1) may 2015 THE INVESTOR NAVIGATING THE CREDIT MARKETS Portfolio Manager Viewpoints Bank loans have had a strong start in 2015. Positive technicals, improved risk sentiment, and a snapback in energy credits have been the primary drivers. In this commentary, Portfolio Managers Jason Rosiak, JP Leasure, and Michael Marzouk discuss the bank loan market and their 2015 outlook. Rosiak: Entering 2015, valuations for credit assets, notably bank Start at the top, assess the capital market environment loans and high yield, were attractive given the weakness seen in late 2014. An improvement in risk sentiment and technicals along with an energy market rebound have created above coupon returns thus far. As we enter the middle of 2015, focus remains on the Federal Reserve and the timing of a tightening cycle. Market sentiment would benefit from a slow and low path to policy hikes, which is conducive for credit risk given a “good enough” economic backdrop and stable corporate Going with the Flow Recent fund flows and technicals have helped fuel above coupon returns for bank loans thus far in 2015. Floating rate mutual fund flows have turned positive over the past two months, and may continue if duration is a headwind to fixed income returns 10 Monthly floating rate mutual fund flows ($bn) 8 6 4 2 0 -2 fundamentals. With unattractive valuations on government debt, we -10 Table 1: 2015 has thus far been a reversal of 2014, with credit Source: Lipper, as of May 24, 2015 believe credit will continue its relative outperformance. risk outperforming duration risk High Yield 2.45 2015 Aggregate 5.97 1.00 Bank Loans Int Corporate Agency MBS Treasury 2.07 4.35 6.08 5.05 Source: Barclays, Credit Suisse Indices, as of May 29, 2015 4.07 December’s $8bn outflow was a record -8 2013 2014 2014 2014 2015 2015 3.19 Demand is outpacing net supply for the first time since 2012 0.92 100 1.82 1.08 Leasure: The past year has seen two distinct periods. The headwinds Describe the bank loan market performance over the past year of late 2014, caused by poor technicals, risk aversion, and energy related volatility. Thus far in 2015, these factors have reversed, becoming tailwinds as bank loans have returned above coupon. -6 2013 2014 Total Return (%) -4 200 Bank loan surplus/(shortfall) ($bn) 151 150 117 80 50 36 38 0 (11) 19 6 3 (3) (9) (0) (4) (5) -50 (56) -100 2001 2003 2005 2007 2009 2011 2013 2015 Source: JP Morgan, as of May 29, 2015. Surplus/shortfall takes net primary issuance and subtracts retail fund flows and CLO issuance to get a net demand. A positive number means supply outpaced demand.
2) portfolio manager viewpoints may 2015 Marzouk: Technicals in the bank loan market have been critical What will be the impact of Dodd-Frank and the risk retention particularly true in December as fund outflows accelerated into will be required to retain 5% of each tranche of the capital struc- in the short term. With the growth of floating rate mutual funds to more than $130bn versus $43bn in 2010 (Source: Lipper), fund flows appear to be influencing short term performance. This was a seasonally weak liquidity environment (Chart 1). Given the strength of institutional demand through CLO issuance and limited net supply, the technicals became a tailwind in the beginning part of 2015 (Table 2). Also, since bottoming in March, loan fund flows have turned mildly positive as duration has become a performance detractor, a reversal from the previous year. Chart 1: Ending a streak of twelve consecutive months of outflows, fund flows have turned positive in the past two months 10 Floating rate mutual fund monthly flows ($bn) 8 Marzouk: As part of Dodd-Frank legislation, sponsors (aka asset for CLO issuance? managers) of any structured product (CMBS, CLO, CDO, RMBS), ture beginning in 2017. The goal is to incentivize better collateral management and deal structures by requiring sponsors to have “skin in the game.” While loan managers and the LSTA fought hard against the ruling, CLO’s were not given an exemption. The capital requirements could be onerous for smaller or independent asset managers, potentially impacting issuance in the future. Rosiak: In the immediate term, we believe we will see a pulling forward of demand, which will continue to support the technical picture in 2015. However, into 2016, as some CLO’s reach refinanc- ing windows, we may see a tapering of issuance given the concerns towards retention requirements. 6 4 Chart 2: While CLO issuance is expected to remain high in 2 0 2015, concerns towards refinancing risk and the retention re- -2 quirements may curtail 2016 issuance 140 -4 -6 120 Negative technicals in late 2014 impacted total returns -8 2012 2013 2013 2014 94 100 -10 2012 2014 2015 Source: Lipper, as of May 24, 2015 Table 2: Demand has outpaced supply thus far in 2015, helping Gross Issuance $bn Paydowns Repricings Total Net Supply Retail Inflows 301 2012 670 2013 467 2015 188 44 2014 (200) (260) (188) 12 63 (24) 80 (37) 64 (242) 169 CLO Issuance Total Demand 56 87 68 150 Surplus/(Shortfall) (4) 19 (91) 132 108 146 (59) (43) (5) 54 49 (5) Source: JP Morgan, as of May 29, 2015. Surplus/shortfall takes net primary issuance and subtracts retail fund flows and CLO issuance to get a net demand. A positive number means supply outpaced demand. 90 87 80 60 to buoy prices and create a positive tailwind 132 Annual CLO issuance ($bn) 40 20 56 52 29 21 19 14 1 0 2003 2005 2007 54 2009 4 2011 2013 2015 Source: JP Morgan, as of May 29, 2015 How do you articulate energy related volatility and its impact Leasure: While only 4% of the Credit Suisse Leveraged Loan Inon bank loans? dex is energy related versus 14% for the Barclays High Yield Index, volatility has been significant, impacting returns. Negative price action for energy issuers hit its peak in late January, coinciding with oil reaching $44 per barrel (Chart 3). Since late January, the stabilization in oil prices along with a positive risk environment has led to an improvement for energy credits. We have seen high quality energy issuers improve the most in price. This is indicative of a market evaluating issuers on underlying fundamentals versus the highly correlated selloff seen in late December. 2
3) portfolio manager viewpoints may 2015 Chart 3: Energy issuers have seen a strong improvement in prices following the December/January volatility 8 Monthly return of the CSLLI Energy Sector (%) 3.6 4 2 0.9 0 1.5 0.5 0.5 0.1 0.6 0.9 0.4 0.4 -2 hedges. The amount of defaults will be dependent upon a combination of the price of oil, asset valuations, capital market conditions, and refinancing risk. 5.4 6 terialize until 2016, given the stabilization in oil and production Chart 4: The lack of refinancing risk supports a below average default rate (1.0) (1.2) (1.7) -4 (4.0) -6 -8 250 Maturity profile ($bn) 200 (1.0) High Yield Bonds Bank Loans 150 (8.8) -10 Jan-14 Mar-14 May-14 Jul-14 Sep-14 Nov-14 Jan-15 Mar-15 May-15 100 Source: Credit Suisse, as of May 29, 2015 Rosiak: We do not find valuations sufficiently appealing to inDo you look at the energy sector as an attractive opportunity? crease our energy exposure. First, while we have selective energy issuers in the portfolio, it is not our preference to have issuers with equity like volatility in our strategy. Second, a lot of the short term volatility around energy is being driven by the price of oil, which is very difficult to forecast. Third, energy issuers have seen strong price improvement since February, removing some relative value opportunities for many credits. Marzouk: We have seen a reversal in technicals and risk sentiment Describe the outlook for the second half of 2015 help propel bank loans to above coupon returns year-to-date. We viewed the total return profile for 2015 as coupon plus, perhaps 5-6%. With such a strong first half, income and yield are likely to drive total returns for the remainder of the year versus the price performance seen thus far. The wild cards will be energy and met- als/mining sectors, which have the ability to impact the couponlike return profile. We have discussed the valuations and technicals. What about Leasure: Our theme in loans over the past few years has been the fundamental outlook? limited refinancing risk, right sizing of corporate balance sheets, and slow but positive U.S. GDP growth extending the credit cycle, creating a favorable fundamental backdrop. U.S. corporate profits are continuing to generate free cash flow and provide the ability to service debt. Refinancing risk remains minimal, reducing the risk of a maturity wall or surge in defaults due to lack of access to capital markets (Chart 4). Excluding energy and metals/mining companies, there remain a limited number of default candidates in the near term. Meaningful defaults for energy issuers may not ma- 50 0 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 Source: ML/BOA as of April 30, 2015 What are your portfolio positioning and themes for the second Rosiak: As is our style, we are focused on the larger companies half of 2015 within the bank loan universe. We are overweight B vs. BB rated issues given the favorable fundamental backdrop. We are overweight housing, retail, and service sectors and underweight healthcare, utility, and technology. We seek to minimize exposure to eurocentric companies due to weak profit growth and systemic risks. We hold limited high yield bonds (less than 2%), favoring an over- weight to second lien bank loans. It is our opinion that the volatility profile of high yield negates the income advantage for bonds over loans. We believe second lien loans are a more attractive way to capitalize on higher returns. Leasure: We have seen non-CLO demand for bank loans over the How would you articulate the value proposition for loans? past three years driven by the ebbs and flows around concerns of higher rates. We view the asset class as a strong diversifier to traditional fixed income given the lack of duration, focused credit risk, yield advantages, and the limited correlation to other traditional fixed income asset classes. Regardless of one’s view on interest rates, the low absolute yield levels of traditional fixed income com- bined with stable credit fundamentals paints a favorable relative value picture for loans. 3
4) portfolio manager viewpoints may 2015 Should rates move higher, or a taper tantrum similar to 2013 develop, bank loans have the added benefit of being a potential hedge against that volatility. Summary: Following a weak 2014, bank loans have seen a snapback in performance as technicals and risk sentiment have improved. A combination of stable fundamentals, “good enough” economic growth, and low absolute yield levels on traditional fixed income paint a favorable relative value picture. Given a coupon like return profile of 5-6% with a lack of duration risk, bank loans continue to serve as an excellent diversifier for traditional fixed income. Pacific Asset Management May 2015 ABOUT PACIFIC ASSET MANAGEMENT Founded in 2007, Pacific Asset Management specializes in credit oriented fixed income strategies. Pacific Asset Management is a division of Pacific Life Fund Advisors LLC, an SEC registered investment adviser and a wholly owned subsidiary of Pacific Life Insurance Company. As of March 31, 2015 Pacific Asset Management managed approximately $4.8bn. IMPORTANT NOTES AND DISCLOSURES Bank loan, corporate securities, and high yield bonds involve risk of default on interest and principal payments or price changes due to changes in credit quality of the borrower, among other risks. Pacific Asset Management is an investment advisor; it provides investment advisory services to institutional clients and does not sell securities. This information is presented for informational purposes only. This is not to be construed as an offer to buy or sell any financial instruments and should not be relied upon as the sole investment making decision. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. The opinions expressed herein are based on current market conditions and are subject to change without notice. FOR MORE INFORMATION Pacific Asset Management • 700 Newport Center Drive • Newport Beach, CA 92660 • www.pam.pacificlife.com 4