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TCW is a leading global asset management firm with over 50 years of investment experience and a broad range of products across fixed income, equities, emerging markets, and alternative investments. In each episode of TCW Investment Perspectives, professionals from the firm share their insights on global trends and events impacting markets and the investment landscape.
Welcome to the TCW Investment Perspectives podcast.
My name is David Vick and I'm a product
specialist in the Fixed Income Group at TCW.
There's been a noticeable pickup in default rates
and downgrades in leveraged loans recently.
This growing trend reflects clear stress on smaller
corporate borrowers stemming from interest rate hikes.
Impacts from rate increases often take some time to work their way through
the market and what we're seeing now could continue to grow given we're
in the largest and fastest rate hiking cycle we've seen in decades.
To discuss this as well as where we think the credit markets are headed,
I'm here today with two senior portfolio managers from our Fixed Income
team, Drew Sweeney and Ken Toshima, to discuss how
rates are affecting corporate borrowers lately.
Drew joined TCW in 2015 and has been in the industry for 26 years
and in addition to his role as a senior PM, is also a trader for
our CLO products and the MetWest Floating Rate Income Fund and is
a member of the Investment Committee in the Fixed Income Group.
Ken brings 22 years of industry experience to his role, more
than half of which at TCW, and in his role as senior PM,
he focuses on credit research in the Fixed Income Group.
Drew and Ken, thanks for joining me today.
Nice to be here.
Hi, nice to be here.
All right, with that, let's get into some of the
questions that other people are thinking about.
So, obviously, the impact of higher rates is felt across financial
markets, but the impact is far more acute in those sectors
with primarily floating rate coupons like bank loans.
What's been the impact of those higher rates so far,
both sort of fundamentally and on the market as a whole?
Yeah, well, if you think about the bank loan market and you think that most of
the acquisitions have been done in the last five years, and the acquisition
purchase price multiples were probably somewhere between 10 and 15 times,
and so leverage is going to be around six or seven times
in a zero rate environment or a low rate environment.
And now fast forward to LIBOR at 5.5%, the interest burden is
materially different and wasn't contemplated at inception.
So I think it's interesting because when you think about private equity,
which owns 60 to 70% of the leverage loan market, they largely seem
to be looking through the problem, waiting for rates to go back down.
And so it's really about do companies have the
liquidity to bridge the gap from here to there?
And what we've seen is so far pretty supportive sponsors, pretty supportive
debt holders trying to help companies get through these periods of time.
But inevitably, they're dealing with a lot.
And if you think about the last three years, it's been kind of crazy because
you've had a period of time with zero revenue, you've had a period of
time with inventory shortages, and you've had a period of time with
massive inflation, and now you're dealing with an interest burden.
So you've had all this volatility, and that's
all impacting how these companies can navigate.
And I'll get pretty basic on if you think of, you know, SOFR
is about 5% and it sort of spreads to the range is 150 to 500.
So you have pretty high interest payments, and clearly
interest payments will have a direct impact on free cash flow.
Say something that's interesting about our process here,
which is we have a loan database with over 700 companies.
And even before rates went up, we did an analysis where we shocked our portfolio
for higher rates to see what happens to free cash flow, in which companies go
from positive free cash flow to negative free
cash flow due to higher rates specifically.
And the end result was that we found less than 10%
of our portfolio turned free cash flow negative.
But when we looked at that sort of left tail of the portfolio, a good majority
were for intentional reasons, which is these companies also had high CapEx,
so they might have some sort of CapEx program for a fiber build out.
And the rest of it was sort of a mix of different companies.
And if you fast forward today, what you find with higher rates where
there's really pressure is where you combine the higher rates with
some other form of inflation or higher wages, issues like de-stocking.
And those are the combination of those factors is where you have problems.
Got it.
And have those factors sort of led to, I know we've seen
some an uptick in downgrades and potentially some defaults.
What's the status of that today?
And how does that look over the next six to 12 months, say?
Right.
So you've got about 12% of the bank loan
universe that's going to mature before 2026.
So that's the most important component.
So those companies that have high interest burden, high
leverage with nearing maturities, those are at highest risk.
And so those companies, the agencies have been
pretty adamant about downgrading quickly.
And even when they're performing well, have been reluctant to upgrade them.
So in terms of the probability of default, we're actually, I think a
lot of people walked into this year saying we'd be at 3.5% by year end.
We're really still under 2%.
That's probably underrepresented because we've had a lot of selective defaults
where companies have gone out and bought back bonds at a discounted level.
Some of them have gone back and bought back loans at a discounted level.
But that's not really calculated in the default rate.
So if we look at the true default rate, we're still under 2%.
That's likely to go higher next year.
But depending how long this rally that goes on, and depending on how much
private equity wants to reinvest in some of these companies to provide
liquidity, will ultimately determine how high the default rate goes.
And I'd say on default rate saying, they've certainly risen since 2021.
But if you look at a longer historical
record, they're within that breathing range.
Let's say the default rate, depending, there's different
methodologies of calculating default rates, but it's
in that breathing range of where companies are.
And you do have periods where defaults
really spike up and we're well below that.
If you look at during the GFC or early 2020, we're well below those levels.
So defaults are obviously one side of the coin.
The other side of the coin, of course, is
how bad is, what's the outcome of a default?
And people typically think, in my mind, that defaults in loan space
typically lead to recovery rates in the 70 to 80% range, given obviously
the seniority and security that's typically associated with those.
What's the recovery rates we're seeing these days?
Lower.
So I think as we look at it over the last few
years, you're looking at something in the 50s.
And probably over the last 20 years now, it's closer to 65% than it
was to 70% just because the last three or four years, it's been lower.
Some of that is overstated because it does not include these selective
defaults and recoveries outside of the actual true default rate.
But overall, I'd say without covenants and with the higher
leverage levels, you're just seeing lower total recovery.
And I'll add, once again, depending on the methodology
of how you calculate recovery rates, that matters.
But we are looking at, if you look at all the defaults
in the last 12 months, you do have some larger defaults.
And for example, you have Envision Health, which
is over $6 billion of loans that defaulted.
If you look at Envision within context historically, it's one
of the biggest defaults that we've had is sort of top 10-ish.
If you look at the previous defaults in that size before, let's
say you take a cutoff of $5 billion, the previous default
was in 2020 and the one before that was like 2016.
So these are big defaults.
And once you move past sort of annualized, like
past Envision, you actually get to a lower rate.
We'll see what comes up in the future.
But these numbers do get moved by sort of
single defaults that are large for sure.
So moving maybe a little more macro, there's signs, I think,
preliminary signs anyway, the economy starting to slow.
Are you guys seeing that reflected in earnings
of companies that are in the loan space?
Yeah, I guess when I sit back and look Q2 2023,
I thought overall the earnings were pretty good.
There are clear spots, segments of the economy that are having more difficulty.
Within chemicals, we've had our third quarter of destocking.
Within healthcare, we've had a lot of wage inflation.
So if it's a healthcare service company, they're dealing
with compressed margins for some period of time.
That does not appear to be easing as quickly as we originally thought it might.
And then within packaging, it's had two quarters of destocking more recently.
That appears to be getting through most of that.
But the problems that we felt thus far have been pretty sector specific.
And then there have been other spaces that have been fine.
I'd say the same thing.
We're seeing mixed results for earnings.
We're seeing some companies that have recovered
strongly from pandemic-related disruptions.
We see some companies where raw material prices are down.
But on the other end, we see companies that are being
challenged due to wage inflation and that's been especially
acute in healthcare services, as Drew pointed out.
And destocking, I would say, has sort of impacted some sectors
where historically, packaging has been a defensive sector.
Generally, food and beverage related, it's a consumable product.
And with packaging, it's suffering from destocking right now.
And that's a little unusual for a non-cyclical end market.
And so this gets back to if you have a nearing maturity and you're in one
of those segments and you're very levered, how do you want to deal with it?
Does the sponsor come in?
Do they provide additional equity to help pay down debt and you re-lever
the balance sheet at something for an interest rate environment
that's higher and wait for true recovery within the space?
Or do they go ahead and turn over the keys to the
lenders and then we'll see where the recoveries are?
Got it.
You talked about, you mentioned some of the sectors
that maybe are under a little more pressure.
Are there any places in the market where you're seeing any
opportunities that look especially attractive at this point?
It's kind of interesting within loans for two things.
One is I throw out food and beverage.
We're still seeing very high purchase price multiples in these spaces.
And so within the loan sector, we have a lot of individual companies
that are operating specific brand within food and beverage.
And so to the extent that we have episodic volatility in the
loan market, we always like to come into those because these
purchase price multiples of these brands continue to be high.
I think the other opportunity that's kind of interesting and we recognized
at the beginning of the year is that the loan market has its own technicals.
And those technicals are driven a lot of times by CLO buyers.
And CLO buyers cannot own a lot of triple C's.
And that's in part because the documents are constructed that way.
And so when the agencies are in a period of time like today where
they're downgrading a lot of things and then they're downgrading
really prospectively and they only upgrade in the rear view mirror.
So when you look at that and you say, okay, you've got this
building triple C basket, that's often an opportunity to be buying.
So at the beginning of the year, the spread dispersion between single
B's and triple C's was in the 90th percentile going back 20 years.
And so as we've moved through the year, we've really seen a big rally in the
last, you know, particularly three months in these little quality names.
Well, Drew, you mentioned CLOs.
That's a good point.
I mean, you can't really talk about bank
loans without talking about the CLO market.
What's been happening in the CLO market and what do
you expect over the next, you know, six to 12 months?
Yeah, it's kind of interesting because while we look at the loan market and we
look at the broader markets and we worry about recessions and things that will
come next year, both the loan market and the CLO
market rallied significantly during the summer.
And so we saw liability spreads compress significantly at the AAA level.
And with those liability spreads coming in, it
makes the ARB more attractive for equity investors.
And so we're seeing a pickup in CLO manufacturing.
And with that, there's a pickup in demand for loans themselves.
And so all of this is, you know, it's sort of a virtuous circle, but liability
costs for CLOs have dropped materially over the last three to six months.
And that's generated more demand in that space.
Great.
So the last question is, CLOs are obviously a big part of
the market, but there's other investors in CLOs as well.
What have you seen from people outside the
CLO universe who are investors in loans?
And is that interest waning with, do you expect it to fall maybe
as interest rates start to come down ultimately over time?
Yeah, it's a good question.
Right now, I mean, 10% yields are plus or minus
what you're yielding in the bank loan index.
So there's still a lot of crossover interest when
you're looking at buying a high coupon like that.
And then if you are worried about defaults and you're earning
something 9%, 10%, it gives you a lot of cushion to get
a nice total return despite potential default rate.
So we're seeing a lot of crossover interest continued at this point.
But yeah, at the end of the day, if we start to see the Fed
signal for lower rates, that will probably change that behavior.
Yep.
All right.
Well, great.
Thanks, Ken.
Thanks, Drew.
Appreciate the comments.
Lots of things to think about.
Some potential speed bumps on the horizon potentially,
but I think some opportunity there as well.
So with that, thanks everybody for listening and we'll catch you next time.
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