ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES ARE IN THE DISCLOSURE APPENDIX. FOR OTHER IMPORTANT DISCLOSURES, PLEASE REFER TO https://firesearchdisclosure.credit-suisse.com.
CREDIT SUISSE SECURITIES RESEARCH & ANALYTICS BEYOND INFORMATION™
Client-Driven Solutions, Insights, and Access
Mid-Year 2012 U.S. Leveraged Finance Outlook
U.S. High Yield and Leveraged Loan Outlook U.S. high yield has returned 8.70% year to date in 2012 and U.S. leveraged loans 5.62%. Renewed European sovereign debt concerns and a further slowdown in U.S. growth put pressure on all risky assets in May and early June, with high yield losing -2.71% peak to trough and loans -1.39%. However, markets made back all of their losses by the first week of July and have continued to push higher. The Credit Suisse high yield and leveraged loan indices are currently at all-time highs.
We suggested in our May 16th report that losses in the U.S. high yield market would be contained by above-average spreads. This theme continues to play out, with recent weak economic data and slowing revenue growth having little downside impact on high yield.
At this point, spreads have absorbed much of the weakness that was priced in and any further economic deterioration would likely lead to higher spreads. However, our economics team projects U.S. GDP will stabilize at 1.5% growth in Q3 before accelerating slightly to 2.2% in Q4, which would be consistent with the current level of spreads near 650 bp. We had maintained projections slightly lower than our forecast models due to concerns about European recession and slowing U.S. growth. Even though our concerns were realized, the market disruption has been fairly minor. Consequently, we are raising our return projections for U.S. high yield and leveraged loans.
We are increasing our total return projection for U.S. high yield for 2012 to 8% to 11%, from 7% to 10% published earlier. We are tightening our projection for 2012 default rates to a range of 1% to 2%. We are increasing our total return projection for U.S. leveraged loans for 2012 to 5% to 8%, from 4% to 7%.
Exhibit 1: U.S. Leveraged Finance Projections
Actual Annual ReturnYTD 8/01/12 Projected 2012
US High Yield Bonds 8.70% 8% to 11%US Leveraged Loans 5.62% 5% to 8%
Actual Default Rate Default Rate Default RateLTM July 2012 Projected 2012 Projected 2013 Projected 2014
US High Yield Bonds 1.93% 1% to 2% 1% to 3% 2% to 4%
US Leveraged Loans 1.10% 1% to 2% 1% to 4% 3% to 6%
Performance
Defaults
Source: Credit Suisse
U.S. High Yield 2
U.S. Leveraged Loans 11
Visit our website at: http://research-and-analytics.csfb.com/R2Action.do
02 August 2012Fixed Income Research
Global Leveraged Finance Strategyhttp://www.credit-suisse.com/researchandanalytics
Research AnalystsJonathan Blau212 538 3533
Daniel Sweeney+1 212 538 8213
Karen Friedlander+1 212 325 8459
02 August 2012
Mid-Year 2012 U.S. Leveraged Finance Outlook 2
U.S. High Yield High yield bond yields, at 7.04%, are now within 37 bp of their all-time lows. Since future total returns are largely determined by yields less some amount of default loss, a 7.04% yield implies annualized total returns in the 2% to 6% area over the next five years. Total returns could be higher if yields durably move to lower levels, but this is difficult to envision given the extended low-growth outlook. However, crossovers and BBs recently have moved to new all-time low yields, pushing the returns for these segments higher than what is normally experienced during an economic expansion.
Exhibit 2: CS HY Index Yield
10/31/199019.10%
1/31/19948.87%
11/30/200015.04%
2/28/20056.98%
5/31/20077.59%
11/28/200820.47%
4/29/20116.75%
0%
5%
10%
15%
20%
25%
YTW
CS HY Index YTW
7.04%8/1/2012
Source: Credit Suisse
We suggested in our May 16th report that losses would be contained by the historically wide spreads. This theme continues to play out, with weak economic data and slowing revenue growth having little downside impact on high yield. Despite the worsening economic data over the past three months, spreads are virtually unchanged over that time period. At 635 bp, spreads are still wide of their long-term average of 588 bp.
Exhibit 3: CS HY Index Spread
1079 bp12/31/90
307 bp2/28/97
1080 bp10/31/02
307 bp2/28/05
271 bp5/31/07
1816 bp11/28/08
0bps
400bps
800bps
1200bps
1600bps
2000bps
Spre
ad to
Wor
st
Average: 588 bp
635 bp8/1/12
Source: Credit Suisse
02 August 2012
Mid-Year 2012 U.S. Leveraged Finance Outlook 3
Exhibit 4 compares the Manufacturing PMI to the high yield spread. These data series have been reasonably well correlated, with the exception of the 2004-2007 credit bubble period. We note that the June and July PMI reports came in below 50 and other economic indicators have also been below expectations.
Exhibit 4: CS HY Index Yield Spread vs. ISM Manufacturing PMI 0
10
20
30
40
50
60
700
200
400
600
800
1000
1200
1400
1600
1800
2000
ISM
Manufacturing P
MIH
Y S
prea
d-to
-Wor
stHY Spread-to-Worst
ISM Manufacturing PMI
Source: Credit Suisse, the BLOOMBERG PROFESSIONAL™ service
Examining the correlation as a scatter plot in the next exhibit shows that the regression is not very robust. The correlation is mostly defined by the extreme values, meaning that if the recession values in the upper left are removed the data reduces to a poorly correlated blob. However, an examination of the data points over the last four years reveals that spreads have been priced for a fairly weak outcome and have now absorbed that weakness.
Looking at the year-end data points starting in December 2008 shows that for most of the recovery, spreads have been wide of the regression line by about 180 bp on average. However, over the past six months, spreads have remained flat while the PMI has dropped by five points, bringing the latest data point right next to the regression. This implies that we have a little more cushion left in spreads, but not much. Any further economic deterioration could lead to higher spreads and lower bond prices.
Exhibit 5: CS HY Index Yield Spread vs. ISM Manufacturing PMI
R² = 0.51
200
400
600
800
1000
1200
1400
1600
1800
30 35 40 45 50 55 60 65
HY
Spr
ead -
to-W
orst
ISM Manufacturing PMI
Dec 2008
Dec '09Dec '10Dec '11Jul '12
Source: Credit Suisse, the BLOOMBERG PROFESSIONAL™ service
02 August 2012
Mid-Year 2012 U.S. Leveraged Finance Outlook 4
A similar phenomenon has occurred in the other high-frequency economic data series, such as the regional Fed surveys. For example, looking at the Philly Fed survey shows that spreads have been wide of the levels associated historically with the survey results since the end of the last recession. However, over the past seven months, spreads have held steady while the Philly Fed survey has declined, meaning that spreads are now tight to expectations. Similar to the PMI, any further deterioration in the Philly Fed survey would likely put upward pressure on spreads. We note that the CS Economics team is forecasting a mild re-acceleration of U.S. GDP growth by the end of the year, which implies that these surveys may improve going forward.
Exhibit 6: CS HY Index Yield Spread vs. Philly Fed Business Outlook Survey
R² = 0.50
200
400
600
800
1000
1200
1400
1600
1800
-60 -50 -40 -30 -20 -10 0 10 20 30 40 50
HY
Spr
ead-
to-W
orst
Philly Fed Business Outlook Survey
Dec 2008
Dec '09
Dec '10
Dec '11
Jul '12
Source: Credit Suisse, the BLOOMBERG PROFESSIONAL™ service
Spreads have historically anticipated default loss by about seven months. The difference between the spread and forward default loss averaged 290 bp from 1986 through 2008. However, this difference has averaged 516 bp since January 2009. The 226 bp difference above the historical levels foots closely with the extra spread above the economic indicators since 2008 in the prior exhibits. The excess spread above the economic data has disappeared over the past several months, and it seems likely that the excess spread over default loss will also erode slightly going forward. We expect loss rates to start climbing slowly in 2013 and to pick up in 2014.
Exhibit 7: CS HY Index Spread vs. Default Loss Rate
12/31/19901079 bp
10/31/20021080 bp
200 bp
400 bp
600 bp
800 bp
1000 bp
1200 bp
1400 bp
1600 bp
1800 bp
STW
& D
efau
lt Lo
ss R
ate
Spread to Worst HY Default Loss Rate (7-Months Later)
Correlation = .82
Average Difference: 1986-2008: 290 bp Average Difference: 2009-2Q12: 516 bp
0.98%
7/31/12 640 bp
Source: Credit Suisse
02 August 2012
Mid-Year 2012 U.S. Leveraged Finance Outlook 5
We are tightening our projection for 2012 default rates to a range of 1% to 2%. Our bottom-up forecast comes to 1.4%, and we weight the risk to the upside. For 2013 we are projecting a slight increase to 1.8%. Several of the large 2006/2007 LBOs start to become vulnerable next year, though absent any recession the odds of bankruptcy filings remain fairly low. Those odds increase further in 2014, pushing our default rate estimate to 2.3%.
Exhibit 8: Historical and Projected High Yield Default Rate
2.9%
4.8%
1.6%
3.8%
7.9%8.8%
3.3%
1.8%0.9%
2.3%1.4% 0.9% 1.4%
4.1% 4.5%
9.2%
15.5%
4.3%
1.3%
2.6%
0.7% 0.5%
5.5%
9.4%
1.6% 1.8% 1.4% 1.8%2.3%
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
Default Rate
Source: Credit Suisse
Exhibit 9: Projected High Yield Default Rates Actual Default Rate Default Rate Default Rate
LTM July 2012 Projected 2012 Projected 2013 Projected 2014
US High Yield Bonds 1.93% 1% to 2% 1% to 3% 2% to 4%
US Leveraged Loans 1.10% 1% to 2% 1% to 4% 3% to 6% Source: Credit Suisse
We build our bottom-up default rate forecast by estimating the odds of each company exchanging/filing in a particular year and multiplying those odds by the face amount outstanding. We then divide that amount for each sector by the total outstanding in the sector. We note that it is quite possible for one company with a large amount of debt but only a 25% chance of default to have an outsized impact on the projected default rate for a particular industry. This is the case for the three industries with the highest projected default rates, broadcasting, gaming, and food and drug.
Exhibit 10: Projected Cumulative 2013-2014 High Yield Default Rates by Industry versus Spread
Aero/DefAirlines
Auto
Broadcasting
Bldg Mat
CableChemicals
Cons Durables
Cons Non-Durables
Diversfd Media
Environ Svc
E & P
Food And DrugGaming
Healthcare
RE Dev
Info Tech
Leisure
Manf
Average
Other MetalsServices
Packaging
Paper
Refining
Retail
Oil Svc & Eq
Shipping
Steel
Telecom
UtilityWireless
R² = 0.47
500 bp
600 bp
700 bp
800 bp
900 bp
1000 bp
1100 bp
0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00% 14.00% 16.00% 18.00%
Spr
ead
Default Rate
Source: Credit Suisse
02 August 2012
Mid-Year 2012 U.S. Leveraged Finance Outlook 6
The top performing high yield industries year to date have been real estate development, building materials and services with total returns of 16.27%, 13.18%, and 12.58%, respectively. The worst performing industries have been food & drug, metal/minerals and energy.
Exhibit 11: CS HY Index YTD Sector Performance
1.36%
3.04%
6.05%
6.75%
7.02%
7.29%
7.61%
8.21%
8.27%
8.33%
8.41%
8.69%
8.70%
8.78%
8.78%
8.87%
9.09%
9.33%
9.45%
9.47%
9.58%
9.84%
9.85%
10.58%
11.54%
12.40%
12.58%
13.18%
16.27%
0% 2% 4% 6% 8% 10% 12% 14% 16% 18%
Food And DrugMetals/Minerals
EnergyInformation Technology
PaperUtility
Cable/Wireless VideoLeisure/OtherFood/TobaccoManufacturing
Diversified MediaWireless Communications
Credit Suisse High Yield IndexPackagingAutomotiveAerospace
Consumer DurablesTelecommunications
BroadcastingConsumer Non-Durables
RetailGaming
HealthcareChemicals
Land TransportationFinancial
ServiceBuilding Materials
Real Estate Development
YTD Total Return
Source: Credit Suisse
In Exhibit 12, we compare net leverage versus spread for each industry sector. There is no discernible relationship because many of these sectors have factors other than leverage that have a greater impact on spread. For example, real estate development and shipping spreads are more closely related to asset coverage. Still, we can combine some of the information below with the results in Exhibit 10 to find some favorable sectors. Telecom, diversified media, healthcare and airlines have somewhat elevated spreads yet have reasonable leverage and a low default outlook. We also note that these are fairly defensive sectors which fits with the on-going earnings deceleration in the global economy.
Exhibit 12: Net Leverage by Sector
ACUTE CARE
AEROSPACE/DEFENSEAIRLINES
ALTERNATE SITE SERVICES
AUTOMOTIVE
BROADCASTING
BUILDING MATERIALS
CABLE/WIRELESS VIDEO
COMMODITY & FERTILIZER
CONSUMER DURABLES
CONSUMER NON-DURABLES
DIVERSIFIED MEDIA
ENVIRONMENTAL SERVICES
EXPLORATION & PRODUCTION
FINANCIAL
FOOD AND DRUGGAMING
INFORMATION TECHNOLOGY
LAND TRANSPORTATION
LEISURE/OTHER
MANUFACTURING
MEDICAL PRODUCTS
OTHER ENERGY
OTHER METALS/MINERALS OTHER SERVICES
PACKAGING
PAPER
REAL ESTATE DEVELOPMENTREFINING
RETAIL
SERVICE & EQUIPMENT
SHIPPING
SPECIALTY CHEMICALS
STEEL
TELECOMMUNICATIONS
UTILITYWIRELESS COMMUNICATIONS
400
500
600
700
800
900
1000
1100
0 2 4 6 8 10 12 14
Spr
ead-
to-W
orst
Net Leverage
Source: Credit Suisse
02 August 2012
Mid-Year 2012 U.S. Leveraged Finance Outlook 7
Year-to-date for 2012, the Credit Suisse High Yield Index is up 8.70%. CCCs have led the rally, returning 11.93%, while Bs and BBs have returned 9.00% and 7.89%, respectively.
While all rating categories currently have spreads well above the lows experienced during previous economic expansions, spreads are especially wide in higher-rated bonds. For example, crossover bond spreads are 17% above their long-term average while CCC bond spreads are 10% below average.
Exhibit 13: Crossover Bonds Spread-to-Worst Exhibit 14: CCC Bonds Spread-to-Worst
1/31/91380 bp
2/28/94197 bp 2/28/97
121 bp
9/30/02570 bp
2/28/05126 bp
5/31/07149 bp
11/28/081121 bp
3/31/11272 bp
0 bp
200 bp
400 bp
600 bp
800 bp
1000 bp
1200 bp
Jan-
86
Jan-
88
Jan-
90
Jan-
92
Jan-
94
Jan-
96
Jan-
98
Jan-
00
Jan-
02
Jan-
04
Jan-
06
Jan-
08
Jan-
10
Jan-
12
Spl
it B
BB
Spr
ead-
to-W
orst
Split BBB Spread-to-Worst
343 bp
Average: 292 bp
12/31/903457 bp
2/28/94559 bp
12/29/002805 bp
5/31/07475 bp
2/27/093299 bp
2/16/11798 bp
0 bp
500 bp
1000 bp
1500 bp
2000 bp
2500 bp
3000 bp
3500 bp
4000 bp
Jan-
86
Jan-
88
Jan-
90
Jan-
92
Jan-
94
Jan-
96
Jan-
98
Jan-
00
Jan-
02
Jan-
04
Jan-
06
Jan-
08
Jan-
10
Jan-
12
CC
C S
prea
d-to
-Wor
st
CCC Spread-to-Worst
1133 bp
Average: 1262 bp
Source: Credit Suisse Source: Credit Suisse
The wider spread of higher-rated bonds can be illustrated by looking at the ratio of crossover spreads to CCC spreads. This ratio reached its highest levels ever in late 2009 and has remained elevated over the past 30 months. Currently, the crossover spread is 343 bp and the CCC spread is 1133 bp, which is a ratio of 30.25%. Though this ratio is still quite high historically, it is actually near the low end of the range that has prevailed since 2009.
Exhibit 15: CS HY Index: Ratio of Crossover Spread to CCC Spread
33.95%
25%
27%
29%
31%
33%
35%
37%
39%
41%
Cro
ssov
er S
prea
d as
a %
of C
CC
Spr
ead
Crossover Spread as a % of CCC Spread
30.25%
Source: Credit Suisse
This high ratio has insulated crossover bonds against market volatility. Crossover bonds have outperformed since the end of 2010, returning 18.10% versus 9.53% for CCCs.
Exhibit 16: High Yield Total Returns by Rating since 12/31/2010
-15.0%
-10.0%
-5.0%
0.0%
5.0%
10.0%
15.0%
20.0%
Tota
l Ret
urn
sinc
e 12
/31/
10
Split BBB
BB
B
CCC/Split CCC
18.10%
9.53%
15.57%16.21%
Source: Credit Suisse
02 August 2012
Mid-Year 2012 U.S. Leveraged Finance Outlook 8
This is a new phenomenon in the high-yield market, where below average economic growth leads to consistent outperformance by the interest rate sensitive portions of the market. Meanwhile, spreads remain wide due to the heightened risks of below average growth, causing underperformance by the CCC segment.
Exhibit 17: CS HY Index: Correlation by Rating with Treasuries and Equities Yield-to-Worst Correlation Return Correlation
Jan 2010 - Jul 2012 w ith 5-Yr Treaury Yield w ith S&P 500Split BBB 0.69 0.32BB 0.48 0.58Split BB 0.25 0.60B 0.01 Credit Sensitive 0.65Split B -0.37 0.67CCC/Split CCC -0.55 0.71CS HY Index 0.09 0.65
Interest Rate Sensitive
Source: Credit Suisse
Though the split BBBs have outperformed over the 2010 - 2012 timeframe, there are distinct shorter periods of outperformance and underperformance for each of these rating categories. We can see these periods by subtracting the split BBB total returns from the CCC total returns over the previous 30 days on a rolling basis to produce the cycles shown in the next exhibit. The peaks in this differential during early 2010, early 2011 and February 2012 show clearly.
Exhibit 18: Performance Differential: CCCs - Crossovers, Trailing 30 Days
-10.0%
-8.0%
-6.0%
-4.0%
-2.0%
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
2/17
/201
03/
17/2
010
4/17
/201
0
5/17
/201
0
6/17
/201
0
7/17
/201
0
8/17
/201
0
9/17
/201
0
10/1
7/20
10
11/1
7/20
10
12/1
7/20
10
1/17
/201
1
2/17
/201
13/
17/2
011
4/17
/201
1
5/17
/201
1
6/17
/201
1
7/17
/201
1
8/17
/201
1
9/17
/201
1
10/1
7/20
11
11/1
7/20
11
12/1
7/20
11
1/17
/201
2
2/17
/201
2
3/17
/201
2
4/17
/201
2
5/17
/201
2
6/17
/201
2
7/17
/201
2
Per
form
ance
Diff
eren
tial
Performance Differential: CCCs - Crossovers, Trailing 30 Days Source: Credit Suisse
We think this data indicates the relative performance of credit risk versus interest rate risk within the confines of the high-yield universe. Below we show a long-term view of this return differential. We include a crude interpretation of this indicator as a signal to shift ratings exposure. Credit risk reached a trough in early June, and currently relative performance is balanced between rates and credit. This suggests that BB/B credits could now be more attractive.
Exhibit 19: Performance Differential: CCCs - Crossovers, Trailing 30 Days
-20%
-15%
-10%
-5%
0%
5%
10%
15%
20%
Per
form
ance
Diff
eren
tial:
CC
Cs
-C
ross
over
s, T
raili
ng 3
0 D
ays
Performance Differential: CCCs - Crossovers, Trailing 30 Days
Overweight Crossovers
Overweight BBsOverweight Bs
Overweight CCCs
Source: Credit Suisse
02 August 2012
Mid-Year 2012 U.S. Leveraged Finance Outlook 9
Fundamental credit metrics deteriorated slightly across nearly all ratings categories from the fourth quarter to the first quarter. The ongoing weakness in second-quarter 2012 earnings reports is a cause for some concern, though we won't have a complete picture for several more weeks.
Exhibit 20: Net Leverage by Rating Exhibit 21: Coverage by Rating
0
1
2
3
4
5
6
7
8
Split BBB BB B CCC/Split CCC
Net
Lev
erag
e
2Q11 3Q11 4Q11 1Q12
Note: Bonds with net leverage that exceeds 20x or with negative EBITDA are excluded. Bonds with spread-to-worst > 3,000 bp excluded. Bonds in the Real Estate Development sector are excluded.
0
1
2
3
4
5
6
Split BBB BB B CCC/Split CCC
Inte
rest
Cov
erag
e
2Q11 3Q11 4Q11 1Q12
Note: Bonds with coverage that exceeds 12x are excluded. Bonds with spread-to-worst > 3,000 bp excluded. Bonds in the Real Estate Development sector are excluded.
Source: Credit Suisse Source: Credit Suisse
Exhibit 22: Net Leverage versus Spread by Rating Exhibit 23: Coverage versus Spread by Rating
Split BBB
BBSplit BB
B
Split BCCC/Split CCC
R² = 0.98
0 bp
200 bp
400 bp
600 bp
800 bp
1000 bp
1200 bp
1400 bp
2 2.5 3 3.5 4 4.5 5 5.5 6 6.5 7
7/27
Spr
ead-
to-W
orst
Net Leverage (1Q12)Note: Bonds with net leverage that exceeds 20x or with negative EBITDA are excluded. Bonds with spread-to-worst > 3,000 bp excluded. Bonds in the Real Estate Development sector are excluded.
Split BBB
BBSplit BBB
Split B
CCC/Split CCCR² = 0.99
0 bp
200 bp
400 bp
600 bp
800 bp
1000 bp
1200 bp
1400 bp
2 2.5 3 3.5 4 4.5 5 5.5
7/27
Spr
ead-
to-W
orst
Coverage (1Q12)Note: Bonds with coverage that exceeds 12x are excluded. Bonds with spread-to-worst > 3,000 bp excluded. Bonds in the Real Estate Development sector are excluded.
Source: Credit Suisse Source: Credit Suisse
02 August 2012
Mid-Year 2012 U.S. Leveraged Finance Outlook 10
We are increasing our total return projection for U.S. high yield for 2012 to a range of 8% to 11%, from the 7% to 10% range we published earlier. In the next exhibit, our model suggests we will end up near the high end of the new range. However, when we run the model for different scenarios, such as using a growth rate equal to the current GDP of 1.5% or increasing the risk of recession to 10%, spreads could be driven to the low 700s, and returns would be at the lower end of our range.
Exhibit 24: CS US High Yield Projections Detail Spreads at 12/31/12
5% Mild Recession 1080 bp
95% Base Growth of 1.9% 643 bp
Weighted Average 665 bp
Return Estimate Methodology8/1/12 Spread 635 bpFuture Spread 665 bp
Spread Change 29 bpTreasury Change -6 bpRequired Yield Change 23 bp
8/1/12 Yield-to-Worst 7.04%Future Yield-to-Worst 7.28%
8/1/12 Price 102.0Future Price (Implied by Yield) 101.4Principal Return -0.63%Interest Return 3.34%Default Loss -0.42%
Total Return 2.29%YTD Total Return as of 8/1/12 8.70%Full Year Return 10.99%
100%
Source: Credit Suisse
Methodology notes: The base GDP growth of 1.9% is the year-over-year projection of our economics team. The 5% risk of a mild recession is from the recession barometer of the economics team (they are actually projecting the risk of a recession in the U.S. in the next six months as less than 5%, so we are being conservative here). The spreads associated with each of these economic outcomes is from the historical correlation of GDP with high yield spreads as seen in the next exhibit.
Exhibit 25: Next Quarter YoY Real GDP %Change versus HY Spread-to-Worst
0 bp
200 bp
400 bp
600 bp
800 bp
1000 bp
1200 bp
1400 bp
1600 bp
1800 bp-10%
-8%
-6%
-4%
-2%
0%
2%
4%
6%
8%
10%
Spread to W
orst
Nex
t Qtr
YoY
Rea
l GD
P %
Chn
g
Next Qtr YoY Real GDP %Chng HY Spread-to-Worst
YoY% CS Economic Forecasts
Correlation = .75
Source: Credit Suisse, the BLOOMBERG PROFESSIONAL™ service
We are using the projection of our interest rates team that the 5-year treasury yield will decrease by 6 bp by year-end (and we use the 5-year because that is the average worst-call date). The interest return is the current yield (average coupon / average price) scaled by the number of days left in the year. We are estimating the default loss rate from our default projection and scaling that by the number of days left in the year.
02 August 2012
Mid-Year 2012 U.S. Leveraged Finance Outlook 11
U.S. Leveraged Loans The CS leveraged loan index discount margin is still well above its long-term average, reflecting the re-pricing of the loan market that began in mid-2009. This re-pricing is largely complete, with just 21% of institutional loans outstanding issued prior to April 2009, down from 33% at the end of 2011.
Exhibit 26: CS Leveraged Loan Index Three-Year Discount Margin
616 bp10/31/01
632 bp10/31/02
235 bp3/30/07
12/31/081842 bp
8/31/2011724 bp
100bps300bps500bps700bps900bps
1100bps1300bps1500bps1700bps1900bps
Disc
ount
Marg
in
Average : 449 bp
*Discount margin (DM) assumes 3-year average life
8/1/12591 bp
Source: Credit Suisse
Leveraged loans have returned 5.62% year-to-date, with loans issued/extended after 1Q09 returning 5.17% and older vintage loans returning 6.61%. Among the older vintage loans, Clear Channel and Tribune have been the largest contributors to total returns.
Exhibit 27: Total Returns since 12/31/2011
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
6.00%
7.00%
Dec-11 Feb-12 Apr-12 Jun-12
YTD
Tot
al R
etur
n
Loans Issued Before Apr. 2009
CS LL Index
Loans Issued After Apr. 2009
6.61%
5.17%
8/1/12
5.62%
Source: Credit Suisse
02 August 2012
Mid-Year 2012 U.S. Leveraged Finance Outlook 12
Of the $102.8 billion of YTD redemptions and extensions, $54.1 billion were facilities maturing before 12/31/2014, which is 53% of the YTD total. Extensions are on pace to exceed last year’s total of $37 billion.
Exhibit 28: Institutional Loan Events Loan Events ($Bln) 2010 2011 2012*New Issuance 154.2 220.0 113.1Issued in Extension 47.5 37.2 24.8Issued in Exchange 3.1 2.5 0.0Fallen Angel 2.2 0.0 0.0Additions: 207.0 259.7 138.0
Prepaid w/ Bonds 48.1 32.3 14.1Prepaid w/ Equity 4.5 1.2 0.2Prepaid w/ Loans/Cash 152.9 173.8 78.0Extended 47.5 37.2 24.8Matured 0.0 0.1 0.3Bankruptcy Resolution 51.0 10.4 3.3Rising Star 14.8 7.4 0.2Illiquid/Unknown 24.7 20.7 13.2Deletions: 343.5 283.1 134.0
Net Change: -136.6 -23.3 4.0
Starting Size 778.9 642.3 619.0Ending Size 642.3 619.0 622.9*As of July 31, 2012
Source: Credit Suisse
As the older loans continue to be replaced, the bulge of maturities in 2013-2014 have continued to shrink. The next two exhibits compare the maturity schedules on April 30th and today. The total 2013 maturities have shrunk by $5 billion while the 2014 maturities have shrunk by $19 billion. Interestingly, the face amount of facilities that trade below 90 has remained constant: $4 billion in 2013 maturities and $19 billion 2014 maturities remain in distressed territory.
Exhibit 29: Leveraged Loans Maturing by Year as of 4/30/2012
Exhibit 30: Leveraged Loans Maturing by Year as of 7/26/2012
1 419
616 18 24
22
83
45
131150
120
306
26
102
51
147
168
123
30
0
20
40
60
80
100
120
140
160
180
2012 2013 2014 2015 2016 2017 2018 2019
$ B
illio
ns
Leveraged Loans Price >= 90 Maturing by Year (As of 4/30/12)
Leveraged Loans Price < 90 Maturing by Year (As of 4/30/12)
1 420
5 19 21 5316
63
43
119
160
134
464
21
83
48
137
182
139
46
0
20
40
60
80
100
120
140
160
180
200
2012 2013 2014 2015 2016 2017 2018 2019
$ B
illio
ns
Leveraged Loans Price >= 90 Maturing by Year (As of 7/31/12)
Leveraged Loans Price < 90 Maturing by Year (As of 7/31/12) Source: Credit Suisse Source: Credit Suisse
Looking at the distressed maturities of institutional facilities in 2013/2014 shows that Texas Competitive Electric Holdings, Dex One, and Marsico are the largest institutional loans in that group.
Exhibit 31: Institutional Leveraged Loans Maturing by 12/31/2014 and Current Price < 90
2013 & 2014 Loans OutstandingTexas Competitive Electric Holdings 3777Dex One 2090Marsico Capital Management 1200GateHouse Media Operating 937Penton Media 625Ports America Holdings 575Advanstar 503Berry Plastics 500Longview Pow er 451IAP Worldw ide Services 413
Source: Credit Suisse
02 August 2012
Mid-Year 2012 U.S. Leveraged Finance Outlook 13
The year-to-date loan performance by rating has been uniform, with performance closely in line with the relative yields for each rating.
Exhibit 32: Leveraged Loan Returns by Rating
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
6.00%
7.00%
8.00%
YTD
Tot
al R
etur
n
B Loans
Split BB Loans
BB Loans
Split BBB Loans
6.95%
5.06%
4.12%
2.81%
Source: Credit Suisse
After widening significantly during the summer of 2011, the relationship between B and BB yields has tightened back towards last year’s equilibrium of 200 basis points.
Exhibit 33: BB Bonds – BB Loans Yield Difference versus Next Three Months Return Difference: July 2009 to July 2012
0 bp
200 bp
400 bp
600 bp
800 bp
1000 bp
1/31
/199
2
1/31
/199
3
1/31
/199
4
1/31
/199
5
1/31
/199
6
1/31
/199
7
1/31
/199
8
1/31
/199
9
1/31
/200
0
1/31
/200
1
1/31
/200
2
1/31
/200
3
1/31
/200
4
1/31
/200
5
1/31
/200
6
1/31
/200
7
1/31
/200
8
1/31
/200
9
1/31
/201
0
1/31
/201
1
1/31
/201
2
B -
BB
Yie
ld B
asis
B Loan Yield - BB Loan Yield
209 bp
7/31/2012
Source: Credit Suisse
02 August 2012
Mid-Year 2012 U.S. Leveraged Finance Outlook 14
Loan yields (calculated to a three-year refinancing) are 6.40%, 65 bp tighter than high yield bond yields of 7.05%. This is slightly tighter than the average difference of 86 bp since December 2009.
Exhibit 34: Leveraged Loan Yield versus High Yield Bond Yield
5%
7%
9%
11%
13%
15%
17%
19%
Jan-
92
Jan-
94
Jan-
96
Jan-
98
Jan-
00
Jan-
02
Jan-
04
Jan-
06
Jan-
08
Jan-
10
Jan-
12
Yie
ld
HY Yield-to-Worst
CS Lev Loan Index Yield(Assumes 3-yr Refi)
Correlation = 0.87
7/31/12 7.05%6.40%
Source: Credit Suisse
Since July 2009, there has been a fairly consistent relationship between the relative yields of BB bonds and loans and the subsequent differential in their performance. As mentioned in our report dated March 16, 2012, in mid-March the yields of BB bonds were very tight relative to BB loans, a spread of about 50 bp. Subsequently BB loans outperformed by 110 bp over the next month. At our last update on May 16th, the yield differential was 72 bp, a fairly neutral level. The current difference of 55 bp is somewhat compelling, suggesting BB loans will outperform BB bonds over the next three months.
Exhibit 35: BB Bonds – BB Loans Yield Difference versus Next Three Months Return Difference: July 2009 to April 2012
R² = 0.43
-3.0%
-2.0%
-1.0%
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
0 bp 20 bp 40 bp 60 bp 80 bp 100 bp 120 bp 140 bp 160 bp 180 bp 200 bp
Nex
t 3 M
onth
s R
etur
n D
iffer
ence
BB Bonds - BB Loans Yield Difference
Current: 55 bp
Bonds Outperform
Loans Outperform
Source: Credit Suisse
02 August 2012
Mid-Year 2012 U.S. Leveraged Finance Outlook 15
We are maintaining our projection for 2012 loan default rates in the range of 1% to 2%. Our bottom-up forecast comes to 1.4%. For 2013 we are projecting a slight increase to 2.0%. Several of the large 2006/2007 LBOs start to become vulnerable next year, though absent any recession the odds of bankruptcy filings remain fairly low. Those odds increase further in 2014, pushing our default rate estimate to 4.3%. Note that several of these at-risk LBOs are already trading at or near recovery value, so these increased defaults will not necessarily have an impact on market performance. The count of at-risk LBOs is small, but the face value is large. Since we calculate the default rate by volume, the potential impact of a default on the default rate could be sizeable. This is why the top end of the range for 2013 and 2014 is 4% and 6%, respectively.
Exhibit 36: Historical and Projected Leveraged Loan Default Rate
0.45%1.32%
0.55%0.85%
2.50%
5.29%
6.84%
8.10%
3.82%
1.01%1.55%
0.37%0.23%
2.91%
9.57%
2.61%
0.62%1.40%
2.00%
4.30%
0%
2%
4%
6%
8%
10%
12%
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012(est.)
2013(est.)
2014(est.)
Loan
Def
ault
Rat
e
Defaulted loans defined as missed coupon, filed chapter 11, distressed exchange, or cross-defaults. Source: Credit Suisse
Exhibit 37: Projected U.S. Default Rates
Actual Default Rate Default Rate Default RateLTM July 2012 Projected 2012 Projected 2013 Projected 2014
US High Yield Bonds 1.93% 1% to 2% 1% to 3% 2% to 4%
US Leveraged Loans 1.10% 1% to 2% 1% to 4% 3% to 6% Source: Credit Suisse
Leveraged loan discount margins are elevated relative to default loss rates, providing 600 bp of excess spread on average since 2009. We anticipate loss rates to climb slightly in 2013 and 2014, tightening some of this excess spread.
Exhibit 38: CS Leveraged Loan Discount Margin vs. Default Loss Rate
10/31/2002632 bp
12/31/20081842 bp
0 bp
400 bp
800 bp
1200 bp
1600 bp
2000 bp
3-Yr Discount Margin Loan Default Loss Rate (9-Months Later)
Correlation = .85
Average Difference: 1996-2008: 264 bpAverage Difference: 2009-Jun 2012: 606 bp
7/31/2012 594 bp
61 bp
Source: Credit Suisse
02 August 2012
Mid-Year 2012 U.S. Leveraged Finance Outlook 16
$19.7 billion of new CLOs have priced year to date, while the outstanding amount of 2005-2007 vintages has decreased by about $7.1 billion. This means that there has been approximately a net $13 billion inflow from CLOs. With $1.5 billion of inflows into mutual funds and ETFs, there has been plenty of liquidity supporting the primary market.
Exhibit 39: CLOs as a Percentage of the Primary Institutional Loan Market
201140.64%
50.60%
30%
35%
40%
45%
50%
55%
60%
65%
70%
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
% o
f P
rimar
y M
arke
t
CLOs as % of Primary Institutional Market Source: S&P Capital IQ LCD
We are increasing our total return projection for U.S. leveraged loans for 2012 to a range of 5% to 8%, from the 4% to 7% range we published earlier. In the next exhibit, our model suggests we will end up near the high end of that range. Note that the model is linked to our high yield projection in Exhibit 24 and assumes that the relationship between loan yields and bond yields remains constant over time. If we run the model for different scenarios, such as using a lower GDP growth rate or a higher risk of recession, yields could be driven to about 7%, and returns would be at the lower end of our range.
Exhibit 40: US Leveraged Loan Projections Detail Loans NO Floors Loans With Floors
8/1/12 Loan Yield 6.41% 6.37%Future Loan Yield 6.58% 6.28%
8/1/12 Price 92.03 98.37Future Price (Implied by Yield) 92.39 98.75Principal Return 0.40% 0.38%Interest Return 1.72% 2.46%Default Loss -0.42% -0.08%
Total Return 1.70% 2.76%
% of Loan Market 45% 55%
Blended Total Return 2.29%YTD Total Return as of 8/1/12 5.62%Full Year Return 7.91%
Source: Credit Suisse
Methodology notes: We derive the future loan yield by assuming that the current relationship between loan yields and bond yields will remain constant through 2012. The interest return is the current yield (average coupon / average price) scaled by the number of days left in the year. We are estimating the default loss rate from our default projection and scaling that by the number of days left in the year.
Disclosure Appendix
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Global Leveraged Finance StrategyJonathan Blau - Head of Global Leveraged Finance Strategy