Q1 2020 CORPORATE CREDIT OUTLOOK

Being selective in 2020Fundamentals are generally solid, but high dispersion among ratings and issuers calls for an active approach to credit investing.

Robert HoffmanManaging Director, Investment Research

As Managing Director of Investment Research, Robert leads the team that analyzes the fundamentals behind market movements, macroeconomic trends and the performance of specific industries – as well as their potential impact on investors. His nearly two-decade tenure in the financial services industry includes experience as a loan portfolio manager and senior credit analyst focused on corporate loan issues. Robert serves as the firm’s primary subject matter expert on the corporate credit markets and select alternative investment solutions, developing targeted communications and educational resources.

FS Investment Solutions, LLC 201 Rouse Boulevard, Philadelphia, PA 19112 www.fsinvestmentsolutions.com 877-628-8575 Member FINRA/SIPC© 2019 FS Investments www.fsinvestments.com

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Investment Research

Robert Hoffman, CFA Managing Director

Lara Rhame Chief U.S. Economist Managing Director

Andrew Korz Associate

Kara O’Halloran, CFA Associate

Contact research@fsinvestments.com

INDEXESHigh yield bonds represented by the ICE BofAML High Yield Master II Index. ICE BofAML U.S. High Yield Master II Index is designed to track the performance of U.S. dollar-denominated below investment grade corporate debt publicly issued in the U.S. domestic market. Loans represented by the S&P/LSTA Leveraged Loan Index. S&P/LSTA Leveraged Loan Index is a market value-weighted index designed to measure the performance of the U.S. leveraged loan market.

This information is educational in nature and does not constitute a financial promotion, investment advice or an inducement or incitement to participate in any product, offering or investment. FS Investments is not adopting, making a recommendation for or endorsing any investment strategy or particular security. All views, opinions and positions expressed herein are that of the author and do not necessarily reflect the views, opinions or positions of FS Investments. All opinions are subject to change without notice, and you should always obtain current information and perform due diligence before participating in any investment. FS Investments does not provide legal or tax advice and the information herein should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact any investment result. FS Investments cannot guarantee that the information herein is accurate, complete, or timely. FS Investments makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information.

Any projections, forecasts and estimates contained herein are based upon certain assumptions that the author considers reasonable. Projections are necessarily speculative in nature, and it can be expected that some or all of the assumptions underlying the projections will not materialize or will vary significantly from actual results. The inclusion of projections herein should not be regarded as a representation or guarantee regarding the reliability, accuracy or completeness of the information contained herein, and neither FS Investments nor the author are under any obligation to update or keep current such information.

All investing is subject to risk, including the possible loss of the money you invest.

Q1 2020 CORPORATE CREDIT OUTLOOK

Investment Research FS Investments 1

Being selective in 2020

Executive summary 2019 was a remarkable year for credit markets. A stable U.S. economic backdrop combined with low corporate default rates and surging U.S. equity markets set the stage for a broad-based rally following volatility in the fourth quarter of 2018. Total returns for high yield bonds and senior secured loans ended 2019 at 14.4% and 8.6%, respectively, roughly double the average return for both markets over the past 10 years.

However, despite the strong returns for credit markets overall, there was a wide dispersion in returns. For both high yield bonds and senior secured loans, the CCC rated portion of the market significantly underperformed BB and B rated credits. Given well above average returns for both credit and equity markets, the underperformance of CCC rated names is highly unusual. We believe dispersion in returns and a corresponding need to be selective are key themes heading into 2020.

Looking ahead to 2020, there are several factors that lead us to have a favorable outlook from a top-down risk perspective. U.S. economic growth is expected to remain stable, albeit at a level that may not exceed 2% annualized GDP growth. Global growth concerns, once considered a major risk in 2019, have receded as markets rallied in December. Furthermore, the prevalence of negative-yielding debt around the world only serves to make positive-yielding U.S. fixed income that much more attractive. Lastly, interest rate expectations are also stable, with Fed funds futures only pricing in a roughly 50% chance of one rate cut next year.

Bottom-up, fundamental and technical conditions are also mostly positive. While corporate earnings growth has slowed considerably, leverage and interest coverage levels across the high yield and loan markets continue to support default rates below historical averages. Supply/demand conditions are also neutral to net positive, although the drivers of market technicals vary considerably between high yield bonds and senior secured loans.

The positive conditions we’ve outlined above could easily sway us to predicting another above-average year for credit. However, there is one meaningful statistic that tempers our enthusiasm for 2020 a bit. Spreads are tight, especially for the high yield market. In our opinion, given the generally positive conditions created by the longest U.S. economic expansion on record, this is not much of a surprise. We would expect spreads to be tight in an environment of steady growth, low defaults and substantial returns (and high P/E multiples) for equities. However, in our view, the meaningful tightening of spreads that occurred late in 2019 likely pulled forward some of the excess return for credit that might have been generated in 2020.

Q1 2020 CORPORATE CREDIT OUTLOOK

Investment Research FS Investments 2

Where does that leave our return outlook for 2020? For high yield, we expect spreads to average roughly where they ended 2019, reflecting an overall favorable picture for credit. This means that the high yield market’s current yield-to-worst, at 5.41%, is a decent proxy for return expectations in 2020. For senior secured loans, spreads are tight to 10-year averages, but not nearly as tight as high yield. However, offsetting the more favorable spread picture for loans, as discussed below, there are technical conditions in the loan market that are potentially more concerning than those in high yield. For these reasons, we are not calling for further spread tightening for loans, which also makes that market’s current yield-to-maturity of 6.13% a reasonable expectation for 2020 returns.

Highlighting the need for selectivity, we recognize that the highest quality parts of both markets, BB rated credits, are also the most expensive from a spread perspective. Supported by dispersion within the B rated part of the market, we favor an active bottom-up approach to credit picking among these names. While CCC rated names are cheap relative to longer-term averages, the slowdown in corporate earnings gives us pause to make a sweeping recommendation to add CCC beta exposure.

Risks in 2020

Outside of an unexpected broad market event, like issues related to geopolitics or the U.S. presidential election, we believe a deterioration in macroeconomic fundamentals in the U.S. poses the largest downside risk to our outlook for high yield and loans. While earnings slowed considerably in 2019, it was still a generally supportive environment for companies to maintain their overall credit profile. A deterioration in economic conditions could be enough to change that balance, resulting in higher leverage, weaker interest coverage and potentially higher defaults. Given relatively tight spreads heading into 2020 and an already cautious outlook for the lowest-rated names in the credit markets, additional economic weakness would likely result in spread widening and index returns below our expectations.

Technical conditions within the loan market could also pose a problem if demand for loans from CLO buyers was to slow. While CLOs have long been the largest buyer of loans, retail outflows from loan funds have contributed to CLOs representing the largest percentage buyer of loans today than at any prior point in history. While the CLO market is generally expected to remain a strong buyer of loans in 2020, the over-reliance on a single, large source of demand could pose a unique risk to the loan market.

There are also upside risks to our outlook for 2020. As noted, while spread levels for BB and B rated high yield bonds are tight, CCC rated bonds look quite a bit more attractive. If economic and/or market conditions improve, this could bring buyers back to CCC rated positions, which trade considerably wide of where they were in September 2018. Similarly for loans, the market has suffered from bad publicity related to heavy issuance of covenant-light, lower-rated and loan-only issuers (see our report “Overbloan concerns?”). If underlying conditions were to improve enough for buyers to look past these risks, it’s not unreasonable to see loan spreads tightening further in 2020.

Q1 2020 CORPORATE CREDIT OUTLOOK

Investment Research FS Investments 3

Return outlook KEY TAKEAWAYS

• Return backdrop for 2020 looks stable.

• Income returns dominated 2H 2019 and will continue to drive Q1 returns.

• Opportunity for further spread tightening is limited.

2019 was, by most accounts, a banner year for high

yield bonds, which returned 14.41%. Senior secured

loans lagged high yield, but still posted a solid 8.64%

return. Strong performance across risk assets was

largely driven by an improving global growth outlook,

the central bank’s pivot to accommodative policy and

progress toward a long-awaited trade deal with China.

The question entering 2020 is how much more room

does credit have to run?

Generally, the macro backdrop for credit looks stable,

and a number of 2019 headwinds now look like market

tailwinds. We are forecasting a steady, albeit slow,

U.S. economic growth rate, low inflation and continued

low interest rates. Company fundamentals are still

relatively strong. All of this leads us to believe the

environment for credit will remain relatively favorable

in 2020. However, as discussed further in our spread

environment section, given current levels, we do not

expect outsized returns.

Returns in 1H 2019 were driven largely by spread

tightening following Q4 2018’s sell-off. Consistent with

our forecasts in our Q3 2019 and Q4 2019 outlooks,

returns during 2H 2019 were driven almost entirely by

income. Our base-case forecast for high yield is a

continuation of this carry-driven environment. Given

the current yield of 5.41%, this implies a roughly

1.35% return for high yield bonds in Q1.

Performance in the loan market during 2019 lagged

that of the high yield market as demand for floating

rate products waned and recent worrisome trends

became more pronounced. We expect a similar carry-

driven return profile for loans. Given their current yield

differential, this implies a slightly higher return target

for loans than for high yield. However, we see more

risks to the loan market than to the high yield market

given trends such as increased covenant-lite issuance

and loan-only borrowers. Investors will need to

consider whether the modest incremental yield pickup

is worth bearing these additional risks.

As discussed further in our return by rating section,

there is wide dispersion in quality and potential return

in both the high yield and loan markets right now. We

view this environment as a credit picker’s market and

stress the need for active management and robust

fundamental analysis.

We could see moderate upside to our return

projections if investors become more comfortable with

the global growth forecast. This outperformance would

likely be driven by lower-rated bonds and sectors such

as energy that have experienced recent weakness.

-2%

-1%

0%

1%

2%

3%

4%

5%

Jan-19 Mar-19 May-19 Jul-19 Sep-19 Nov-19

Source: ICE BofAML U.S. High Yield Index.

HIGH YIELD RETURN DECOMPOSITION

Price return

Income return

Total return

-1%

0%

1%

2%

3%

Jan-19 Mar-19 May-19 Jul-19 Sep-19 Nov-19

Source: S&P/LSTA Leveraged Loan Index.

LOAN RETURN COMPOSITION

Price return

Income return

Total return

0%

4%

8%

12%

16%

Q1 2019 Q2 2019 Q3 2019 Q4 2019 2019

Source: ICE BofAML U.S. High Yield Index; S&P/LSTA Leveraged Loan Index.

HIGH YIELD BOND AND LOAN RETURNS

High yield bonds

Senior secured loans

Q1 2020 CORPORATE CREDIT OUTLOOK

Investment Research FS Investments 4

Return by rating KEY TAKEAWAYS

• Return dispersion was prominent between high- and low-rated assets during 2019.

• Current inter- and intra-rating dispersion highlights the need for active management and bottom-up analysis.

• We expect rating return dispersion will continue in 2020, but that the return gap between highest- and lowest-rated credits will be smaller.

The rosy picture created by last year’s impressive high

yield and senior secured loan returns isn’t without its

thorns. Higher-rated assets outperformed lower-rated

assets over the entire year – an atypical relationship

given strong annual total returns for the indexes.

Within high yield, the highest-rated portions of the

market are now relatively expensive compared to long-

term averages and are yielding signficantly less than

lower-rated segments. 2019’s decline in Treasury

rates (BBs are more duration sensitive than B or CCC

rated assets) combined with investor preference for

less-risky high yield credits drove spreads for BBs to

130 bps tighter than 10-year averages and even

11 bps tighter than levels seen in September 2018.

Demand can also be seen in the spread between BBB

and BB bonds, which hit an all-time low in December.

While we don’t expect investor preference for BB rated

bonds to wane, it will be difficult for BBs to repeat their

relative outperformance given current tight levels.

Likewise, the higher-rated portions of the loan market

are also more expensive. However, BB rated loans are

less tight to 10-year averages compared to high yield

and are currently wide to September 2018 levels.

While we don’t expect BB rated loans to continue to

outperform as much, similar to high yield, the potential

for spread tightening in loans could provide a tailwind

in 2020 if credit concerns stay on the sidelines.

With our view of a generally supportive economic and

market backdrop, this may look like an opportunity to

buy relatively cheaper assets in lower-rated segments.

However, we advocate strongly against this broad-

based market exposure and stress the need for

fundamental analysis. Intra-rating price dispersion,

essentially the price spectrum that assets are trading

at within each rating category, has also hit recent

highs. We view this as an indication that investors are

displaying clear preferences today for credits that are

perceived to be less risky, even within the same

ratings category. While B and CCC rated credits are

cheaper than BBs, the slowdown in corporate earnings

gives us pause in making a sweeping recommendation

to add broad beta exposure to these ratings categories

in favor of a more selective, bottom-up approach

to credit.

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

Q1 2019 Q2 2019 Q3 2019 Q4 2019 2019

Source: ICE BofAML U.S. High Yield Index.

HIGH YIELD RETURN BY RATING

BBBCCC

-4%

-2%

0%

2%

4%

6%

8%

10%

Q1 2019 Q22019 Q3 2019 Q4 2019 2019

Source: S&P/LSTA Leveraged Loan Index.

LOAN RETURNS BY RATING

BB

B

CCC

180

230

280

330

380

430

08-18 10-18 12-18 02-19 04-19 06-19 08-19 10-19 12-19

Source: ICE BofAML U.S. High Yield Index

BB RATED HIGH YIELD BOND SPREADS

BB spread level

BB 10-year average spread

bps

Q1 2020 CORPORATE CREDIT OUTLOOK

Investment Research FS Investments 5

Spread environmentKEY TAKEAWAYS

• Spreads in both markets are relatively tight to 10-year averages.

• We expect spreads to end 2020 roughly where they started, supporting our carry-driven return profile.

High yield bond spreads tightened further in Q4,

ending near their lows on the year. While they ticked

up during the month of October, a strong equity market

backdrop drove them lower during November and

December. Over the course of 2019, spreads

compressed over 150 bps, but still sit slightly above

post-crisis lows reached in September 2018. However,

when looking at spreads in a historic context, the

changing composition of the high yield market must

also be considered. The market has seen an

improvement in credit quality over the past decade,

with BB rated bonds now representing roughly 50% of

the market, up from 25% in 2009. Given that BBs now

make up a larger percentage of the market, current

spread levels, while still tight, are not as tight to

historical averages as they may seem.

While we are not expecting spreads to tighten further

in 2020, current levels are not unreasonable given

favorable market conditions. Thus, we anticipate the

majority of credit returns in 2020 to be driven by carry

(income return). Tempering our enthusiasm for the

year is that the “January rally” that sometimes occurs

in high yield may have already occurred in December

2019, pulling ahead some of the excess return we may

have otherwise expected in 2020.

In the loan market, spreads increased over the fourth

quarter. However, we are still calling for loan spreads to

end 2020 roughly where they began. We believe the

recent widening is likely due to loan market trends

discussed above and in our recent research note.

Current spreads are tight, but less so when compared

to high yield. We think loan market emotions will

vacillate between concerns about underlying loan

characteristics and feelings that current spreads and

yields properly compensate investors for those risks,

leaving spreads roughly unchanged for 2020.

Another interesting dynamic to watch is the yield gap

between senior secured loans and high yield bonds,

which has been negative for most of 2019. For context,

before this year, this dynamic hadn’t occurred since

December 2008, and loans yielded more than high yield

for a total of only six days between 2002 and 2019. The

gap has now been negative for 145 days and counting.

We view this as less of a reflection of diminished

demand for floating rate products and more to do with

the additional risks that loans now pose and the

compensation investors demand to hold them.

300

350

400

450

500

550

600

Sep-18 Dec-18 Mar-19 Jun-19 Sep-19 Dec-19

bps

Source: ICE BofAML U.S. High Yield Index.

HIGH YIELD BOND SPREADS

High yield spread to worst

Post-crisis low

300

350

400

450

500

550

600

Sep-18 Dec-18 Mar-19 Jun-19 Sep-19 Dec-19

bps

Source: S&P/LSTA Leveraged Loan Index.

SENIOR SECURED LOAN SPREADS

Loan spread to worst

Post-crisis low

0%

5%

10%

15%

20%

25%

12-08 12-10 12-12 12-14 12-16 12-18

Source: ICE BofAML U.S. High Yield Index; S&P/LSTA Leveraged Loan Index.

YIELD GAP: HIGH YIELD BONDS VS. LOANS

Loans

High yield

Q1 2020 CORPORATE CREDIT OUTLOOK

Investment Research FS Investments 6

Credit fundamentals KEY TAKEAWAYS

• Revenue and EBITDA growth have slowed considerably.

• Leverage and interest coverage ratios have remained stable.

• We expect low revenue and EBITDA growth rates in both markets and are closely watching fundamentals for deterioration.

Revenue growth for high yield bond issuers managed

to remain positive in Q4, posting slight year-over-year

growth. EBITDA growth was essentially flat (-.2%) year

over year. These growth rates are much slower than

2017–2018’s double-digit pace, and the first three

quarters of 2019 comprised the slowest period since

weakness in the energy sector weighed on 2016’s

results. For context, the average year-over-year

quarterly EBITDA growth rate during the previous two

years was 12.7%.

Both EBITDA and revenue growth for loans was

positive in Q3, and both rates exceeded last quarter’s

growth. Like the high yield market, these rates are still

significantly below their 2-year averages (7% and 10%

respectively, for EBITDA and revenue). These stats

bear watching going forward given the impact

fundamental earnings can have on both credit

statistics and default rates. Weaker EBITDA would

result in higher leverage levels and weaker interest

coverage if companies do not reduce debt outstanding

in advance of lower EBITDA levels.

High yield and loan leverage and interest coverage

ratios both held steady. Leverage levels are at the

higher end of their 10-year range, but interest

coverage levels are also at the higher end, suggesting

that companies have ample cash flow to continue

paying their debt service costs. We are forecasting low

single-digit EBITDA growth rates to continue

throughout 2020. Any downside surprises to our

estimates could quickly cause fundamentals to

deteriorate.

-5%

0%

5%

10%

15%

20%

Q117 Q217 Q317 Q417 Q118 Q218 Q318 Q418 Q119 Q219 Q319

Source: J.P. Morgan, as of September 30, 2019.

HIGH YIELD EBITDA AND REVENUE GROWTH

EBITDA growth

Revenue growth

0

1

2

3

4

5

6

Q217 Q317 Q417 Q118 Q218 Q318 Q418 Q119 Q219 Q319

Source: J.P. Morgan, as of September 30, 2019.

HIGH YIELD LEVERAGE AND INTEREST COVERAGE

Leverage Interest coverage

-2%

0%

2%

4%

6%

8%

10%

12%

14%

16%

Q117 Q217 Q317 Q417 Q118 Q218 Q318 Q418 Q119 Q219 Q319Source: J.P. Morgan, as of September 30, 2019.

LOAN MARKET EBITDA AND REVENUE GROWTH

EBITDA growth

Revenue growth

0

1

2

3

4

5

6

Q117 Q217 Q317 Q417 Q118 Q218 Q318 Q418 Q119 Q219 Q319

Source: J.P. Morgan, as of September 30, 2019.

LOAN LEVERAGE AND INTEREST COVERAGE

Leverage Interest coverage

Q1 2020 CORPORATE CREDIT OUTLOOK

Investment Research FS Investments 7

Default ratesKEY TAKEAWAYS

• Default rates hit 30- and 14-month highs in high yield and loans, respectively, during the quarter but ticked down to end the year slightly lower.

• We expect default rates to remain unchanged in 2020 as growth should continue and balance sheets look well capitalized.

Default rates in the high yield bond market increased

9 bps in the fourth quarter, while default rates for the

senior secured loan market increased roughly 22 bps.

The trailing 12-month default rates for high yield bonds

and senior secured loans at the end of December

were 2.63% and 1.64%, respectively. In the high yield

market, this rate is down 1 bp from 30-month highs

while the loan rate sits just below 14-month highs.

Rates in both markets are still comfortably below long-

term averages for 3.44% and 3.01% for high yield and

loans, respectively.

Default rates for both markets bottomed out in March

before slowly ticking up for the remainder of the year.

The increase has predominantly been due to names in

the energy sector, which has experienced 40% of the

default activity year to date. The combined bond and

loan default rate of the energy sector is currently 12%,

not far off from the 14.2% experienced in 2016. Ex-

commodities, the default rates are 1.26% and 1.39%

for high yield and loans, respectively, significantly

below long-term averages.

We forecast unchanged default rates in both markets

for 2020. Global growth, as well as corporate revenue

and EBITDA growth rates, are all forecasted to remain

positive – albeit at slow rates. Corporate leverage has

remained in check. Many issuers have taken

advantage of lower rates and refinanced their debt,

leaving balance sheets well capitalized entering 2020.

w

0%

2%

4%

6%

8%

10%

12%

Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Dec-17 Dec-18 Dec-19

Source: J.P. Morgan.

TRAILING 12-MONTH DEFAULT RATES

Senior secured loans

High yield bonds

Q1 2020 CORPORATE CREDIT OUTLOOK

Investment Research FS Investments 8

Supply/demand technicalsKEY TAKEAWAYS

• We believe overall supply/demand will be net neutral for both markets.

• High yield bonds will continue to be in demand from retail investors while institutional demand from CLOs will continue to support the loan market.

Retail investors favored high yield bonds over loans for

all of 2019, likely due to a combination of falling rates

and technical trends in the loan market. The overall

supply/demand picture for high yield has remained one

of excess demand.

High yield bonds are being used increasingly to retire

loans, but the demand from investors has been more

than ample to soak up new issue supply. Any

increased volatility in equity markets, however, tends

to negatively impact high yield flows. In both May and

August 2019, negative months for equities, investors

pulled money from high yield. What’s important to note

is that, in both cases, the high yield market was down

less than equities and in August high yield still posted

a positive return. We see this as evidence that high

yield is not driving the trends we’re seeing in the

market – rather, upticks in equity volatility have

investors pulling back from riskier assets across

the board.

Loan funds have seen near-continuous outflows for 58

weeks as investor demand for floating rate products

waned and structural weakness in the loan market

became more prominent. While retail fund flows have

been negative, mutual funds and ETFs only account

for a small portion of the overall loan market, so retail

demand, or lack thereof, can be subsumed by

institutional demand. That was largely the case in

2019 as the market was buoyed by CLO issuance.

With economic growth still positive and record

negative-yielding global debt, demand for higher-

yielding credit should remain positive. Whether driven

by institutional demand from CLOs in the loan market

or retail investors chasing yield, we expect demand to

be net neutral to the overall return environment. We

see more risks to demand for loans than for high yield

as relying solely on one source of demand–CLOs–

presents potential risk to the loan market and

our outlook.

-35

-30

-25

-20

-15

-10

-5

0

Q1 2019 Q2 2019 Q3 2019 Q4 2019

$B

Source: J.P. Morgan.

HIGH YIELD SUPPLY DEFICIT

-20

-15

-10

-5

0

5

10

15

20

Q1 2019 Q2 2019 Q3 2019 Q4 2019

$B

Source: J.P. Morgan.

LOAN MARKET SUPPLY SURPLUS/DEFICIT