Flexible investment sector company, Livermore (LIV), has published annual results to end-December 2019. NAV per share remained broadly stable at $0.99 (2018: $1.00). Given the December year-end, much of the commentary was inevitably around 2019 themes. We have therefore included LIV’s post-period views on covid-19 first:
LIV’s manager notes included the following:
“In March 2020, the World Health Organisation recognised that coronavirus (covid-19) was in the state of a pandemic. The company continues to monitor the covid-19 pandemic situation closely, with a focus on the impact on the company’s CLO and US senior secured loan portfolios. The spread of the virus, government policy responses and changing demand patterns are expected to have a negative impact on the operations and earnings of some of the borrowers in the CLO portfolio. The company has been in close contact with managers of its individual CLO positions and is tracking the level of rating downgrades of underlying loans to CCC+/Caa rating and a worsening default outlook. A significant concentration of CCC+/Caa rated loans can turn off the distributions to the equity and lower mezzanine tranches of CLOs and would result in significant drop in the market values of those CLO portfolio constituents. The full extent of the impact will depend on the length and severity of the crisis and is expected to vary widely between sectors and companies.
The company has been positioned very conservatively for several months with high liquidity and cash reserves (in excess of USD 60m as of 31 March 2020) and a CLO portfolio that consists largely of CLOs with long reinvestment periods, which should benefit somewhat from the volatility in the market. The company has no debt.
Internal risks to shareholders and their returns are related to portfolio risks (investment and geography selection and concentration), balance sheet risk (gearing) and/or investment mismanagement risks. The company’s portfolio has a significant exposure to senior secured loans of US companies and therefore has a concentration risk to this asset class.
A periodic internal review is performed to ensure transparency of Company activities and investments. All service providers to the company are regularly reviewed. The mitigation of the risks related to investments is effected by investment restrictions and guidelines and through reviews at Board Meetings.
As the portfolio of the company is currently invested in USD denominated assets, movements in other currencies are expected to have a limited impact on the business.
On the asset side, the company’s exposure to interest rate risk is limited to the interest-bearing deposits and portfolio of bonds and loans in which the company invests. Currently, the company is primarily invested in sub-investment grade corporate loans through CLOs, which exposes the company to credit risk (defaults and recovery rates, loan spreads over base rate) as well as liquidity risks in the CLO market.
Management monitors liquidity to ensure that sufficient liquid resources are available to the company. The company’s credit risk is primarily attributable to its fixed income portfolio, which is exposed to corporate bonds with a particular exposure to the financial sector and to US senior secured loans.”
LIV’s macro review of 2019
“Global economic growth weakened in 2019, affecting mostly large economies and pronounced mostly in the industrial sector. Global trade in goods deteriorated due to a slump in global manufacturing and subdued investment activity as the trade disputes and tariffs between the US and China worsened. The political unrest caused by the UK’s exit from EU, which was finally achieved at the end of January 2020, also had a dampening effect. Growth slowed in Europe, India, China and Russia. The emergence of the coronavirus towards the end of 2019 led to disruptions in China that started to spill over to the rest of the global economy. Consumer price inflation declined in most advanced economies compared with 2018, primarily as a result of lower increases in energy and food prices. Core inflation changed marginally in most countries. The unemployment rate dropped in most economies and labour market strengthened overall.
Financial conditions eased in second half of 2019 supported by accommodative actions by central banks and positive developments on political front, including progress on the US-China trade negotiations and diminished risks of a disorderly Brexit. Global equity prices moved higher later in the year, sovereign bond spreads in the European periphery narrowed, and emerging markets rebounded as well.
USA: Economic growth slowed somewhat in 2019 with GDP growth rate at 2.3% as compared to 3% in 2018. Consumer spending and residential investments in the US increased a moderate rate in the second half of 2019 whereas businesses fixed investments due to trade policy uncertainty and weak global growth. Lower oil prices curbed investment activity in the energy sector. Private consumption remained a driving force on the back of solid disposable income and upbeat consumer confidence. With mortgage rates declining, construction investment also recovered from the contraction in 2018. Overall capacity utilisation remained good. The labour market continued to strengthen and the labour force participation rate also increased. Wage gains remained moderate but at an above level from last year. The unemployment rate moved down from 3.9% at the end of 2018 to 3.5% in December 2019.
In the US, annual average headline inflation fell to 1.8% in 2019 while core rate remained steady at 2.2%. The Federal Reserve’s preferred price inflation measure, personal consumption expenditure (PCE) deflator, which excludes volatile energy and food prices, weakened in the first half of the year but picked up again later in the year. In December it was 1.6%, slightly below the Federal Reserve’s target of 2%.
The slowdown in economic growth and inflationary pressures, coupled with heightened risks prompted the Federal Reserve to change the course of its monetary policy. In the second half of 2019, the FOMC lowered the target range a cumulative 75 basis points, bringing it to the current range of 1.5 to 1.75 % undoing the increases made in 2018 to counter the possibility of a more pronounced weakening in growth.
Euro Area: Economic activity weakened in the euro area. Real GDP rose by 1.2% on an annual average basis, its lowest value recorded since the sovereign debt crisis in 2013. There was modest growth in equipment investments and exports. Trade tensions and regulatory changes in the automotive industry particularly impacted Germany as overall capacity utilization declined. Despite this backdrop, consumption in the euro area remained supportive due to a robust labour market with the unemployment rate falling to 7.4% and wage growth picking up somewhat.
European headline inflation declined to 1.2%, having at times been pushed above 2% in 2018 by higher energy prices whereas core inflation hovered around 1.0%.
Considering the economic and inflation conditions, the European Central Bank (ECB) lowered its deposit rate by 0.1 percentage points in September taking it further into negative territory (minus 0.5%). It also announced its intention to maintain key rates at their present or lower levels until inflation dynamics are sufficiently robust. Further, the ECB decided to restart asset purchases from November, having previously left its holdings unchanged since the end of 2018. Net asset purchases are expected to end shortly before the ECB raises its key rates again.
Japan: Japan’s GDP grew at 0.8% supported by the solid performance of the services sector. Overall production capacity utilisation remained good. The development of GDP growth over the course of the year was influenced by special factors such as exceptional public holidays in May, a powerful typhoon in October and an increase in the consumption tax as of 1 October. Fiscal policy measures partially cushioned the curbing economic impact of the higher consumption tax. Labour market conditions remained favourable and the unemployment rate declined to its lowest level at 2.2%.Headline inflation in Japan decreased to 0.5%, while core inflation rose to 0.4%. The free education programme introduced to stabilise the economy largely offset the inflation effect of the higher consumption tax. Medium-term inflation expectations also persisted significantly below the Bank of Japan’s target of 2%.The Bank of Japan maintained the target for 10-year government bond yields at around 0% and its short-term deposit rate at – 0.1%. The Bank of Japan intends to maintain interest rates at a low level for as long as progress towards its inflation target of 2% remains uncertain.
China: GDP growth in China was at 7.1%, weaker than 2018. This was due to weaker manufacturing output owing to trade tensions with the US which imposed additional tariffs on more than two-thirds of imports from China by the end of the year. The modest domestic demand for vehicles and weaker demand for information and communications technology (ICT) sector weighed on industrial activity. Growth remained robust in the services sector.
Headline inflation in China rose to 2.9%, whereas core inflation fell to 1.6%.The People’s Bank of China left its policy rate unchanged. However, it cut commercial banks’ reserve requirement ratios in several steps with the aim of reducing financing costs for businesses and boosting lending. The government launched fiscal policy measures to support the economy including tax cuts for households and companies and increased infrastructure spending.Brazil, India and Russia: Economic growth remained lacklustre in Brazil but did not weaken any further compared to 2018, while India and Russia both recorded declines. There were problems at a few banks in India that led to a tightening in credit conditions. GDP growth in India fell well below potential at 5.3% and government lowered the corporate tax rate to provide support to the economy.Headline inflation in Brazil was at 3.7%, largely unchanged from 2018. In India, headline inflation of 3.7% was somewhat lower year-on-year, while the core rate was markedly weaker. Russia recorded a rise in headline inflation of 4.5% driven by the increase in the value added tax and the depreciation of the rouble.Policy rate cuts were made by the central banks of India (by 1.35 percentage points to 5.15%), Russia (by 1.25 percentage points to 6.5%), and Brazil (by 2.0 percentage points to 4.5%).”
“Commodity prices declined over the year, albeit with marked fluctuations. Early 2019 saw recovery in oil prices as OPEC restrained supply but lowered again due to modest economic growth worldwide. Prices of Brent Crude at the end of 2019 stood at approximately USD 66 per barrel. The lower oil prices curbed investment activity in the energy sector. Gold prices rallied. Industrial metals prices declined on average due to US tariffs on China and slowdown in manufacturing industries.”
“The equity market rebounded in early 2019 due to the Federal Reserve’s shift to policy easing. The rally stalled mid-year due to concerns about global economic growth. Emerging markets rebounded as well. The Information Technology sector topped in gains. Demand concerns and lower prices held back energy whereas debate in the US over drug prices weighed on healthcare. Industrials did well despite low manufacturing demand. The financial sector slightly underperformed the MSCI world as flat or inverted yield curves dented earnings.”
“Overall, 2019 delivered strong returns across most major asset classes. The Credit Suisse Leverage Loan Index6 (“CSLLI”) generated a return of 8.17%, while the S&P 500 Index and Merrill Lynch High Yield Master II Index7 (“MLHYI”) generated returns of 31.49% and 14.41%, respectively. U.S. high yield funds saw a net inflow of $18.8 billion for 2019 due to reduction in demand for floating rate exposure as US interest rates trended lower. According to S&P Capital IQ, total institutional loan issuance was $309.4 billion, down 29% from 2018, while total institutional loans outstanding stood at $1.2 trillion as of December 31, 2019. During 2019, the loan market grew 4% from the $1.15 trillion outstanding as of December 31, 2018. For many corporate borrowers in the leveraged loan market, both top-line revenue and EBITDA grew during 2019, though at a slower pace than 2018. Interest coverage ratios remained strong as many corporate borrowers over the last several years were able to take advantage of the strong demand for loans and more flexible terms to refinance their existing debt. They were also able to extend loan maturity dates.”
“After a strong performance in early 2019 across the CLO market, a divergence based on credit quality emerged during 2019, as high- and low-quality assets became increasingly bifurcated. A few one-off credit events in certain borrowers raised idiosyncratic risk in the markets and credits rated B3/B or lower faced increased attention, and investors exhibited a preference for higher quality issuers. This trend reversed itself late in the year, with many investors believing the sell off in B3/B loans was overdone.
2019 was another strong year for CLO issuance. According to S&P Capital IQ, total new US CLO issuance in 2019 was $118 billion, with a modest 8% decline from 2018’s record-breaking $129 billion of new issuance. Refinancing and reset volumes fell markedly as the cost of debt remained relatively high compared to 2017 and 2018. In early 2020, however, the market saw a sharp tightening for most classes of CLO debt versus year end levels and several deals refinanced their cost of debt to lower levels.
The par-weighted default rate finished 2019 at 1.39%, falling from 1.63% at the end of 2018 and significantly lower than the 2.9 long-term default rate, according to S&P LCD.”
LIV: Livermore reports annuals – full extent of pandemic’s impact on CLO portfolio not yet clear