High Yield

Period ended March 31, 2012

The U.S. high yield market delivered its best opening quarter since 2003, as the BofA Merrill Lynch Master II Index posted a 5.2% return.  The market’s advance was prompted by continued signs of a strengthening U.S. economy and the absence of new negative global macroeconomic developments.  As short-term fears subsided and became a less prominent driver of investor behavior, we observed a shift in the market’s focus toward underlying fundamentals and valuations of individual credits.  This type of shift tends to reduce the correlation of returns across credits and forms an environment conducive for bottom-up, fundamental value investors. 

During the quarter, cyclical sectors outperformed non-cyclical sectors.  Banking and insurance credits were the leaders while utility and energy credits were the laggards (though still positive).  As we typically observe during market rallies, lower rated credits outperformed higher rated credits over the quarter.  Credits in the more senior portion of the capital structure outperformed, however, as senior secured credits outperformed senior unsecured and subordinated credits.   Typically, this environment is beneficial to our investment style, which gravitates toward the senior-most portion of the capital structure. 

Spreads over treasuries narrowed by about 140 basis points over the quarter but remain elevated at nearly 600 basis points.  We believe this represents a compelling valuation opportunity given the benign default rate environment.  The current default rate is below 2%, which is considerably lower than the 4.2% long term average.  Robust new issuance has pushed out maturities, which along with improved corporate fundamentals should keep defaults subdued. 

Going forward, we remain optimistic regarding the high yield market’s prospects due to considerable fundamental improvements exhibited across the corporate sector.  Despite modest economic growth, companies have generated robust earnings and cash flows.  Valuations continue to be compelling even after this quarter’s appreciation.  Also, we believe the market’s affection for Treasuries is likely to recede as real yields at/below zero will eventually erode the purchasing power of institutional and individual investors alike.  The rise in treasury yields over the first quarter may well be a harbinger of this cautionary message.  Historically, high yield has a negative correlation with treasuries which could buffer some of the negative impact of rising treasury rates. 

The Hotchkis & Wiley High Yield portfolio (gross and net of management fees) outperformed the BofA Merrill Lynch BB/B Index for the quarter.  All of the outperformance is attributed to positive credit selection as sector allocation was neutral.  Positive credit selection in the basic industry, services, and banking sectors were the largest performance contributors over the quarter.  Credit selection was positive or neutral in 16 of the 17 BofA Merrill Lynch industries.  The only blemish was utilities, where we modestly underperformed the index.

(Scoring Scale: 1 = Very Negative . . . .  5 = Very Positive)
I. Fundamentals (5):  While we believe the high yield default rate could increase from its abnormally-low current level (<2%), we believe it will subsist below normal levels in the near/medium term.  The upgrade/downgrade ratio has descended from record highs but remains elevated.  Over half of newly issued credits in 2011 and 2012 were for refinancing, which has transformed the maturity wall into a speed bump—this should support a continuation of low defaults.  Profitability remains high and financial leverage has been reduced.   

II. Valuation (4):  The yield-to-worst on the market is 7.1% but spreads remain wide at 594 basis points.  Today’s spread implies an excessive default rate, which we view as highly pessimistic and unlikely suggesting an attractive entry point at these levels.  Yields relative to investment grade bonds appear very attractive, even considering the different risk profiles.  The distribution of yields has converged from record-wide levels, but remains reasonably wide—a dynamic that we prefer given our bottom-up research process and focus on small caps/fallen angels.  

III. Technicals (3):  Net flows into high yield have been strong so far in 2012 with nearly $20 billion in net inflows to high yield mutual funds.  This helps absorb the persistently robust new issue calendar, most of which continues to be used for refinancing.  Debt refinancing is a positive fundamental because it reduces default risks in the near term.  We expect a smaller, but still robust new issue market going forward because companies have reduced refinancing needs; this could create widening pressure on spreads.  Countering these pressures are low dealer inventories, which reduces the need for forced selling.