Amid what appears to be a fairly volatile market environment, it’s worth checking in on some of the data to understand where we are.
Here are a few headline indicators that I looked up this morning:
- High Yield Option Adj. Spread: 547bps
- BBB-B ETF CLO % of Par: 88.8 (Janus BBB-B ETF)
- Leveraged Loan 100 Index (% of Par): 91.7
- S&P YTD: -23.6%
- US Dollar Index: +17.3%
On the credit side, it seems the market is headed back to the July lows. The market is pricing in a solid amount of stress in the form of future defaults. I previously wrote about the high yield spread, utilizing Verdad Capital’s research to note a guidepost of when the HY spread is north of 600, things tend to get worse but it’s a good time to be investing.
Apollo commented on BBB CLO tranches in early August:
…we believe BBB-rated tranches issued today can withstand an annualized default of the underlying loan portfolio of approximately 11% for each of the 5 years without being impaired.
APO 2Q-22 Earnings Transcript
Barings also outlined the opportunity in BBB CLOs:
But with opportunities emerging to buy bonds at a discount, there
Barings
is a potentially significant pull-to-par opportunity, which we saw with U.S. BBs late in the second quarter. More recently, the spread differential between BBs and BBBs has compressed, and as a result,
we believe higher-quality BBBs have, somewhat unconventionally, started to look attractive as well.
The BBB CLO ETF is yielding north 6% and south of 90% of par – representing a strong return opportunity given ~0.30% average cumulative credit losses for BBB CLO tranches since 1995.
On leveraged loans, Barings outlined the following:
Credit spreads have accordingly remained wide relative to the fundamental risks of the asset class. In fact, with current spreads in the range of 550-650 bps in the U.S. and Europe, and in the context of historical recovery rates, it would take a default rate of over 10% in order to fully erase the excess credit spread that is being offered today. Yields also remain attractive, at around 9% in both the U.S. and Europe, or roughly 400 bps higher versus a year ago. As such, absent an unprecedented increase in default rates-which is not our base case scenario and given the continued tailwind from rising rates, we believe the asset class is in a position to generate healthy returns over the next 12 months, as has historically been the case when spreads have experienced similar widening.
Barings
Leveraged loan BDCs are trading at healthy discounts to NAV – an already somewhat market price adjusted figure, providing substantial buffer for future defaults.
While prices in the short / medium term are often a function of flows versus fundamentals, in the long run fundamentals tend to win. Across the spectrum of credit and equity, there are opportunities abound. Of course, if one believes that we are headed into a structural depression, there’s more permanent impairment to come.
But in an environment today in which negativity is high, it generally pays to be dollar cost averaging into cheap assets.