All data as of December 31, 2019, unless otherwise noted.
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.
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.
