CIO’s Perspective 2015 Leveraged Credit Review and 2016 ...€¦ · 2015 Leveraged Credit Review...

CIO’s Perspective

2015 Leveraged Credit Review and 2016 Outlook:

Transitioning through the Teens

David J. BreazzanoPresident, Chief Investment Officer

Mr. Breazzano is a co-founder of DDJ and has more than 35 years of experience

in high yield, distressed and special situations investing. At DDJ, he oversees all

aspects of the firm and chairs both the Management Operating and Investment

Review Committees.

> WebelievethatanewcreditcyclebeganinJune2014andthatfurtherspread

wideningislikelyin2016

> Thevelocityofthetransitionofthiscurrentcyclefromloosetotightcreditiskeyto

restoringpositivereturnsquickly

> Securityselectionisofparamountimportanceinaspread-wideningenvironment

Stony Brook Office Park | 130 Turner Street | Building 3, Suite 600 | Waltham, MA 02453

Phone 781.283.8500 Web ddjcap.com

DDJ CAPITAL MANAGEMENT, LLCSPECIALISTS IN HIGH YIELD AND SPECIAL SITUATIONS INVESTMENTS

JANUARY 2016VOLUME 3 • ISSUE 1

CELEBRATING 20 YEARS! 1996-2016

2015 LEVERAGED CREDIT REVIEW AND 2016 OUTLOOK

DDJ | CAPITAL MANAGEMENT 2

Introduction

Anyone who has parented a teenager has likely experienced a period of time like 2015 was

for the leveraged credit market.1 The fifteenth year of this current century was rife with angst,

wild mood swings, and insecurity, just like many kids endure around the same age. In fact,

for much of the fourteenth year, the market behaved similarly, and our expectations are for a

continuation of such patterns into 2016, which draws a relatable parallel to the transition that a

person makes from child to young adult.

In other words, in our view, the leveraged credit market is going through a sometimes painful

but very much normal and healthy transformative stage. Such change has been necessitated

by many factors that are outside of the leveraged credit market, such as a weak global

economy and a tenuous domestic economic recovery, along with a reversal of a persistently

lax monetary policy in the U.S.

Also contributing to the rough transition is the relative dearth of market-making activity

by broker/dealers, a feature that is intrinsic to the leveraged credit market. In light of this

development (largely spurred by recent regulatory changes), the liquidity of the leveraged

credit market has deteriorated significantly compared to similar market eras, which, as we will

discuss later, tends to exacerbate the volatility of price movements.

As these external and internal factors have emerged, the market has adjusted its risk premium

higher. However, based on the historical record, we believe that further adjustments will

be necessary to align market pricing with the risks presented by the unfolding economic,

geopolitical, and liquidity backdrop.

1 In DDJ’s view, all below investment-grade corporate debt comprises the leveraged credit market, including high yield bonds, syndicated and non-syndicated leveraged loans, and other similar corporate debt instruments.

The leveraged

credit market is

going through a

transformative

stage.



2015 Review

Exhibit 1: Performance and Characteristics of High Yield Bonds and Leveraged Loans2

December 31, 2014 1H 2015

December 31, 2015 Δ 2H 2015

High Yield Bonds (HYBI)

Total Return YTD 2.50% 2.49% -4.64% -6.96%

Yield (YTW) 6.65% 6.65% 8.76% +2.20

Spread (OAS) 504 bps 500 bps 695 bps +195 bps

Price 98.87 98.21 88.82 -9.39

Coupon 6.92% 6.79% 6.66% -0.13%

Current Yield 7.00% 6.91% 7.50% +0.59%

Average Rating B1 B1 B1 Unch

Eff. Duration 4.46 4.49 4.38 -0.11

Default Rate (Par)* 1.63% 2.12% 2.56% +0.96%

Leveraged Loans (JPM)

Total Return YTD 2.05% 3.01% 0.54% -2.40%

Yield (3-year) 6.16% 5.81% 7.55% +1.74%

Spread (3-year) 491 bps 458 bps 617 bps +159 bps

Price 96.99 97.76 93.39 -4.37

Default Rate (Par)* 1.70% 1.79% 1.74% +0.23%

* Includes distressed exchanges.

Past performance is no guarantee of future results.

Report Card

After posting solid first-half grades, high yield bonds succumbed to an array of negative

influences and flailed in the second half of 2015, going from a +2.49% return to end the year

at -4.64%. During such time, for the first time in its history, the market saw four consecutive

months of negative returns. The full year loss marked the end of a gainful, seven year

run following the 2008 financial crisis, in which the high yield bond market produced an

annualized return of +12.6%.3

Leveraged loans behaved in a similar fashion to bonds, registering a strong +3.01% return

for the first half of 2015, but then giving up most of the gains to end the year at +0.54%.

Interestingly, 2015 was actually the first time since 2007 that leveraged loans outperformed

high yield bonds. Also, in response to substantial retail outflows and declining new

Collateralized Loan Obligation (“CLO”) issuance, 2015 also marked the lowest primary volume

in leveraged loans since 2011.

High yield bonds entered the year offering an average current yield4 of 7.0%, of which almost

all of such yield was expected to be generated by coupon income. However, as the year

progressed and the market turned negative, any coupon income was offset by the market re-

pricing itself lower, concluding the year with a roughly 10-point drop in the average price and

2 High Yield bond data was sourced from the BofA Merrill Lynch US High Yield Index (“HYBI”). Leveraged loan data was sourced from the JP Morgan Leveraged Loan Index (“JPM”).

3 According to the BofA Merrill Lynch US High Yield Index for the period between 12/31/08 and 12/31/15.4 Current Yield = Average Coupon/Average Price.



over 190 basis points (bps) of spread widening. As expected by their safer risk profile relative

to bonds, loans were more resilient over the year with only an approximate 3.6 point decline in

average price and 126 bps of spread widening compared to the start of the year.

A Few Troublemakers in the Group

As was the case at the end of 2014, the main culprits behind 2015’s poor high yield bond

market performance were issuers within three industry sectors: Metals & Mining, Energy,

and Steel, which returned -26.2%, -23.6%, and -20.7%, respectively (shown in Exhibit 2). All

together, these three sectors represent over 20% of the HYBI and as we will discuss later, their

weighted-average returns and characteristics heavily skew the overall market averages.

Unlike the breakdown of returns by industry, which had numerous positive contributors, Exhibit

2 also displays that all three ratings classifications produced losses. Interestingly, although

triple C rated bonds lost more than three times the overall market average, their negative

impact was more than offset by the heavier-weighted double B rated bonds, which performed

well on a relative basis, losing only about one-fifth of the market average, essentially leaving

the returns of single B paper more representative of overall market performance.

Exhibit 2: High Yield Bond Performance Breakdown by Industry and Ratings (January 1, 2015 - December 1, 2015)

Source: Bank of America Merrill Lynch.


With loans (Exhibit 3), there were fewer troublemakers, with only five industry sectors

posting negative returns. Similar to the high yield bond market, both the Energy and

Metals & Mining sectors generated the worst returns, though their relatively lower weighting

prevented an overall loss for the index. Also, as was the case with ratings tiers, the lower-tier

underperformed the index dramatically but was offset by double B rated loan performance,

which performed well on a relative basis.

3M LIBOR Fed Funds Average (Pre-‘08)

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Average 5.4%

-30% -25% -20% -15% -10% -5% 0% 5% 10%

Metals/MiningEnergy

SteelPaper

AerospaceChemicals

UtilitiesTransportation

BroadcastingTelecommunications

Non-Food RetailRailroad

PublishingServices

InsuranceTechnology

FinancialsMedia

AutomotiveHealthcare

Capital GoodsCable TV

EnvironmentalGamingAirlines

Real EstateContainers

LeisureBuilding Materials

Consumer ProductsBanks

EntertainmentHotels

RestaurantsFood & Drug Retail

Food/Beverage/Tobacco


01/

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3

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Average 5.4%

-15%

-12%

-9%

-6%

-3%

0%CCCsBsBBs

Issuers in the

Metals & Mining,

Energy, and Steel

sectors led the

poor performance.



Exhibit 3: Leveraged Loan Performance Breakdown by Industry and Ratings (January 1, 2015 – December 1, 2015)

Source: JP Morgan.


Lots of Bullying

A confluence of both macroeconomic and market-specific factors kept the investment

community on edge for most of the year. Whether new data emerged reflecting a slowdown

in China, or the release of minutes from a Federal Reserve meeting conveyed a confusing

message, investors often reacted intensely, leading to a number of tantrum-like selloffs.

For example, the price action on a number of heavily traded high yield bonds of issuers such

as JCrew, Valeant, and several large hospitals responded severely to negative news and in

some cases dove by 20-30% in short order.5 Meanwhile, capital flows in the mutual fund

complex were tumultuous throughout the year and in the case of the Third Avenue Focused

Credit Fund, investor withdrawals led to the near collapse of a legendary investor’s 24-year-

old firm. Finally, record merger and acquisition activity in 2015 against a backdrop of skittish,

on-again off-again investor interest prompted a return to the days of the 2007-era “hung

deals”6 at some of the major investment banks.

In the end, 2015 was one of the most significant years for the leveraged credit markets that

we have seen since the financial crisis of 2008 and from which we investors must extrapolate

potential outcomes for the asset class in the context of the overall credit cycle.


01/

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Average 5.4%

-25% -20% -15% -10% -5% 0% 5%

Metals/Mining

Energy

Broadcasting

Utility

Diversified Media

Retail

Industrials

Healthcare

Automotive

Consumer Products

Services

Technology

Paper/Packaging

Cable/Satellite

Transportation

Telecom

Chemicals

Financial

Gaming/Leisure

Housing

Food/Beverage


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Average 5.4%

-20%

-15%

-10%

-5%

0%

5%Split B/CCCBsBBs

5 The DDJ Opportunistic High Yield Fund does not hold JCrew or Valeant as of January 31, 2016. 6 In leveraged credit parlance a ‘hung deal’ typically refers to a debt financing that, due to poor market conditions, is unintentionally held on the balance sheet of

a bank.



2016 Outlook: The Velocity of the Transition is Key

As they transform from children into young adults, some teenagers barely sprout a pimple

while others linger in pubescent purgatory for years. Such is the case with credit cycles as

they transition from low yields during periods of loose and easily-attained credit, to peak

yields in tight, inflexible credit environments, and then back again. In other words, different

phases of credit cycles can last anywhere from several months to several years.

When viewed in the context of historical market barometers like the average high yield bond

spread over Treasuries, credit cycles are plainly evident and are marked by “inflection points”,

as shown in Exhibit 4.

Exhibit 4: The Anatomy of a Credit Cycle

Source: BofA Merrill Lynch.


While the occurrence of each inflection point within the high yield market is evident in

hindsight, in real time, identifying when an inflection point is reached is truly anyone’s guess.

It is pretty clear to us that a new credit cycle (Cycle II) began in the beginning of June 2007

when the high yield bond spread reached a historic low of 241 bps, signifying what may have

been the easiest point at which a debtor could obtain credit.

Cycle I Cycle II

Average (Pre-‘08)

12/3

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1/15

Op

tio

n A

dju

sted

Sp

read

(b

ps)

0

500

1,000

1,500

2,000

2,500

Inflection PointOctober 17, 1997

244 bps

Inflection PointOctober 10, 2002

1120 bps

Inflection PointDecember 15, 2008

2147 bps

Inflection PointJune 1, 2007

241 bps

Inflection PointJune 24, 2014

337 bps

Long Term Average 515



On the flipside, it is also clear that the market reached its stingiest point for borrowers to

obtain debt financing on or around December 15th, 2008, when the high yield spread topped

out at 2,147 bps, an all-time high. In this case, the transition from loose credit conditions to

tight took approximately 18 months. This timeframe was actually relatively quick compared to

the previous credit cycle (Cycle I), which took roughly five years (December 1997 to October

2002) to see the same loose-to-tight credit transition. Then, it took another five years for

credit conditions to loosen up, culminating in the completion of the 1997 to 2007 credit cycle.

Now, however, only time will tell whether the credit cycle that began in 2007 has run its

course. In fact, we believe that a new cycle started around the end of June 2014 when

the average spread hit a recent low of 337 bps. If we assume that this is the case, the big

unknowns now become, 1) the absolute level at which the spread reaches a pinnacle (tight

credit) for this cycle and, 2) when that will happen.

In our view, the quicker that the spread widening occurs, the sooner the market can return to a

healthier state and offer strong risk-adjusted returns. Alternatively, if the market transitions at

a slow pace, a prolonged period of volatility is likely to result.

Sometimes Being Average is Not Average

At year-end 2015, the average spread for high yield bonds was 695 bps. While such spread

was significantly wider than the long term average of 515 bps, it is still well below the peak

levels of other inflection points seen in the past. In actuality, the recent average spread level

is a bit deceiving as a barometer of market richness/cheapness due to the impact of the three

troublemaking sectors mentioned earlier: Metals & Mining, Energy, and Steel.

Given the significant (20%+) index weighting of these three sectors, coupled with the extreme

spread widening that occurred within these sectors, the overall average of the broader market

is somewhat overstated. Furthermore, the bullied condition of a number of issuers in other

sectors (e.g., Sprint, JCrew, etc.) skews the average (calculated as a mean) higher.

So for an investment strategy that targets performing bonds and loans that are not expected

to undergo a restructuring or otherwise become distressed, the true value propositions of the

market as described by the average spread level is not as cheap as advertised.

The quicker the

spread widening

occurs, the sooner

the market can

become healthier.



Exhibit 5: Industry Spreads (Minimum, Maximum, and Median) at 12/31/15

Source: BofA Merrill Lynch.


Exhibit 5 presents an analysis of the industry sectors that comprise the HYBI, adjusted for

extreme outliers, i.e., bond issues that appear destined for some kind of debt restructuring.7

Based on this chart, two substantial observations appear to us.

First, based on the median spread in each industry as compared to the mean,8 outside of

the three most troubled sectors, no sector offers a median yield that is above the headline

market mean. In statistical terms, because the median spread is below the mean, the majority

subgroup within the population of spreads are skewed “to the left”, or below the mathematical

average. Or, in real-world terms, the chart is showing us that there are fewer bonds that yield

at or above the market than bonds that offer a below-average yield (especially outside of the

troublesome sectors).

The second major observation relates to the extensive dispersion of spreads within each

industry sector. Even after adjusting for the outliers, in many industries, the maximum spread

offered by a particular issue was 1,000 bps wider than the average.9 To us, this means that

some, but not many, bonds are already “correcting” to new spread levels, but because the

sector median is still very low, the majority of bonds have yet to adjust.

7 For simplicity purposes, all bonds at or yielding above 20% were excluded from this analysis.8 An investor typically cannot buy a bond that is offering a mean yield, but realistically may buy one that offers the median yield. 9 We did not exclude short-term maturities and/or yield-to-call bonds in this analysis, which contribute toward a wide dispersion.

776

582

1678

396

1038

871

1655

1848

939 992

1714

1420

1576

1782 1794

1695 1746

1455 1419 1445

658

1680

1236

1827

1629 1676

1827

1439 1436

1701

1907

1807

1716

1831

72

225 213 215 232 211

119 205

165 233

116 170

93 164 198 175

131 134

338

201 272

173 228 249

195 181 178 246

192 167 139 186

311 236

257 265 323 326 332 357 363 372 373 394 397 397 403 403 411 417 422 430 431 432 432 446 463

500 503 521 573 605 608

618 667

816 857

1078

0

500

1000

1500

2000

2500

Op#

on Adjusted Spread

(bps)

Average (Median) OAS

Market Average (Mean): 695 bps



Keep Your Friends Close but Your Enemies Closer

While a market correction and/or turn in the credit cycle is not yet a foregone conclusion,10

the heightened volatility and negative trends in the high yield bond market suggest to us that

the current credit cycle is in a transformative phase that will likely involve a continuation of

the behavior observed for most of 2015. To the extent that such a condition holds, as we have

observed in the past, spreads would probably move much wider than current levels before

reaching another inflection point and beginning a tightening phase.

But, just because the market is generating headwinds, all is not necessarily bad. Even as the

default rate begins to rise, we believe that the vast majority of companies will still keep current

on their interest payments and ultimately successfully refinance or payoff their principal at or

before maturity. That means that to the extent that the issuer avoids default losses, the yield

offered by a bond (or loan) purchased in the current market can eventually be realized.

Consequently, our contention is that the optimal investment strategy to generate strong

risk-adjusted returns in the current leveraged credit market is to be highly focused on credit

selection (“bond picking”). Such a strategy should identify not only the strong, resilient

issuers (i.e., “friends”) that will pay off their obligations, but equally if not more important, the

weak issuers (i.e., “enemies”) that stand the greatest risk to produce default losses.

While such a bond picking strategy is important to finding outperforming investments in bull

markets, it is invaluable in bear markets. Such is the case because in bull markets, the risk of

losing principal either due to a default or a garden-variety re-pricing of the market is usually

very low. However, as the market enters a phase like the one it is in now, default risk becomes

far more palpable. Therefore, avoiding money-losing securities in such a market becomes of

paramount importance.

In addition to possessing the skills necessary to select the right credits, to truly take advantage

of a market in transition, such as the current one, we believe that investors must maintain

a long-term focus, which from time to time can entail enduring temporary, mark-to-market

losses. In our experience, many of the time periods in which mark-to-market losses occur are

exactly the times to prudently and opportunistically add to high-confidence positions based

on careful credit selection. Being a judicious contrarian during these periods is important

because once the beneficial inflection point11 becomes evident and spreads begin a tightening

trend, investors, hungry for yield, typically rush in and crowd the market, rendering compelling

value propositions much scarcer.

10 The U.S. economy is still growing and recessions are usually the main driver of spread widening and credit cycle reversals.11 Like October 10, 2002 and December 15, 2008 — Exhibit 4.

A successful

“bond picking”

strategy is

invaluable in bear

markets.



Summary

To much of the investment community, the leveraged credit market misbehaved like a

disgruntled teenager in 2015. After years of stable behavior (i.e., low volatility) and good

grades (i.e., returns), the market turned south and disappointed us.

The reasons for the poor returns primarily involved few, but important, industry sectors

that are tied to hydrocarbons and other commodities. The difficulties experienced in those

industries are reflective of anemic global economic growth, particularly that of developing

countries and the relatively new “big man on campus”, China. As we have seen, debt issues in

the affected industry sectors have generally adjusted to the new environment, specifically by

dropping dramatically in price. In many of these cases, such issues will need to be reorganized

either in or out of a bankruptcy court proceeding.

Notwithstanding the significant impact of the beaten-down sectors on the overall market,

we still observe many issuers that are weathering the proverbial storm reasonably well and

whose securities presently trade at or below the average spread of the overall high yield

market. Judging by history, most of the market will pay off or refinance its debt and provide a

return close to its yield. However, to the extent that credit conditions continue to tighten and

spreads widen, we believe that there will be more pain (in the form of mark-to-market losses

and increased default activity) experienced in the near-term.

Encouragingly, however, the high yield market has never experienced two consecutive

negative-return years, so if there is a transitional phase in 2016, we are hopeful that it will

occur swiftly so that the market can return to a more normal, stable state. We believe that

investors who take a long-term, holistic view of the leveraged credit markets will ultimately

realize compelling risk-adjusted returns and now, even more so than in the seven-year bull

market we just experienced, careful security selection will be the key to achieving

such rewards.



Organizational Update

Six Months Ending December 31, 2015 June 30, 2015

Total Assets Under Management (MM) $7,401 $8,655

Total Number of Accounts 43 44

Personnel Updates: Material Changes (Positions) John Sherman*

(Lead Portfolio Manager of the Opportunistic Loan Strategy)

Material Additions (Positions) Michael Weissenburger (Managing Director, Head of Origination)

Sameer Bhalla (Senior Research Analyst)

Joseph Catalano (Research Analyst)

Material Departures (Positions) Dimitri Cohen (Senior Research Analyst)

Michael Yeomans (Director, Business Development and Client Service)

Michael Burke (Research Analyst)

* John Sherman previously served as Assistant Portfolio Manager on the Opportunistic Loan Strategy. He continues to maintain his coverage of the Healthcare sector.



Appendix

BPS: Stands for basis points. A basis point is one one-hundredth of one percent (0.0001).

Collateralized Loan Obligation (“CLO”): A CLO is a form of securitization where payments

from multiple middle sized and large business loans are pooled together and passed on to

different classes of owners in various tranches.

Coupon: The stated interest rate paid on a bond. Coupon payments for high yield bonds

are typically made semi-annually.

Effective Duration: A duration calculation for bonds with embedded options. Effective

duration takes into account that expected cash flows will fluctuate as interest rates change.

High Yield Bond: A high yield bond is a debt security issued by a corporate entity where

the debt has lower than investment grade ratings. It is a major component – along with

leveraged loans – of the leveraged credit market.

Investment Grade: investment grade are those securities rated Baa3/BBB-/BBB- or above

by Moody’s, S&P, and/or Fitch, respectively.

Monetary Policy: Monetary policy is the actions of a central bank, currency board or other

regulatory committee that determine the size and rate of growth of the money supply,

which in turn affects interest rates. Monetary policy is maintained through actions such as

modifying the interest rate, buying or selling government bonds, and changing the amount

of money banks are required to keep in the vault (bank reserves).

Option Adjusted Spread: A measurement of the spread of a fixed-income security rate and

the risk-free rate of return, which is adjusted to take into account an embedded option.

Typically, an analyst would use the Treasury securities yield for the risk-free rate. The

spread is added to the fixed-income security price to make the risk-free bond price the

same as the bond.

Spread: The yield of a bond minus the yield of the government bond that matches the

maturity (or appropriate call date) of the bond.

Disclosures

Funds distributed by ALPS Distributors, Inc. DDJ Capital Management and ALPS

Distributors, Inc. are not affiliated.

Information in this document regarding market or economic trends or the factors

influencing historical or future performance reflects the opinions of management as of the

date of this document. These statements should not be relied upon for any other purpose.

The BofA Merrill Lynch Global High Yield Index tracks the performance of USD, CAD, GBP

and EUR denominated below investment grade corporate debt publicly issued in the major

domestic or eurobond markets. Please note that one cannot invest in the index.

J.P. Morgan Global High Yield Index is designed to mirror the investable universe of the U.S.

dollar global high yield corporate debt market, including domestic and international issues.

Please note that one cannot invest in the index.

Moody’s Investors Service and Standard and Poor’s Financial Services use a different

nomenclature for their ratings system. For example, the Moody’s equivalent to a S&P

rating of CCC+ is Caal. For information on the rating agencies’ methodology go to:

https://www.moodys.com or www.standardandpoors.com.

DDJ000236 8/31/2020



JANUARY 2016VOLUME 3 • ISSUE 1

CIO’s Perspective

2015 Leveraged Credit Review

and 2016 Outlook:

Transitioning through the Teens

ABOUT DDJ CAPITAL MANAGEMENT

DDJ Capital Management’s goal is to consistently produce attractive long-term

investment returns, while minimizing downside risk for our investors, which include:

> Corporate pension accounts and public retirement plans

> Endowments and foundations

> Insurance companies

> Other institutional clients

The underpinning of DDJ — a disciplined investment philosophy, coupled with a

commitment to exhaustive credit research — has remained constant since our founding

in 1996. Our highly skilled team is steadfast and focused on executing our strategy to

identify strong risk-adjusted investment opportunities in the leveraged credit markets.

For information on DDJ’s investment capabilities, please contact:

Jack O’Connor

Head of Business Development and Client Service

[email protected]

Phone 781.283.8500

Web ddjcap.com

Jack O’Connor, head of business development and client service at DDJ, is a

representative of ALPS Distributors, Inc.

CIO’s Perspective 2015 Leveraged Credit Review and 2016 ...€¦ · 2015 Leveraged Credit Review...

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Transcript of CIO’s Perspective 2015 Leveraged Credit Review and 2016 ...€¦ · 2015 Leveraged Credit Review...