Increased risk but a positive 2014 for US leveraged credit, says DDJ

DDJ Capital Management is forecasting increased risk in 2014 along with positive returns for investors in non-investment grade bonds and leveraged loans, which comprise the US leveraged credit market.

In 2013, US high yield bonds and leveraged loans were the two best-performing asset categories within the global credit markets, significantly outperforming other fixed income strategies, according to David Breazzano, DDJ's president and chief investment officer, in the firm's Leveraged Credit Review and Outlook: The Tale of the Taper.  
"With an improving economy and very few potential catalysts for widespread corporate defaults, we think that investors will once again be able to capture most, if not all, of the market's coupon in 2014 while not suffering much price degradation from rising interest rates," says Breazzano.
Historically, the high yield market has performed relatively well in rising interest rate environments, as economic tailwinds benefit company fundamentals, resulting in spread tightening that somewhat offsets the effects of a rate increase, Breazzano states.
"Looking ahead, if rates rise in concert with an economic uptick, we expect the associated negative effect on high yield bonds' total return to be somewhat counteracted by spread compression,” he says.
As for leveraged loans, given their standard, floating-rate coupons, they are relatively well-insulated from an increase in short-term rates, Breazzano says.  Additionally, their senior and oftentimes secured position in a company's capital structure can provide for better protection in adverse credit scenarios.
Still, discerning investors need to monitor the increased frequency of lax underwriting standards and the riskier use of proceeds typically seen in later stages of a credit cycle. The record new issuance in leveraged credit during 2013 was driven by consistently high and powerful investor demand. Yet eager investors more frequently accepted looser credit terms, as 2013 saw record new issuance of "covenant lite" loans, along with a proportionally high amount of second lien loans.  Both of these types of financings lack certain contractual and/or structural protections traditionally embedded in high yield instruments, which may lead to larger principal losses in the event of an adverse development, such as a default or financial restructuring.

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