U.S. Credit Market Outlook€¦ · 2019 U.S. Credit Market Outlook; Midyear Update 2 Credit...

U.S. Credit Market Outlook

Mid-Year 2019 Update

September 2019

2019 U.S. Credit Market Outlook; Midyear Update 1

Executive Summary

Five Critical Assumptions Shaping Our Credit Market Outlook

1. Trade conflict will remain the most important risk factor to global markets and the U.S. economy. We do not expect a

meaningful de-escalation of trade tensions between the U.S. and China through 2020, with non-zero probabilities of

escalating trade disputes between the U.S., Eurozone, and Japan

2. Profit margins have compressed to a 10-year low before the full brunt of tariffs and slowing growth impact expenses and

end demand. Investors will increasingly price in lower margins and a corresponding period of negative or low profit growth

on highly leveraged companies into their downgrade and default assumptions

3. Technological and consumer preference changes are reshaping business models across sectors and will for the

foreseeable future. In the medium term (2+ years) expect a prolonged period of above-average default rates (and below-

average recovery rates) where future revenue growth is misaligned with debt burdens

4. In advance of rising defaults, price dispersion among issuers and industries will continued to increase. Credit markets

have begun to punish issuers where structural concerns are already impacting growth and debt service

5. While we are concerned about rising credit loss risk in the medium term, over the next 12 months there is a high probability

that an insatiable thirst for yield and duration (global debt yields ~1.2%) will lead global credit investors to bid up

higher grade USD corporate debt and keep credit spreads flat to tighter despite rising recession risk and macro uncertainty

Fundamentals: Slowing Growth, Lower Margins, Rising Debt Burdens

Global economic growth has and is likely to continue to decelerate through 2020 as the negative impacts of escalating trade

and geopolitical conflict further impact business confidence and investment.1

▪ Markets incorrectly anticipated a détente in trade relations during 2019; it now appears tariffs will escalate without

meaningful de-escalation until the U.S. presidential election in late 2020.

▪ Further, rising economic and political risks in Britain, the Middle East, Italy, Turkey, Hong Kong, and Argentina add to

the sense of uncertainty restraining business confidence and investment.

U.S. real GDP growth is forecast by consensus to decelerate from 2.3% in 2019 to 1.8% in 2020; we see downside risk to this

forecast given the potential for late-cycle margin pressures and rising uncertainty to impact the labor market / consumer.2

▪ We are concerned by the sharp downward revision and trend in corporate margins; companies (especially small and mid-

sized) will struggle to pass through higher labor and tariff-related materials costs through to consumers.3

▪ In addition to impacting business fixed investment, slowing top-line growth may depress hiring and nominal income

growth, impacting consumer confidence and spending.

Central banks have responded to lower growth and downside risks with a dovish pivot; this has been a positive for bonds

and risk asset prices but is unlikely to materially boost real economic growth as it cannot assuage business uncertainty.

▪ We think consensus is overestimating the magnitude of Fed policy cuts through 2020 (futures call for 4+ cuts), but the

Fed has clearly communicated they will lower rates to help cushion the real economy from trade-related disruption.4

Corporate debt burdens are elevated, which are a risk to corporate credit in an economic slowdown.

▪ Post-crisis, U.S. corporates have leveraged up their balance sheets with low cost debt capital. The ratio of non-financial

debt to GDP is now 74%, up ~200bp since 2008 and the highest on record. 5

1 Morgan Stanley, “The Wheels for a Slowdown Are in Motion,” August 20, 2019. 2 Bloomberg consensus real GDP forecasts, retrieved on September 3, 2019. 3 JP Morgan, “Equity Strategy; Impact from Latest Round of Tariffs,” August 16, 2019. Bureau of Economic Analysis. Profits after tax with IVA and CCAdj divided by

Nominal GDP, data through 2Q 2019 4 Forecasts for future Federal Reserve rate from Bloomberg, retrieved on September 3, 2019. 5 Dallas Federal Reserve, “Corporate Debt as a Potential Amplifier in a Slowdown,” March 5, 2019. Board of Governors of the Federal Reserve System, Nonfinancial

business; debt securities and loans; liability, Level. U.S. Bureau of Economic Analysis, Gross Domestic Product. Data through 1Q’19.


Credit Markets: Expect an Increase in Credit Market Volatility and Dispersion

We expect volatility and price dispersion in the credit markets to increase over the next 1-2 years as part of a multi-year

credit cycle marked by disruptions to business fundamentals resembling the early 1990s and early 2000s cycles.

▪ Unique to this cycle is the pace and magnitude of technological disruption and changing consumer preferences which are

fundamentally altering the business models of certain previously ‘defensive’ industries.

Pretium’s view is that the next credit cycle is unlikely to suffer from systematic, liquidity driven dislocation as experienced

in 2008-09. Rather we forecast issues to arise where debt burdens are misaligned with revenue growth at the issuer and

industry level.

▪ We believe the combination of late cycle fundamentals and rising disruption threats will exacerbate price / spread

movements for those companies and industries that show disappointing growth, as downgrade and recovery fears

outweigh need for yield.

▪ There is widening dispersion in the loan and high yield markets; we expect to see greater levels of distress given the number of industries impacted by disruption, and outlook for lower recoveries leading to higher cumulative losses.6

Loan and CLO Market Outlook: Several Crosscurrents to Consider

Loans: Slower Growth, Increasing Credit Concerns

The leveraged loan and CLO markets grew significantly over the past several years, with strong demand allowing more

issuance from lower rated companies, using higher leverage and fewer covenants.

▪ Since 2012, the amount of leveraged loans outstanding has increased by 115%, and the amount of CLOs outstanding has

increased by 130%.7 Along with rapid growth, underwriting standards have deteriorated with 62% of loans rated B or

lower, record high first-lien leverage, and nearly 80% of loans issued with one or fewer covenants.8

▪ We believe this combination of fast growth and loose underwriting will lead to higher defaults and lower recovery rates

across the loan and CLO markets.

Net loan issuance fell 34% YTD through August 2019 relative to 2018. Interestingly, net CLO new issuance (ex-refi and

reset activity) was only down 8% YTD.9

In our view, the pace of loan growth is likely to slow over the next 2 years, with weaker demand technical not fully offset by

a need for yield.

▪ CLO formation is likely to slow, given a narrow arb between asset spreads and liability costs (see below). Further, loan

fund flows have turned negative over the past 12 months as investors shifted to expecting rate cuts (and therefore lower

future yields on floating rate products).

CLOs: Asset/Liability Spread Is Likely to Remain Tight for New Issue

CLO liability costs have widened in 2019 more than asset spreads. This has pressured the net arbitrage between CLO liability

costs and loan spreads and will likely lead to less CLO creation going forward.10

▪ In August 2019, new issue CLOs carried AAA spreads of 133bp, with BBB spreads of 383bp. Respectively, these spreads

are +17bp and 76bp wider vs August 2018 levels.11

Discount margins for loans have not moved materially wider; the Credit Suisse Leveraged Loan Index discount margin (3Yr

life) is now 473bp, compared to 433bp on average in the fourth quarter of 2018.12

▪ Loan demand has been supported by global demand for yield; through August the Barclays Global Aggregate Index yield was 1.18% (-100bp vs. 4Q’18) while the U.S. Aggregate Index yield was 2.13% (-140bp). Further, narrow asset spreads reflect the amount of capital raised in 2018 for new issue CLOs, as well as CLO warehouses which priced in 1H 2019 and needed to add assets during their ramp period.

6 Goldman Sachs, “The Credit Trader; Surging dispersion, rising defaults, and higher illiquidity premia,” August 15, 2019. 7 Deutsche Bank, U.S. Credit Strategy Chartbook, data through July 31, 2019. Bank of America, “CLO Weekly,” August 23, 2019. 8 BofA Merrill Lynch Global, S&P LCD, Bloomberg, Intex, July 2019. 9 JP Morgan, “Credit Strategy Weekly Update,” August 23, 2019. 10 Morgan Stanley, “CLO Tracker September 2019,” September 17, 2019. 11 Bank of America, “CLO Weekly,” August 30, 2019. 12 Bloomberg Barclays Global Agg Index, retrieved from Bloomberg on September 3, 2019. Credit Suisse Leveraged Loan Index, data through August 30, 2019.


Contents

Executive Summary 1

Section I: Economic and Rate Outlook 4

Risk-Free Yields Rallied Sharply… 5

Risks to the Economic Outlook Skewed to Downside 6

Section II: The Credit Market Outlook 10

Monetary Easing and Trade Conflict Escalation Drove 1H Returns… 10

Fundamentals Likely To Drive Performance and Dispersion Over Next 12-18 Months 11

Default Cycle: Expect Increased Loss Severity Given Fundamental Pressures 13

At risk industries over the next 12-18 months 14

Section III: Select Asset Performance and Pretium Outlook 17

Investment Grade 17

High Yield Bonds 19

Bank Loans 21

CLOs 25

Confidentiality and Other Important Disclosures 27


Section I: Economic and Rate Outlook

Decelerating Growth + Rising Downside Risks

Through August 2019, the U.S. economy was expanding at a moderate pace, with the U.S. labor market and consumer spending

increasingly the primary drivers of the economic expansion. Consumer confidence, spending, and savings rates are all above average,

bolstered by low unemployment and modest wage growth. Supportive growth factors include:

Real GDP grew 2.3% in the second quarter on a year-over-year basis, a deceleration from 2.9% in 2018. Consensus estimates

from Wall Street economists forecast real GDP growth of 2.3% for 2019, 1.8% for 2020, and 1.8 % for 2021.13

Non-farm employment grew 1.5% Y/Y in July 2019 (slowing from +1.8% in December 2018). The U.S. created an average

of ~165k jobs per month in 2019, below the ~225k average during 2018 or ~180k pace in 2017. Unemployment fell to 3.7%

in June from 3.9% in December 2018. Wall Street economists forecast unemployment to remain at 3.7% through 2020.14

Tightening labor markets led to improving wage growth and increased labor participation. Average hourly earnings

increased 3.4% Y/Y in June, while the Employment Cost Index rose 2.9% Y/Y in 2Q’19, near the fastest pace this cycle.15

Productivity growth continues to surprise to the upside, driven by robust business capital expenditures in equipment and

intellectual property in 2018-2019.16

Exhibit 1: Healthy Labor Markets A Cornerstone of Economic Expansion

Source: U.S. Bureau of Labor Statistics, All Employees: Total Nonfarm Payrolls, Civilian Unemployment Rate, Average Hourly Earnings of

Production and Nonsupervisory Employees: Total Private, through July 2019.

That said, more headwinds have emerged to the growth outlook over the past 3-6 months, led by the negative impact of tariff and

trade policy on global growth, business confidence, and investment. Looking forward, consensus expects the U.S. economy will

continue to decelerate, with downside risks to the labor markets from escalating trade conflict. Downside risk factors include:

Global growth is slowing and is expected to continue decelerating through 2019. The International Monetary Fund and the

World Bank recently downgraded their growth outlooks for the United States, China, the European Union, and emerging

markets due to trade and investment uncertainty.17

U.S. GDP is expected to slow from 2.3% in 2019 to 1.8% in 2020. Uncertainty surrounding trade policy has impacted the

U.S., and is likely to lower business investment activity, trade, and employment growth over the next 12-24 months.18

Manufacturing and non-manufacturing output and confidence surveys suggest business activity is at its weakest since 2013,

with manufacturing at its lowest level since 2009.19

13 Bureau of Economic Analysis, Gross Domestic Product, 2Q’19. Bloomberg consensus real GDP forecasts, retrieved on September 3, 2019. 14 U.S. Bureau of Labor Statistics, All Employees: Total Nonfarm Payrolls, through July 2019. U.S. Bureau of Labor Statistics, Civilian Unemployment Rate, through

June 2019. Wall Street forecasts are Bloomberg consensus, retrieved September 3, 2019. 15 U.S. Bureau of Labor Statistics, Average Hourly Earnings of Production and Nonsupervisory Employees: Total Private, through July 2019. U.S. Bureau of Labor

Statistics, Employment Cost Index: Total compensation: All Civilian, through 2Q’19. 16 Cornerstone Macro, “1Q Productivity Breaks Higher, ULCs Sag”, May 2, 2019. 17 Morgan Stanley, “Global Manufacturing PMI: Sentiment Dips Further to 2015-16 Cycle Lows, July 1, 2019. IMF, “World Economic Outlook: Growth Slowdown,

Precarious Recovery”, April 2019. World Bank, “Global Growth to Weaken to 2.6% in 2019, Substantial Risks Seen”, June 4, 2019. 18 Bloomberg consensus real GDP forecasts, retrieved on September 3, 2019. Morgan Stanley, “Trade Tensions Escalating, Recession Risks Rising,” August 5, 2019. 19 IHS Markit Flash U.S. PMI, August 2019.

-8%

-6%

-4%

-2%

0%

2%

4%

-8,000

-6,000

-4,000

-2,000

0

2,000

4,000

Non-Farm Payrolls,Y/Y %Non-Farm Payrolls, Y/Y Change (000's)

0%

2%

4%

6%

8%

10%

12%

Unemployment RateAvg. Hourly Earnings Growth


Risk-Free Yields Rallied Sharply…

One of the more important changes in global capital markets during 2019 was the sharp change in expectations

for forward interest rates.

From local highs in November 2018, global yields declined as trade tensions between the U.S. and China increased, gradually

showing up in decelerating global growth. Monetary policymakers in the U.S. and Europe responded to a slower growth

outlook with both outright rate cuts as well as forward guidance suggesting further easing in 2H’19.20

Through August 2019, $16.8tn of global debt, or 30% of all debt outstanding, had a negative interest rate.21

Exhibit 2: 30% of Global Debt has a Negative Yield Exhibit 3: Global Yields Declined Meaningfully in 2019

Source: Bloomberg Barclays Negative Yielding Debt Index (I32542 Index), Bloomberg Barclays Global Agg Index (LEGATRUU Index), and

Bloomberg Barclays US Agg Index (LBUSTRUU Index). Data through August 30, 2019.

U.S. rates rallied across the curve, with rates now inverted from 3mo through 10 years.

On the short end, the Federal Reserve lowered overnight rates in July by 25bp to a range of 2.0% to 2.25%. The FOMC has

communicated since December 2018 that they are likely to embrace more dovish monetary policy in the face of growing

downside risks to the U.S. economy. The Fed funds futures market is pricing in a ~50% chance of 75bp of additional cuts by

the Fed’s December 2019 meeting.22

On the longer-end, 10-Year Treasuries fell sharply as investors sought duration with declining growth and increasing

expectation of dovish monetary policy. The 10-Year Treasury was 1.5% in August 2019, down from 2.7% at year-end 2018.23

The yield curve flattened with no spread between the 2Yr Treasury and 10Yr Treasury.24

Exhibit 4: U.S. Treasury Yield Curve Exhibit 5: Fed Funds Futures

Source: Bloomberg, U.S. Treasuries Active Curves, priced on September 3, 2019. CME Group, CME FedWatch Tool. Market pricing as of August 30, 2019.

20 See Goldman Sachs, “Not So Synchronized,” July 25, 2019, or Morgan Stanley, “Policy Easing Will Not Be Enough,” June 25, 2019.

21 Bloomberg Barclays Negative Yielding Debt Index (I32542 Index) and Bloomberg Barclays Global Agg. Index (LEGATRUU Index). Data through August 30, 2019. 22 FOMC July Press Release, https://www.federalreserve.gov/monetarypolicy/files/monetary20190731a1.pdf. 23 Bloomberg, Generic 10 Year Treasury Yield. 24 St. Louis Fed FRED system, 10-Year Treasury Minus 2-Year Treasury, data through August 30, 2019.

0%

10%

20%

30%

40%

$0.0

$5.0

$10.0

$15.0

$20.0

Negative Yielding Debt (Barclays Global Agg) As % of Total

2.13%

1.19%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%

4.00%

US Agg., YTW Global Agg., YTW

1.20%

1.45%

1.70%

1.95%

2.20%

2.45%

2.70%

2.95%

3.20%

3mo 1Yr 2Yr 5Yr 7Yr 10Yr 30Yr

Current 1 Month Ago 1 Year Ago

0%

20%

40%

60%

80%

100%

Apr-19 May-19 Jun-19 Jul-19 Aug-19

Fed Rate Cut Proability by YE 2019

25bp Cut 50bp cut 75bp cut 100bp cut

https://www.federalreserve.gov/monetarypolicy/files/monetary20190731a1.pdf


Risks to the Economic Outlook Skewed to Downside

With a re-escalation of U.S. – China trade tensions, the risks to the base case economic outlook became squarely

skewed to the downside.

For the U.S. economy and credit markets, we see five critical areas to monitor over the next 12-18 months:

1. While the U.S. economy has outperformed the global slowdown to date, the economy and corporate earnings are intimately

tied with global growth. With several large economies in recession or slowing sharply, we believe the U.S. may see growth

below the consensus high 1% range.

2. Corporate earnings growth is sharply decelerating, and profit margins are weakening, especially for small and mid-size

companies. We see further risk to both top-line growth and margins from rising wages and tariff impacted inputs.

3. U.S. labor markets and capex spending have remained positive, but both are slowing sharply. There is a growing risk to

employment growth, and therefore consumer confidence and spending.

4. Financial conditions have not tightened dramatically but could if financial markets price in dramatically lower growth into

equities / credit spreads, and/or central banks fail to deliver adequate stimulus.

5. While it is not our or the consensus base case, there remains a possibility for a more constructive change in the outlook for

U.S. – China trade talks, including a resolution and rollback of tariffs before the U.S. presidential elections in 2020. Any

positive developments in trade would have a lagged, but positive impact on global growth relative to current trends.

1. Will U.S. Economic Growth “Catch Down” To Slower Global Growth

As shown in Exhibit 6, U.S. growth decoupled from a slowing global economy due to significant fiscal tailwinds from both

tax cuts and larger federal budget deals. However, as those tailwinds wane, tariffs and slower global growth should have a

bigger impact on U.S growth. This is most evident in the slowdown in U.S. manufacturing that is converging with slower

activity abroad.

Trade represents 27% of U.S. total GDP, which while down from a peak of 31% in 2012 is well above the 25% contribution

in 2000, 20% in 1990 or 1980.25

The U.S. economy and U.S. firms are not immune to the trade-induced global growth slowdown occurring in China, the EU,

and elsewhere. S&P 500 companies derive nearly 45% of sales outside the U.S.; a prolonged slowdown will impact revenues

and profits.26

Exhibit 6: U.S. Growth Diverged from Rest of the World Due to Fiscal Stimulus in 2018

Source: Haver Analytics, IMF, Morgan Stanley Research forecasts. Global ex U.S. includes all countries under Morgan Stanley coverage excluding

U.S. Markit Manufacturing PMIs, Bloomberg. As of August 2019

25 U.S. Bureau of Economic Analysis, Gross Domestic Product, Exports of Goods and Services, and Imports of Goods and Services. Data through Q2 2019. 26 S&P Dow Jones, https://us.spindices.com/indexology/djia-and-sp-500/sp-500-global-sales.

-6%

-4%

-2%

0%

2%

4%

6%

-3%-2%-1%0%1%2%3%4%5%6%7%

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

Global ex U.S. Real GDP growth Y/Y (ls)

U.S. Real GDP growth Y/Y (rs)

49

50

51

52

53

54

55

56

57

Aug-1

6

Oct

-16

Dec-

16

Feb-1

7

Apr-

17

Jun-1

7

Aug-1

7

Oct

-17

Dec-

17

Feb-1

8

Apr-

18

Jun-1

8

Aug-1

8

Oct

-18

Dec-

18

Feb-1

9

Apr-

19

Jun-1

9

US Manufacturing PMI Global Manufacturing PMI


2. Corporations Facing Slower Growth…27

Over the past 12 months, revenue growth for the S&P 500 has slowed dramatically, to 5.0%, down from a recent peak of

over 10% in late-2018. Similarly, year-over-year EBITDA growth is now 8.5%, from a recent peak of +16% in mid-2017.

Looking forward, consensus expects sales growth per share for the S&P 500 to decelerate further to 4.7% by YE 2018 and

3.8% in early 2020.

Exhibit 7: S&P 500 Sales and EBITDA Growth Decelerating

Source: Bloomberg. Trailing 12 Month EBITDA and Sales per Share for the S&P 500 Index. Data through September 3, 2019.

…and Compressing Margins28

Profit margins have compressed to their lowest point in this cycle, before slower top-line growth and higher costs impact

profitability over the next 12+ months.

Margin compression has been more significant / pronounced for non-S&P 500 firms, i.e. small and mid-cap companies less

able to pass along rising costs to consumers or benefit most from low cost of debt capital.

We believe earnings growth (EBITDA and EPS) will come under further pressure throughout 2H’19 and 2020 as firms tackle

not only higher input costs, but top-line pressures from slower economic growth.

Exhibit 8: Corporate Profits as a % of National Income are Falling

Source: Bureau of Economic Analyses, Table 1.12. National Income by Type of Income. Last Revised on: July 26, 2019. N ote: Inventory valuation

adjustment (IVA) is an adjustment made in the national income and product accounts (NIPAs) to corporate profits and to proprietors' income in

order to remove inventory "profits," which are more like a capital-gain than profits from current production. Capital consumption adjustment

(CCAdj) is the difference between private capital consumption allowances (CCA) and private consumption of fixed capital (CFC) . S&P 400, 500, and

600 profit margins retrieved from Bloomberg on August 22, 2019.

27 Actuals and consensus forecasts retrieved from Bloomberg on September 3, 2019. 28 JP Morgan, “Equity Strategy; Impact from Latest Round of Tariffs,” August 16, 2019. Bureau of Economic Analyses, Table 1.12. National Income by Type of Income.

Last Revised on: July 26, 2019

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

TTM EBITDA per Share TTM Sales per Share

4%5%6%7%8%9%

10%11%12%13%14%

Corporate profits with IVA and CCAdj

Profits after tax with IVA and CCAdj

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

Large Cap Profit Mgn (TTM)

Mid Cap Profit Mgn (TTM)

Small Cap Profit Mgn (TTM)

NIPA: After-tax Profits as % of National Income

Consensus is expecting S&P 500

sales growth of ~4% by early 2020

on a trailing 12-month basis.


3. Slowing Investment Spending / Rising Uncertainty May Slow Hiring Going Forward29

Following the passage of the Tax Cuts and Jobs Act of 2017, spending on capital expenditures enjoyed a meaningful boost.

Nonresidential fixed investment increased at almost 8% year over year during each quarter in 2018.

However, due to increasing uncertainty from an escalating trade war, investment growth has moderated in 2019 and total

nonresidential fixed investment recently peaked at 13.7% of GDP in Q1’19.

Businesses tend to invest in capital and employment at the same time. Since 1990, the correlation between the change in

fixed investment and the growth in aggregate hours worked is over 75%.30

Although the labor market remains healthy with the unemployment rate at 3.7% in July and initial jobless claims remaining

stable, further deterioration in business confidence and investment should slow the rate of job growth. Job growth in 2019

has already ticked down from an average of 223k per month in 2018 to just 165k per month in 2019 through July.31

Exhibit 9: Nonresidential Fixed Investment Spending Decelerating but Remains at Average Levels

Source: U.S. Bureau of Economic Analysis, Gross Domestic Product and Private Nonresidential Fixed Investment. Data as of Q2’19.

Exhibit 10: Risk to Job Growth if Business Investment Slows Further

Source: U.S. Bureau of Economic Analysis, Private Nonresidential Fixed Investment and Index of Aggregate Weekly Hours: Production and

Nonsupervisory Employees: Total Private Industries. Data as of Q2’19. U.S. Bureau of Labor Statistics, All Employees: Total Nonfarm Payrolls . Data

through July 2019.

29 Morgan Stanley, “The Wheels for a Slowdown Are in Motion,” August 20, 2019. 30 U.S. Bureau of Economic Analysis, Private Nonresidential Fixed Investment and Index of Aggregate Weekly Hours: Production and Nonsupervisory Employees: Total

Private Industries. Data as of Q2 2019. 31 U.S. Bureau of Labor Statistics, All Employees: Total Nonfarm Payrolls. Data through July 2019.

-20%

-15%

-10%

-5%

0%

5%

10%

15%

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

2014

2016

2018

Private Nonresidential Fixed Invesment Y/Y

10%

11%

12%

13%

14%

15%

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

2014

2016

2018

Private Nonresidential Fixed Invesment % of GDP

-2%

-1%

0%

1%

2%

3%

4%

5%

-10%

-5%

0%

5%

10%

15%

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

2014

2016

2018

Nonresidential Fixed Investment Y/Y (ls)

Aggregate Weekly Hours Worked Y/Y (rs)

0k

50k

100k

150k

200k

250k

300k

350k

Jan-1

7Feb-1

7M

ar-

17

Apr-

17

May-1

7Ju

n-1

7Ju

l-17

Aug-1

7Sep-1

7O

ct-1

7N

ov-1

7D

ec-

17

Jan-1

8Feb-1

8M

ar-

18

Apr-

18

May-1

8Ju

n-1

8Ju

l-18

Aug-1

8Sep-1

8O

ct-1

8N

ov-1

8D

ec-

18

Jan-1

9Feb-1

9M

ar-

19

Apr-

19

May-1

9Ju

n-1

9Ju

l-19

Monthly Payroll Growth Average


4. Financial Conditions Remain Loose, Thanks To Monetary Policy Pivot

In 2019, financial conditions have been relatively loose despite increased macro uncertainty. Financial conditions reached

their tightest levels in late 2018 driven by a sell-off in the equity and bond markets as growth expectations slowed and

markets priced in greater risk of policy mistakes.

Conditions loosened through much of 2019, as investors first priced in easier monetary policy and a de-escalation of trade

tensions through April. Even after trade discussions deteriorated this spring, financial conditions changed little as looser

monetary policy (in the U.S and globally) successfully prevented financial conditions from tightening even as growth

concerns have enveloped markets.32

▪ Today, the FCI sits below the long-term average and in the ~20th percentile of most loose conditions since 1990.

The question is whether financial conditions can become more accommodate given the amount of ‘good news’ priced into

rates markets, in addition to whether lower short rates will boost economic growth given the amount of uncertainty

restraining business investment.33

▪ Markets are pricing in a ~50% probability of a total of 75bp of cuts by the end of 2019 as of the end of August.34

Exhibit 11: Goldman Sachs Financial Conditions Index

Source: Goldman Sachs, Bloomberg. Data accessed on August 30, 2019.

32 Goldman Sachs Financial Conditions Index, Bloomberg. Data accessed on August 30, 2019. 33 JP Morgan, “The J.P. Morgan View; Too little, too late -- policy backtracking, policy impotence and late-summer strategy, August 16, 2019. 34 CME Group, CME FedWatch Tool. Market pricing as of August 30, 2019.

98

98.5

99

99.5

100

100.5

101

GS Fincl. Cond. Index Current

After tightening throughout 2018,

financial conditions have loosened

substantially in 2019.

Tighter

Looser


Section II: The Credit Market Outlook

Monetary Easing and Trade Conflict Escalation Drove 1H Returns…35

Year to date through August, credit markets posted strong total returns on a year-to-date and year-over-year basis.

Returns and performance trends were driven by macro factors.

Fixed income prices benefitted from rapidly declining base rates, driven by both more dovish monetary in the U.S. and

globally as policymakers responded to slower economic growth and growing downside risks from trade conflict.

▪ Global yields plummeted. Currently 30% of global debt outstanding has a negative yield, up from 17% at YE 2018.36

▪ The average coupon on U.S. Treasuries outstanding fell from 2.6% to 1.57%, driving risk-free total returns of 8.6%.

▪ Market expectations for the Fed Funds rate at YE 2019 fell from 2.4% to 1.6%, while the expectation for YE 2020 rates

fell from 2.2% to 1.0%.

Credit spreads increased year over year but have compressed relative to YE 2018 levels.

▪ YTD, investment grade spreads have compressed 31bp to 121bp, although these are now 7bp above the August 2018 level.

▪ Similarly, YTD HY spreads have compressed by 128bp to 394bp, but remain 60bp wide of their August 2019 level.

Fixed income total returns quite positive, as investors sought yield and duration.

Investment grade total returns were +13.9% year to date, which if maintained would be the strongest annual performance

since 2009 and third in the last 30 years. The best returns were in longer duration (10+ year index total return of +23.7%)

and lower credit (BBB index +15.1%).

High yield total returns were +11%, with higher returns in better rated companies (+12.4% for BBs, compared to +5.7% for

CCCs). Investors were looking for yield but remained wary of dipping too low in quality with recession fears rising.

Loan returns were more muted, with total returns of 5.9% year to date. Loan prices rose nearly $3, but lower base rates

provided a headwind to returns as well as demand.

Exhibit 12: Select Bloomberg Barclays Fixed Income Index Metrics

Source: Bloomberg Barclays fixed income indices and S&P LSTA loan index returns, accessed on Bloomberg on August 30, 2019.

35 Bloomberg Barclays fixed income indices and S&P LSTA loan index returns through August 30, accessed on Bloomberg on September 3, 2019. 36 Bloomberg Barclays Negative Yielding Debt Index (I32542 Index) and Bloomberg Barclays Global Agg Index (LEGATRUU Index). Data through August 30, 2019.

Coupon Current MoM -3mos YTD YoY MoM -3mos YTD YoY -3mos YTD YoY

US Agg. $23,002 2.1% 48bp 6bp -1bp -5bp 6bp 2.0% 4.0% 9.3% 10.4% 0.3% 0.9% 0.1%

US Treasuries $9,130 1.58% 2.6% 4.1% 8.9% 10.7%

Investment Grade $5,797 2.8% 120 12 -8 -32 6 2.5% 6.1% 14.1% 13.5% 1.1% 3.6% 1.0%

AAA $543 1.75% 19 2 -1 -6 -5 1.9% 3.3% 7.7% 9.2% 0.3% 0.7% 0.6%

AA $654 2.25% 63 6 -5 -16 -1 2.6% 5.1% 11.4% 12.3% 0.6% 1.8% 0.8%

A $2,453 2.52% 91 9 -7 -26 -1 2.6% 5.8% 13.3% 13.1% 0.9% 2.8% 0.7%

BBB $3,188 3.19% 158 14 -8 -37 11 2.5% 6.4% 15.3% 14.1% 1.4% 4.5% 1.4%

IG 1-5Yr $2,587 2.13% 62 5 -6 -28 3 0.8% 2.0% 5.8% 6.7% 0.5% 1.6% 1.0%

IG 5-10Yr $1,911 2.64% 116 9 -12 -40 0 2.0% 5.2% 13.4% 13.4% 1.2% 4.1% 1.7%

IG 10Yr+ $2,341 3.50% 170 16 -9 -28 5 4.8% 11.1% 23.9% 21.2% 1.8% 5.3% 0.5%

High Yield $1,237 5.72% 393 22 -40 -129 55 0.6% 3.2% 10.9% 6.4% 1.2% 5.5% -0.7%

BB $584 3.98% 221 0 -65 -129 0 1.2% 4.4% 12.3% 9.3% 2.1% 6.5% 1.7%

B $490 5.90% 405 30 -35 -123 70 0.7% 3.3% 11.1% 6.9% 1.5% 6.2% 0.2%

CCC $154 10.81% 913 104 87 -73 302 -1.5% -0.6% 5.5% -3.2% -2.5% 0.6% -9.8%

Loans $1,230 6.18% $96.29 ($0.75) ($0.70) $2.48 ($2.03) -0.2% 0.7% 6.0% 3.4%

Securitized Products $6,750 2.27% 49 9 3 10 18 0.8% 2.0% 5.9% 7.4% -0.1% -0.2% -0.6%

US ABS $100 1.90% 34 -2 2 -16 -8 0.8% 1.5% 4.4% 5.7% 0.2% 0.8% 0.8%

US MBS $6,169 2.28% 47 8 3 11 18 0.7% 1.9% 5.6% 7.2% -0.1% -0.3% -0.8%

US CMBS $473 2.17% 70 8 3 -13 6 1.7% 3.6% 9.7% 11.0% 0.3% 1.8% 1.0%

US CLO - AAA $341 2.60% 124 0 1 -22 14 0.3% 0.9% 3.5% 3.5%

US CLO - BBB $33 5.12% 375 17 36 -32 89 -0.6% -0.6% 6.0% 2.6%

Credit Spreads and Total Returns

Market

Size ($bn)

Spreads / Price Total Return Excess Returns


Fundamentals Likely To Drive Performance and Dispersion Over Next 12-18 Months

We believe credit returns will be increasingly driven by industry and issuer level credit considerations.

Over the next 1-2 years, we expect a pickup in both dispersion among issuers and industries, as well as a significant rise in

the distressed index in loans and high yield, which we define here as loans and bonds trading below $90.

▪ Since 1994, 14% of the loan universe and 19% of the HY bond universe has traded at prices below $90. These percentages

spike heading into economic slowdowns (lower growth and/or recessions) and when select industries face secular

pressures (see: energy in 2015-16).37

Beyond year 2, we expect a significant and long-duration increase in downgrade and default rates. We will discuss our views

on the next downgrade/default cycle on page 12.

Exhibit 13: Loan and High Yield Distressed Ratios (trading <$90) Relative to Default Rates (both series TTM)

Source: JP Morgan Distressed Bond Universe, data through August 30, 2019. Credit Suisse Distressed Loan Index, data through August 30, 2019.

We expect increased distress and dispersion going forward38

Despite increased volatility across capital markets, distressed pricing in the loan market is relatively muted to date.

According to JP Morgan, 4.5% of leveraged loans currently trade with a price below $80, above the trailing twelve-month

average of 3.0% but in-line with the long-term median of 4.6%.

Intra-sector dispersion has also increased from a low level, with the standard deviation of average prices between the 20

sectors in the CS LLI now ~$3.40, in-line with the average since 1992.

Exhibit 14: Loan Price Dispersion Has Begun to Increase

Source: JP Morgan, “JPM High-Yield and Leveraged Loan Morning Intelligence,” September 10, 2019.

37 JP Morgan Distressed Bond Universe, data through August 30, 2019. Credit Suisse Distressed Loan Index, data through August 30, 2019. 38 Credit Suisse Leveraged Loan Index, data through August 30, 2019. JP Morgan, “JPM High-Yield and Leveraged Loan Morning Intelligence.

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Loan Default Rate (JPM) Loan Distressed as % of Total

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

HY Default Rate (JPM) HY Distressed as % of Total

0%

1%

2%

3%

4%

5%

% of Loan market below $60

% of Loan market below $80


In recessions, sectors trade down together. Outside of recessions, one or several industries selloff due to

idiosyncratic issues.

Since 1992, there have been periods where many industries saw large declines in loan prices, which typically align with

economic downturns and hence broader financial stress (2001-2003, and 2008-2010 in particular)

In addition, there have been periods where industries have experienced sector specific problems (retail in the late 1990’s,

financial firms in the early 2000’s, utilities in 2011-16, energy firms in 2015-2016, retail firms again in 2017-current)

Exhibit 15: Loan Sector Price Dispersion Over Time

Source: Credit Suisse Leveraged Loan Index, data through August 30, 2019.

Exhibit 17 illustrates the loan index with and excluding the two sectors in a given month with the lowest price.

Much of the current dislocation in the loan markets is coming from issues within a small number of industries, including

Retail ($87 average price), Metals and Mining ($87), and Energy ($91).

▪ Interestingly, excluding the weakest industries the overall index is priced at $97, on average.

This is like the experience in 2015-16, when Energy loan prices declined sharply but the overall loan index remained priced

in the low $90s.

Exhibit 16: Weak Sectors Have Had Less Impact on Broader Loan Market

Source: Credit Suisse Leveraged Loan Index, data through August 30, 2019. Pretium Partners calculations.

$40

$50

$60

$70

$80

$90

$100

CS LLI Avg. Ex-Default Lowest Priced Sector

$80

$85

$90

$95

$100

CS LLI Avg. Px

Px of Bottom 2 Industries

Ex-Bottom 2 Industries

$50

$60

$70

$80

$90

$100

CS LLI Avg. Px

Px of Bottom 2 Industries

Ex-Bottom 2 Industries


Default Cycle: Expect Increased Loss Severity Given Fundamental Pressures

Over the next 24 months, we expect the credit cycle will progress from wider spreads to realized

downgrades and defaults that are made more severe by debt burdens and technological disruption.

We expect the next credit cycle will be fundamentally driven (like 2000-04 and the early 1990s), occurring over a multi-year

period, where several industries facing fundamental pressures experience rolling downgrades and defaults. We do not

expect defaults driven by an illiquidity crisis / financial firm stress.

In credit cycle downturns, two critical considerations for returns are the shape of the default curve (magnitude

and duration) and the intensity of losses suffered.

Along with rising defaults, we expect below-average recovery rates due to higher leverage, lower credit quality, and weaker

covenant protection for lenders. Since 1998, loan recoveries have averaged 67% while high yield bond recoveries averaged

43%, but we expect substantially lower recoveries in the next downturn

In our loss severity models for high yield credit, our base case for the next downturn includes:

▪ Default rates like 2001 (i.e., lower peak defaults than 2008-09, but higher cumulative defaults over a multi-year period)

▪ Recovery rates below long-term averages, and more like 2008-09 than 2000-2004 as we believe deteriorating credit

quality will impact recoveries

▪ Prepayments will remain low as widening spreads make companies less likely to proactively refinance debt until credit

conditions loosen

Exhibit 17: We expect the next default cycle will have a similar ‘shape’ as 2000-2004

Source: JP Morgan HY Bond and Leveraged Loan Default Rates, data through August 30, 2019.

Exhibit 18: Leveraged Loan Recovery Rates

Source: Credit Suisse, Moody’s Investor Service, Morgan Stanley Research, through May 2019.

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

Default Rate - HY Bonds Default Rate - Loans

20%

30%

40%

50%

60%

70%

80%

90%

100%

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

Dec-

13

Dec-

14

Dec-

15

Dec-

16

Dec-

17

Dec-

18

US LL Recovery Rate US HY Recovery Rate

JP Morgan projects HY and

Loan default rates of 1.5% in

2019 and 2.0% in 2020


Several ‘Defensive‘ Industries At Risk Over The Near Term

As in past cycles, we expect credit issues to arise where debt burdens are misaligned with revenue growth and pricing power,

impacting idiosyncratic credits and entire industries.

Unique to this cycle is an expectation that several traditionally defensive sectors for credit are experiencing

dramatic changes to their business models, including consumer, technology/telecom, and healthcare companies.

We are seeing a dramatic shift in consumer purchasing habits which is impacting a range of industries.

▪ The first companies impacted were the brick & mortar retailers. Companies that have not developed omnichannel

strategies to offset in-store sales declines have been impacted in the initial restructuring phase and this will continue over

the coming years. Retailers are attempting to offset these pressures by rationalizing their store bases, but this is not being

done fast enough.

▪ In addition to how they are making purchases, we are encountering a generational shift away from longstanding brands

from food to apparel to entertainment. We would expect brand multiples to contract and we have already seen that for

companies like DelMonte, JCrew and Ann Taylor.

▪ Associated with this trend supermarkets in the US are impacted as purchasing habits have shifted away from center of

the store and shelf stable products. This coupled with new competition coming in from discount European players Lidl

and Aldi is pressuring all but the best capitalized supermarkets and suppliers in the distribution chain.

Technology and telecommunications sectors are experiencing rapid transitions across business models. Technology is

comprised of several subsectors which combined represent one of the largest components of the leveraged loan market.

▪ The semiconductor segment is impacted by plateauing smartphone sales and a lengthening of the replacement cycle.

▪ SaaS businesses, one of the more levered segments of the credit market, are seeing operational hurdles as they adjust to

the cloud-based world.

▪ The telecommunications and cable sectors have top line pressure from cord cutting and wireline displacement. This is

further pressured as telecommunications companies are shifting from being hardware businesses to integrated

software/service providers. This has disrupted standard recurring revenue models and put increasing pressure on

margins.

Healthcare is another historically defensive sector that is experiencing unique pressures. We expect this to intensify over

the next 12-18 months as the US election cycle accelerates.

▪ After several years of headline pressure, the pharma sector continues to be negatively impacted most recently with the

bankruptcy filing of Purdue Pharma.

▪ The hospitals and service providers are impacted by the balanced billing regulations coming into effect which are focused

on the overall cost of healthcare service. Again, only the best capitalized companies are avoiding price declines.


Will Prepayments Support the CLO and Loan Market in the Next Downturn?

In our view, one of the primary drivers of outsized CLO equity performance for 2006-07 vintage CLOs was the

sharp increase in prepayment rates during 2010-13 which forced managers to redeploy loans repaid at $100 into

loan assets priced at significant discounts to par.

Over the past ~15 years, there have been several periods of sharply rising repayments: mid 2003-mid 2005, 2010-2011, late

2012-early 2013, and late 2016-early 2017. In general, above-average prepayment rates occurred in periods with either:

1. An economic incentive for borrowers to refinance – In general, loans are pre-payable without penalty after one year outstanding. In periods where spreads narrow, issuers can gain a refinance incentive to call existing loans and reissue at lower spreads.

2. Higher proportions of loans nearing maturity – In periods of economic / capital markets distress, there is less

proactive debt issuance / refinancing. Therefore, coming out of economic downturns where credit markets were more

constrained, you naturally have more issuers who have debt closer to maturity to refinance.

We do not expect the factors which encouraged prepayments in 2010-13 to repeat in the near-term.39

The rate incentive is low today, with ~100bp delta between current new issue pricing and in-place coupons. It is unlikely

that new issue loan spreads will narrow materially over the next 12-18 months given projections for slower growth.

The proportion of loans outstanding with less than 36 months of term is at ~11%, near-the lowest level since 2009. In

contrast, during the 2010-2012 refinancing waves 28% of loans on average had a maturity within three years.

Therefore, we expect repayment rates will remain at or below the long-term average over the near-term, with the biggest

risks to this outlook: 1) a sharp contraction in credit spreads which would make refinancing more attractive for borrowers,

and 2) increased migration of loan borrowers to the high yield market to lock in fixed, rate, longer maturity debt, and 3)

M&A increases given large amounts of dry powder raised by private equity firms.

Exhibit 19: Drivers of Above Average Repayment Rates

Source: Intex, Credit Suisse Leveraged Loan Index. Data through August 30, 2019

39 Intex, Credit Suisse Leveraged Loan Index. Data through August 30, 2019

20052006200720082009201020112012201320142015201620172018 LTM2019

0%

10%

20%

30%

40%

50%

-100 bp

0 bp

100 bp

200 bp

300 bp

400 bp

500 bp

600 bpAverage Repayment Rate (RHS)New Issue Spread - CS LLI Spread (LHS)

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 LTM2019

0%

10%

20%

30%

40%

50%

0%

10%

20%

30%

40%

50% Average Repayment Rate

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 LTM2019

0%

10%

20%

30%

40%

50%

0%

20%

40%

60%

80%

100% Average Repayment Rate (RHS)% of CS LLI Trading Between 80 and 95 (LHS)

The elevated prepayments seen

in the mid 2000’s and 2016-

2018 were driven primarily by

optimal or improving financing

conditions

Post-crisis refinancings were

broadly uneconomic for

borrowers relative to their

existing cost of debt

These prepayments were

instead driven by near-term

maturities as borrowers

approached the maturity wall

Following the financial crisis,

CLOs benefitted from a unique

market condition with elevated

repayment rates and depressed

loan prices


Improved Hedging Costs Should Increase Foreign Bid For USD Debt

One positive for US corporate credit demand is the decreasing hedging costs for foreign investors.

According to Wells Fargo, “USD hedging costs declined across the board this past month and are hovering near the trailing

12-month lows for most global currencies, as central bank policies started to converge.”40

In August, the average cost to hedge dollars into yen was ~2.5%, while the cost to hedge from dollars into euros was ~2.7%.

These costs were ~40bp and 35bp lower than the trailing 12-month average, respectively.41

We expect these trends will support additional foreign investment in U.S. fixed income going forward.

While we placed this analysis of hedging costs after the Investment Grade section, we believe it carries positive

implications for all USD credit markets.

We expect global investors will bid U.S. IG, HY, and leveraged loans over the next 12 months, to take advantage of the

attractive currency-hedged yields in the U.S. markets

Exhibit 20: Hedging Costs into USD

Source: JPY-USD hedging cost from Bloomberg, ticker FXHCUSJP. EUR-USD hedging cost from Bloomberg, ticker FXHCUSEU Data through

August 30, 2019. Wells Fargo, “WFS Credit Hedge, Global FX to USD Credit,” August 5, 2019.

40 Wells Fargo, “WFS Credit Hedge, Global FX to USD Credit,” August 5, 2019. 41 JPY-USD hedging cost from Bloomberg, ticker FXHCUSJP. EUR-USD hedging cost from Bloomberg, ticker FXHCUSEU Data through August 30, 2019.

-4.00%

-3.50%

-3.00%

-2.50%

-2.00%

-1.50%

Hedging Cost from USD to JPY Hedging Cost from USD to EUR

CAD EUR GBP JPY AUD KRW

US $ FX Hedging Costs - 3mo -0.54% -2.84% -1.55% -2.56% -1.11% -0.77%

Change in 3mo Hedging Cost

MoM -12bp -12bp -14bp -15bp -4bp -24bp

YTD -28bp -29bp -23bp -40bp 50bp -62bp

TTM Tight Hedging Costs -0.54% -2.80% -1.55% -2.51% -0.08% 1.65%

TTM Wide Hedging Costs -0.96% -3.64% -2.02% -3.41% -1.22% -3.70%

Current vs. TTM Tights 0bp -4bp 0bp -5bp -103bp -242bp

Current vs TTM Wides 42bp 80bp 47bp 85bp 11bp 293bp

EMEA APAC

USD Credit Hedged to Local FX


Section III: Select Asset Performance and Pretium Outlook

Investment Grade

As of August 2019, IG credit is on pace for its best performance since 2009 with total returns of +9.1% YTD.42

Spreads ended August at 121bp, which is 32bp lower than the start of 2019 but 7bp wider than one year earlier as modestly

wider spreads reflected more challenged global growth and trade policy concerns.43

Post the May 2019 increase in trade conflict (and actual tariffs) spreads moved somewhat wider but were restrained as the

weight of negative yields in Europe and Asia led to strong demand for U.S. Corporate IG bonds.

IG credit was positively impacted by a sharp increase in demand for duration and yield due to sharply lower long rates in

the U.S. and globally. Longer-duration 10+ Year IG produced higher excess returns (+5.4%) than shorter duration 1-5-year

IG (+1.6%), while BBB rated credit produced higher excess returns (+4.6%) than A or higher bonds (+2.4%).44

Issuance continued to decline, with 2019 forecasted gross supply of $1.19tn after $1.24tn in 2018 and $1.4tn in 2017. There

has been a similar decline in net issuance, as Bank of America forecasts $510bn of net supply in 2019 after $590bn in 2018

and $785bn in 2017.45

Over the next 12-18 months, we expect flat to lower IG spreads due to strong demand from global investors looking

for duration and yield.

Despite concerns over IG credit quality and the length of the economic cycle, investors need duration and yield in a world

where 30% of all global fixed income has a negative yield and the U.S. is one of the few markets with positive yields (although

lower on an FX adjusted basis).

We believe credit risk will increase in the long-run as the economy slows, but we do not expect a severe economic downturn

through 2020.

That said, a sluggish economic growth outlook coupled with renewed central bank stimulus (lower policy rates, quantitative

easing in Europe) is likely to stimulate fund flows into USD corporates.

Exhibit 21: Investment Grade OAS

Source: Bloomberg Barclays U.S. Credit Index OAS. LT Average since 1994. Data through August 30, 2019.

42 Bloomberg Barclays Corporate Credit indices, accessed from Bloomberg on September 3, 2019. 43 Ibid. 44 Ibid. 45 Bank of America, Credit Market Strategist, August 23, 2019.

60bp

80bp

100bp

120bp

140bp

160bp

180bp

Inv. Grade OAS Inv. Grade OAS LT Avg

0bp

100bp

200bp

300bp

400bp

500bp

600bp

700bp

Inv. Grade OAS Inv. Grade OAS LT Avg


Focus on Growth of IG Market and IG Leverage

Since 2008, the IG market has increased by $3.7tn, or 144%. The BBB ratings bucket has increased in size by 460% or $2.3tn, which

has been a concern for several years, with bonds rated BBB now comprising 45% of the IG index.46

While many of the larger BBB issuers have communicated to investors a desire to bring down debt levels, we remain

concerned that over the next 2-4 years there is a high potential for considerable downgrades from BBB to high yield.

A desire to deleverage is one thing, but an ability for highly indebted companies to reduce leverage in a decelerating economy

and with structural challenges to business models is another. The question is what magnitude of downgrades, and over

what period, will enable the high yield market to digest the “fallen angel” paper in an orderly manner.

Exhibit 22: Growth of Overall IG and BBB Debt Markets Exhibit 23: BBB debt as % of IG

Source: Deutsche Bank, U.S. Credit Strategy Chartbook, data through July 31, 2019.

Overall, leverage in the IG market is moving higher and interest coverage ratios are moving lower. Not materially

so, but enough to take notice of in advance of slower economic growth.

Gross leverage is 3.0x, above the long-term average of 2.0x (since 2000), and net leverage of 2.5x, above the long-term

average of 1.4x.47

Interest coverage remains healthy for IG borrowers (9.8x vs. 11.3x average), driven by low in-place costs of financing but

has trended downward for several years.48

Exhibit 24: Investment Grade Gross and Net Leverage Exhibit 25: Investment Grade Interest Coverage Ratio


46 Deutsche Bank, U.S. Credit Strategy Chartbook, data through July 31, 2019. 47 Ibid. 48 Ibid.

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

BBB Rated Debt A-AAA Rated Debt

0%

10%

20%

30%

40%

50%

BBB as % of IG

0.0x

0.5x

1.0x

1.5x

2.0x

2.5x

3.0x

3.5x

Total Leverage Net Leverage

4.0x

6.0x

8.0x

10.0x

12.0x

14.0x

16.0x

Interest Coverage


High Yield Bonds

Like the IG market, the high yield market largely reversed a historically bad 2018 with a historically good start to 2019. Year to date

in 2019, high yield has posted a total return of 6.6% with an excess return of -0.4%.49

HY spreads have compressed dramatically since YE 2018, from +526bp at YE 2018 to +394bp at the end of August. Like

the IG market, credit spreads widened with a renewed escalation of the trade conflict and increased uncertainty surrounding

the longevity of the economic cycle.50

High yield spreads were impacted not only by the general risk off sentiment post-May, but also due to the potential increase

in energy-related distress / downgrades. Energy-related issuers make up 15% of the high yield market outstanding, but 29%

of the YTD defaults. With WTI oil prices in 2019 12% lower than FY 2018, there is an expectation of more credit issues in

that sector.51

HY defaults have increased with 2019 defaults 2.1% through July on a trailing twelve-month basis (up from 1.8% in 2018).

J.P. Morgan expects modest HY defaults in 2019 and 2020 of 1.5% and 2.0%, respectively. For context, since 1998 HY

defaults averaged 3.5%.52

Technicals remain positive for HY. According to Bank of America, the High Yield Index saw negative net issuance of $18bn

in the first six months of 2019, after negative net issuance of -$98bn in 2018.53

▪ The HY market has not grown despite an increase in companies choosing to finance through the HY market vis-a-vis the

leveraged loan market with yields compressing sharply in both but fewer covenants and longer duration available in the

HY market.54

Longer-term, we remain concerned about the HY market’s ability to digest a sharp increase in net supply from both fallen angels out

of BBB investment grade buckets, as well as the potential for current loan issuers to shift back to the high yield market.

As noted earlier, we expect the downgrade cycle out of IG to be a multi-year issue, but the relative size of the markets makes

any large movement of BBB IG issuers into HY difficult to handle.

In addition to the increase in debt, there is a repricing of risk which occurs when high quality companies move from high

grade to high yield as existing high yield issuers are now competing for capital with potentially higher quality credits.

Exhibit 26: High Yield OAS

Source: Bloomberg Barclays High Yield and U.S. Credit Index OAS. LT Average since 1994. Data through August 30, 2019.

49 Bloomberg Barclays High Yield Index OAS. Data through August 30, 2019. Accessed from Bloomberg on September 3, 2019. 50 Ibid. 51 Bank of America, “High Yield Strategy; Where to Hide”, August 16, 2019. West Texas Intermediate oil prices from the St. Louis Fed FRED system, through August 30,

2019. 52 JP Morgan, “Default Monitor,” August 1, 2019. 53 BofA Merrill Lynch Global Research, “High Yield Credit Chartbook,” July 2019. 54 JP Morgan, “JPM High-Yield and Leveraged Loan Morning Intelligence,” August 20, 2019.

250bp

300bp

350bp

400bp

450bp

500bp

550bp

600bp

HY OAS HY OAS LT Avg

0bp

200bp

400bp

600bp

800bp

1000bp

1200bp

1400bp

1600bp

1800bp

2000bp

HY OAS HY OAS LT Avg


Focus on HY Leverage

Like the IG market, HY leverage has increased of late, with both rising debt-to-EBITDA ratios and declining interest coverage.55

Gross leverage of 5.0x compares to the long-run average of 4.6x (since 2006), with net leverage of 4.6x above the long-run

average of 3.7x.

Cash flow coverage is above average, with interest coverage of 3.9x, compared to 3.5x over the past 13 years, although down

recently from its consistent uptrend since the energy credit crisis of 2015-16.

Exhibit 27: High Yield Gross and Net Leverage Exhibit 28: High Yield Interest Coverage


One interesting feature of the HY market is the improving index rating, with a greater proportion of BB rated issuers than at any

point in the past 19 years. This is in contrast with the IG market (seeing more BBB issuers) and the loan market (with more B rated

issuers).56

Exhibit 29: Credit Quality of HY Index Improving

Source: Deutsche Bank, U.S. Credit Strategy Chartbook, data through July 31, 2019 .

55 Deutsche Bank, U.S. Credit Strategy Chartbook, data through July 31, 2019. 56 Deutsche Bank, U.S. Credit Strategy Chartbook, data through July 31, 2019.

3.0x

3.5x

4.0x

4.5x

5.0x

5.5x

6.0x

6.5x

7.0x

Total Leverage Net Leverage

1.5x

2.0x

2.5x

3.0x

3.5x

4.0x

4.5x

5.0x

Interest Coverage

0%

10%

20%

30%

40%

50%

60%

$0

$100

$200

$300

$400

$500

$600

$700

$800

$900

BB Rated Debt BB as % of HY


Bank Loans

2019 was a difficult year for leveraged loan returns, as rising credit concerns due to a weakening economy coupled

with less demand for floating rate product as central banks turned squarely dovish.

Loans posted a total return of +5.9% through August 2019, as expectations for 2019/2020 rate hikes receded.

Returns were stronger for higher rated loans: Loans rated BB and higher posted YTD total returns of +7.0%, while B rated

loans posted returns of +5.8% and loans rated CCC and below returned +2.7%.

▪ While the market demanded higher yielding products, they were less willing to stretch for yield in the lowest quality loans.

Further, CLOs are prevented from owning too much CCC exposure.

Loan prices and spreads showing greater divergence as fundamentals / issuer risks become more important late

cycle

Loan prices averaged $96.49 in August 2019, up from $94 at YE 2018.57

Discount margins (3Yr life) decreased from 550bp at YE 2018 to 470bp in August 2019. That said, the average loan spread

YTD in 2019 was 60bp higher than the average YTD in 2018.

There is a widening dispersion within the loan index relative to the past several years, due in part to distress in select sectors

(retail, metals and mining, and energy). We explore this issue more on page 10.

We expect lower loan issuance levels to persist through 2020

YTD loan issuance totaled $215bn through August, which was down 62% on a gross basis and down 34% on a net basis

relative to YTD 2018. Issuance has been negatively impacted by both waning demand from retail funds (impacting spreads

to borrowers) and less new issuance from corporates overall.

Demand from new CLOs remains strong, but maty slow going forward due to a more limited arbitrage for new deals.

▪ YTD CLO 2019 net issuance of $81bn is down 8% compared to YTD 2018 net issuance.

▪ That said, the CLO “arbitrage” is decidedly less positive today than in the past several years, placing pressure on CLO

managers to raise equity capital to fund de novo deals.

▪ CLOs remain a critical part of the loan funding market as they acquire ~60% of net loan issuance; therefore, a slowing

pace of new CLO issuance would impact demand and pricing for loans.

Further, retail mutual fund and ETFs saw $26.4bn of outflows from YE 2018 through August 2019. In total, loan funds have

reported a $46bn outflow or ~30% of their October 2018 peak of $154bn.58

Exhibit 30: Average Loan Price (CS LLI) Exhibit 31: Loan spreads (CS LLI)

Source: Credit Suisse Leveraged Loan Index. Data through August 2019.

57 Credit Suisse Leveraged Loan Index. Data through August 30, 2019. 58 JP Morgan, “Credit Strategy Weekly Update,” August 23, 2019.

$85$87$89$91$93$95$97$99

$101

Average Price

350 bp400 bp450 bp500 bp550 bp600 bp650 bp700 bp750 bp

Discount Margin to Maturity


Exhibit 32: Average Yield to Maturity (3Yr Life)

Source: Credit Suisse Leveraged Loan Index. Data through August 2019.

4%

6%

8%

10%

12%

14%

16%

18%

20%

Yield (3Yr Life)


Loan Market Has Grown Substantially with Increasing Share of Lower Ratings Quality

Since 2007, the leveraged loan market has increased in size to $1.4tn and is now comparable in size to the high yield debt

market. Loans now make up 15% of the publicly listed corporate debt market, up from 13% in 2013 and 10% in 2006.59

Growth in the loan market came at the expense of credit quality, reflected in both a sharp increase in covenant lite (“cov-

lite”) loans. And a decrease in credit quality illustrated by the increasing ratio of B and below issuers in the market.

▪ In 2019, 79% of new loans were cov-lite, compared to 46% issued since 1998. We believe higher proportions of cov-lite

loans will lead to a more prolonged default curve than in past cycles where there were more ‘triggers’ to lead to a default.

Further, a lack of covenants gives term loan lenders fewer options for addressing businesses with deteriorating

fundamentals / balance sheets early on.60

▪ 62% of the loan universe is rated B+, B, or B-; this proportion was 38% in December 2009 and 32% in December 2006.

We expect that lower rated loans, all else equal, will experience higher levels of defaults and lower recoveries than a higher

average rated index.61

Exhibit 33: Loans Quickly Growing as % of Debt Markets


Exhibit 34: 62% of the Loan Universe Is Rated B Exhibit 35:Like IG, Average Loan Rating Deteriorating

Source: JP Morgan, “High-Yield and Leveraged Loan Morning Intelligence,” August 13, 2019. Deutsche Bank, U.S. Credit Strategy Chartbook, data

through July 31, 2019.

59 Deutsche Bank, U.S. Credit Strategy Chartbook, data through July 31, 2019. 60 Bank of America, “High Yield Chartbook”, July 2019. 61 JP Morgan, “High-Yield and Leveraged Loan Morning Intelligence,” August 13, 2019.

$0.0

$0.2

$0.4

$0.6

$0.8

$1.0

$1.2

$1.4

$1.6

Loans

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

Sect

or

% o

f D

ebt

Mark

et

Loans HY IG

0%

10%

20%

30%

40%

50%

60%

Above BB BB/Split BB

B Below B

0%

10%

20%

30%

40%

50%

60%

70%

% of Loans B or Below % of HY B or Below

% of IG BBB or Below


Risks: Higher Leverage and Fewer Covenants

The risks to the leveraged loan market over the next 2-4 years are increasing and two issues are concerning for future recoveries. The

increase in leverage and decrease in covenants are likely to result in lower recoveries and longer timelines to resolve credit issues

when they arise.

First-lien loan leverage has increased to more than ~4.4x, compared to a long-run median of 3.3x. Leverage has been in the

4x range for the past three years, which coincided with a dramatic increase in loan issuance.62

One key difference in this cycle is the increasing lack of covenants in the loan market, which we expect will lead to a more

prolonged default curve than in past cycles where there were more ‘triggers’ to lead to a default.

▪ Since 2013 almost 80% of issued loans have been cov-lite.63 For those loans that do have covenants, there are generally

fewer covenants utilized, with a debt-to-EBITDA covenant the most commonly used covenant.64

▪ A lack of covenants gives term loan lenders fewer options for addressing businesses with deteriorating fundamentals /

balance sheets early on. Generally, there are still covenants with the revolving line of credit lender, but those lenders may

have different priorities than the term loan lenders.

Exhibit 36: New First-Lien Loan Issuance Leverage Exhibit 37: Covenant-Lite as % Of Loan Issuance

Source: S&P Global, LCD. Morgan Stanley Research, “U.S. Credit Strategy: U.S. Credit Strategy Chartbook”. BofA Merrill Lynch Global Research,

Leveraged Loan New Issue Volumes, from “HY Credit Chartbook,” July 2019.

62 S&P Global, LCD data through 2Q’19, “Credit Stats: Average Debt Multiples of Highly Leveraged Loans.” 63 S&P Global, LCD data through 2Q’19, “Volume: New-Issue U.S. Covenant-Lite Loans.” 64 S&P Global, LCD data through 2Q’19, “Covenant/Security: Incidence of Key Covenants in First-Lien Lev. Loans.”

2.0x

2.5x

3.0x

3.5x

4.0x

4.5x

First Lien New Issue Loan Leverage Median

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

1H

19


CLOs

In 2019, the CLO market was among the weakest performing credit or structured products markets, with only

modest spread compression from the widest levels seen in December 2018. CLO demand has been impacted by

three primary factors:

1. CLO market has been impacted by slowing demand for floating rate product given the outlook for monetary policy.

2. Demand for lower rated credit products has been weak, over concerns for slowing growth and energy-related credit issues.

3. In addition, many of the primary CLO AAA buyers in Japan were less active in the market in 2H’18 and 1H’19, leading to

higher than expected spreads for new issue CLOs.

2019 saw healthy new CLO creation despite wider liability spreads

In August 2019, new issue CLOs carried AAA spreads of 133bp, with BBB spreads of 383bp. Respectively, these spreads are

+17bp and 76bp wider vs August 2018 levels.65

▪ More broadly, liability costs in 2019 are much higher than in 2018. Full year 2018 new issue spreads averaged 110bp for

AAA and 294bp for BBB, compared to 2019 YTD average discount margins of 132bp and 378bp, respectively.

Despite lower floating demand and less spread compression, CLO issuance remained healthy in 2019.

▪ CLO issuance YTD was $113bn gross and $81bn net, or 41% and 6% below 2018’s YTD volumes. Keep in mind that 2018

gross supply includes a large amount of refi/reset volume which was much lower in 2019.66

CLOs remain the primary buyer of loan originations. According to S&P LCD, CLOs have acquired over 60% of loan volume

in 2014-2018. Similarly, over 60% of loans originated in the first half of 2019 were acquired by CLOs. Consensus forecasts

are generally for net CLO issuance of 60-65% of net loan issuance.67

We expect the CLO market will see flattish spreads and lower new issue volumes over the next 12-18 months.

We expect CLO AAA spreads will benefit from fund flows driving lower IG spreads, as global investors are likely to continue

to move out on the risk curve to achieve higher yields.

That said, we expect weaker loan fundamentals in a slowing global economy, and the narrow CLO arb to depress demand

for new issue CLO equity.

Exhibit 38: CLO AAA and BBB New Issue Spreads Exhibit 39: CLO AAA Secondary DMs vs IG Spreads

Source: New issue CLO spreads from BofA Merrill Lynch Global Research, S&P LCD. JP Morgan post-crisis CLO indices and Bloomberg Barclays

IG OAS, accessed through Bloomberg. Data through August 30, 2019.

65 Bank of America, “CLO Weekly,” August 30, 2019. 66 JP Morgan, “Credit Strategy Weekly Update,” August 23, 2019. 67 BofA Merrill Lynch Global, S&P LCD, Bloomberg, Intex, July 2019.

0bp

100bp

200bp

300bp

400bp

500bp

600bp

700bp

0bp

20bp

40bp

60bp

80bp

100bp

120bp

140bp

160bp

180bp

AAA BBB

50bp

100bp

150bp

200bp

250bp

Investment Grade OAS

JPM AAA CLO Discount Margin


Despite slowing fund flows to floating rate product, CLOs outstanding continue to grow AUM at a healthy pace.

YTD in 2019, net CLO creation was $81bn, or 8.0% below net creation in YTD 2018.

Looking forward we expect the pace of CLO creation will slow as a tighter CLO ‘arb’ makes raising incremental equity for de

novo CLOs more difficult.68

Exhibit 40: CLO Purchases as % of Loan Issuance

Source: Bank of America Merrill Lynch Global, “HY Credit Chartbook”, Intex, Bloomberg, data through August 2019. JP Morgan, “Credit Strategy

Weekly Update,” August 23, 2019.

Post-crisis, CLOs have become the primary buyer of loan originations.

According to S&P LCD, CLOs have acquired over 60% of loan volume in 2014-2018, with 60.2% of loans originated in the

first half of 2019 acquired by CLOs.69

Over the past 17 years, CLOs have acquired, on average, 48% of net loan issuance.

Exhibit 41: CLO Purchases as % of Loan Issuance

Source: BofA Merrill Lynch Global, S&P LCD, Bloomberg, Intex, July 2019.

68 BofA Merrill Lynch Global, S&P LCD, Bloomberg, Intex, July 2019. 69 BofA Merrill Lynch Global, S&P LCD, Bloomberg, Intex, July 2019.

$0

$100

$200

$300

$400

$500

$600

$700

CLO outstanding ($bn)

$0.0

$20.0

$40.0

$60.0

$80.0

$100.0

$120.0

$140.0

Net CLO Issuance 2019 Annualized

0%

10%

20%

30%

40%

50%

60%

70%

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

1H

19

CLO Purchases as % of Loan Issuance LT Average


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