In its outlook for 2014, DDJ Capital Management forecasts increased risk 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, said David Breazzano, DDJ’s president and chief investment officer, in the firm’s Leveraged Credit Review and Outlook: The Tale of the Taper.

Breazzano added: "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."

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 said.

Breazzano added: "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."

As for leveraged loans, given their standard, floating-rate coupons, they are relatively well-insulated from an increase in short-term rates, Breazzano said. Additionally, their senior and oftentimes secured position in a company’s capital structure can provide for better protection in adverse credit scenarios.

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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, DDJ’s Breazzano said. 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, Breazzano said.

DDJ’s highlights over the past year include:

  • The firm expanded its employee ownership pool to 14 additional members from DDJ’s investment, legal, business development and client service, and operations areas;
  • DDJ introduced a dedicated senior loan strategy, seeded initially with approximately US$100 million by an existing European-based sub-advised client;
  • The firm’s US core high yield strategy celebrated its first anniversary in October with more than US$1.9 billion in client assets;
  • As of December 31, 2013, DDJ exceeded US$7 billion in assets under management, an increase of approximately 42% over December 31, 2012. This increase stemmed from net inflows from both new and existing clients, as well as positive investment performance. Over half of DDJ’s assets are managed for clients in Canada, the UK, continental Europe, and the Middle East, with the remainder managed on behalf of US investors;
  • Danske Invest, the Danish fund complex, appointed DDJ to manage two UCITS funds to pursue the US core high yield strategy and seeded with more than US$700 million;
  • DDJ was appointed for a US$235 million mandate for its opportunistic high yield strategy from a public pension fund based in Scandinavia;
  • The firm was hired for a US$70 million mandate pursuing the DDJ strategic income strategy from a private foundation based in California;
  • The pension plan of a Canadian subsidiary of a large US-based retailer appointed DDJ for a senior loan mandate of US$50 million.
  • DDJ’s US opportunistic high yield and strategic income strategies rank in the 15th and 1st percentiles, respectively, for the three-year period ended December 31, 2013, according to eVestment, a leading source of investment performance for institutional investors.