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High yield has outperformed in the current and most recent Fed tightening cycle, but the 1994 and 1999 tightening campaigns saw leveraged loans perform better. In order for leveraged loans to have another day in the sun in 2018, we will need to see a combination of rising U.S. Treasury yields and rising treasury implied volatility. The current modest pace of rising yields and low volatility will continue to favor U.S. high yield over leveraged loans.
Comment
In response to a client inquiry, yesterday’s U.S. Credit Update examined the relative performance of U.S. high yield bonds and leveraged loans during Fed tightening cycles. As the chart at the top of the post shows, high yield has been the dominant class of U.S. credit markets in 2017. With the strong performance of high yield in this cycle, the record between high yield and leveraged loans is split over the past four tightening campaigns.
The chart below shows the spread between the Bloomberg Barclays U.S. High Yield and Credit Suisse Leveraged Loan total return indices during the current and prior three Fed tightening cycles. Leveraged loans outperformed high yield in the 1994 and 1999 cycles by 8.8% and 4.2%, respectively. But the 2004 and present tightening campaigns have seen high yield outperform. U.S. high yield bested leveraged loans by 5.5% during the 2004 cycle and rocketed away from leveraged loans during the first two years of the current tightening cycle.
The degree of high yield outperformance moderated late in the year. Are we beginning to see a shift in conditions that would favor leveraged loan outperformance again?
In yesterday’s U.S. Credit Update, we discussed how floating rates and shorter durations help leveraged loans outperform during rising rate environments. The two key tendencies we pointed out were that leveraged loans perform well during periods of total return losses for U.S. Treasuries and that leveraged loans outperform high yield when Treasury implied volatility rises.
Here we illustrated how rising Treasury yields, rising Treasury implied volatility and other factors influence the likelihood of leveraged loan outperformance over high yield. Using a generalized additive model (GAM), we estimate the probability that leveraged loan total returns will exceed high yield total returns over the following quarter. We used quarterly changes in short-term U.S. rates, U.S. Treasury yields, LIBOR, credit market total returns, measures of volatility, and commodities as predictors.
The charts below show the smooth functions for four of the key predictors, the quarterly change in the U.S. 10yr yield, U.S. Treasury implied volatility, U.S. 10yr TIPS breakeven spread and gold. The charts show how the response, the probability that leveraged loans would outperform high yield over the following quarter, changes assuming other predictors are held constant.
The top two charts illustrate the two key influences we discussed yesterday. The likelihood of leveraged loan outperformance rises with increases in the U.S. 10yr yield and U.S. Treasury implied volatility. Rising rates allow the floating rates for leveraged loans to reset, the key advantage over fixed rate high yield bonds. Rising implied volatility increases the value of this optionality for investors.
Recent conditions, especially the collapse in volatility as 2017 came to a close, have not favored leveraged loan outperformance. U.S. ETF investors have taken notice. The next chart shows total assets and net 20-day flows for U.S. leveraged loan ETFs. Net outflows peaked at -$615 million on December 6 and totaled -$244 million over the past 20 days.
Conclusion
We highlighted in yesterday’s Newsclips how expectations for higher inflation and volatility might finally be realized in 2018. This would be a favorable development for leveraged loans. The combination of higher Treasury yields and higher volatility is critical for leveraged loan outperformance. Until we see those conditions develop, high yield is likely to remain the dominant class in U.S. credit markets.