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Comparing market and rating agency views of loans

| June 19, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

The leveraged loan market has taken a view on which industries have good prospects coming out of the current crisis and which do not, and that view broadly aligns with rating agency actions. Returns this year on leveraged loans to consumer-cyclical businesses rank among the lowest, on one hand, and rating agencies have taken the most negative actions there. Returns on loans to technology and utilities companies rank high, on the other hand, and rating agency action there is light. If there is a surprise, it is that loan pricing seems much more bullish than rating actions.

The median industry return in a sector tends to fall as Moody’s negative actions there intensify (Exhibit 1). This trend shows general agreement between the loan market and the rating agencies on the future performance of the sectors. Returns in Financial, Consumer Non-cyclical, and Industrial sectors even suggest a more optimistic view than the rating actions there signal.

Exhibit 1: Downward trend between Moody’s negative actions as % of universe and median YTD TRR of sectors

Source: Moody’s, S&P, Amherst Pierpont Securities. Note: Median YTD TRR is the median of year-to-date total rates of return for industries in each sector, and Moody’s negative actions as % universe is the ratio between Moody’s negative actions in 2020 to date and the number of leveraged loans for each sector. Diversified sector is excluded due to its miscellaneous nature.

Consumer cyclicals have taken the hardest hit from the market and the rating agencies. The value at the end of May of $1 invested on January 1 in different industries in the sector ranges from $0.75 to $0.93 with a median of $0.86. Moody’s has also taken negative actions, overwhelmingly CreditWatch Negative, against 52% of the loans to the sector outstanding at the start of the year.

Energy has also fallen hard. Putting $1 in the sector to start the year has netted $0.80 so far. Moody’s has taken negative action on 49% of loans to energy companies.

Basic materials is the first of several sectors with more moderate levels of rating action. Year-to-date value in basic materials ranges from $0.82 to $0.98 with a median of $0.90. Moody’s has taken action against 31% of loans.

Consumer non-cyclical is next with slightly over 31% of loans placed on CreditWatch Negative or downgraded by Moody’s. Its year-to-date industry returns range between $0.88 and $1.01 with median of $0.96. Consumer demand for food and drugs has remained strong despite stay-at-home orders.

Financials shows year-to-date value of $0.97 to $0.98 with a median of $0.976. Moody’s actions there have affected 30% of loans. Financial firms and insurers have delivered higher returns than the frequency of rating actions indicates.

Industrial presents a wider range of year-to-date returns, between $0.91 and $0.99, and a median of $0.95. Lockdown measures have taken a more serious toll on transporters than manufacturers. Moody’s has acted against 30% of loans in this sector.

Communications displays year-to-date values between $0.94 and $0.98, with median at $0.96. With 26% of loans having received negative rating actions, this sector shows relatively stable returns. Digital services have mostly continued operations through the pandemic.

Technology provides year-to-date returns of between $0.94 and $0.97 with median of $0.96, and Utilities gives a similar year-to-date return of $0.97. Moody’s has taken lighter negative actions in these sectors, respectively on 18% and 15% of loans.

Exhibit 2: Market and rating agency views of leveraged loan sectors

Source: S&P, Amherst Pierpont Securities. Note: Median TRR is the median of total rates of return for industries in each sector between January and May in 2019 and in 2020.

Beyond the general correspondence between returns and rating actions, the overall level of returns implies the market believes many of the CreditWatch Negative rating actions will not ultimately play out as defaults. Year-to-date value above $0.90 and especially above $0.95 suggest reasonable prospects the loans will continue to perform. Sectors with values below $0.85 and especially below $0.80 suggest otherwise, but not many sectors fall into that camp.

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