades, which often stabilized price declines and resulted in broker dealer firms holding an inventory of bonds and loans, which they would later sell. As banking reform laws such as Dodd-Frank are being implemented, broker dealer capital used for holding inventories is becoming scarcer, which tends to exaggerate price volatility during times of market dislocation. In fact, during one major sell-off in October, broker dealers were shedding inventory along with mutual funds, a combination that led to a sharp decline in returns.
Other pending financial reform legislation may also have onerous impacts on markets, such as when new rules on Collateralized Loan Obligations are implemented in 2016. Due to significantly higher capital reserve provisions and risk retention required by the new laws, it is widely anticipated that the formation of new CLOs will shrink dramatically, possibly beginning in 2015 as market participants position themselves for the new regulations. Because firms issuing new CLOs have historically been the dominant buyers of newly-issued leveraged loans, their possible retreat from the market may have a meaningful impact on the supply/demand dynamics of the leveraged loan market.
For many, the leveraged credit market went from beauty to beast in just six months. But to us, the opposite was the case; in our opinion, beneath the “ugly” face of the second half of 2014 lies the beauty of opportunity.
As the saying goes, during times of unbridled enthusiasm and insatiable demand by investors, “a rising tide lifts all boats,” even if many of the boats are overloaded and leaking. While returns during a rising tide environment are pleasing to investors, valuations tend to move too far and too fast to the upside, reaching excessive levels which, when confronted with risk factors such as those experienced in the second half of 2014 can move just as excessively on the downside.
The recent correction of valuations unfolded against a backdrop of technical factors related to mutual fund flows and diminishing broker dealer inventories, which exaggerated the decline not only for companies directly affected by headwinds like oil prices, but even companies unaffected by global macroeconomic factors. When such an environment exists and widespread selling occurs, we believe that security prices can detach from true valuation metrics, resulting in market dislocation.
For “bond pickers” — investors whose philosophies and investment processes rely on credit selection—market dislocations, while temporarily ugly, frequently offer compelling value propositions. To successfully maneuver through a more volatile market in 2015, we believe that managers must not only possess reliable and independent valuation capabilities, but also have a long-term investment horizon and access to “patient” capital. Being a provider of capital in a market with high volatility and low liquidity can be quite advantageous to clients as long as the targeted opportunities are afforded the time needed to achieve fruition of the manager’s investment theses.
We believe that 2015 will offer numerous and compelling buying opportunities and, given their multi-year investment horizons, that certain high-yielding corporate debt instruments can offer an attractive return stream not only for 2015 but for several years to come.
Whether these opportunities arise because of a temporary interruption of an ongoing bull market or because an inflection point in spreads is reached, signaling the end of the current credit cycle, there will be beauty to be found in the leveraged credit market in 2015.
David Breazzano is a co-founder of DDJ and has more than 34 years of experience in high yield, distressed and special situations investing. At DDJ, he oversees all aspects of the firm and chairs both the Senior Management and Investment Review Committees.
