High Yield

Market Commentary

Period ended September 30, 2019
 

MARKET COMMENTARY

The ICE BofAML US High Yield Index returned +1.2% in the third quarter of 2019 and is now up +11.5% since the beginning of the year.  The Federal Reserve’s FOMC lowered the Fed Funds rate by 25 basis points for the second time this year, which now stands at 2.0% (upper bound).  With inflation benign and economic growth modest, albeit positive, the rate cut was widely expected and triggered investor reaction.  The price of crude oil spiked following the drone attacks on Saudi refineries, but this was short-lived and WTI crude finished the quarter down -8%.  Energy was the high yield market’s worst-performing sector, declining -4.6% while every other sector was positive.  It is also the index’s only negative sector over the past 12 months, returning -7.5% compared to the overall index’s return of +6.3%. 

Concerns about slowing economic growth and a possible recession have become increasingly pervasive amid erratic trade negotiations and geopolitical uncertainty (e.g. Brexit in the UK, potential impeachment proceedings in the US).  As a result, treasuries rallied during the quarter with the yield on the 10 year note falling below 1.5% in late August—for about a week, the 2-year treasury yield exceeded the 10-year treasury yield.  This caught investors’ attention because contemporary recessions have been preceded by similar 10-year/2-year yield curve inversions.  The time between inversion and recession has varied significantly, from several months to more than 2 years. 

Within the high yield market, higher rated credits outperformed lower rated credits.  BB rated bonds returned +2.1%, single B rated bonds returned +1.2% and CCC (and below) rated bonds declined -2.3%.  Yields fell and spreads tightened for BBs and single Bs, but rose/widened for CCCs.  The high yield market finished the quarter with yield-to-worst of 5.87% and spreads over treasuries of 402 basis points, slightly lower than one quarter ago.  The spread advantage of CCCs vs. BBs widened (now 1,059 bps vs. 232 bps). Small and mid cap credits underperformed large cap credits by a modest magnitude (+1.1% vs. +1.3%).  The spread advantage of small/mid caps vs. large caps widened slightly (now 443 bps vs. 382 bps).  Outside of energy, which was a notable outlier (-4.6%), performance by sector ranged from +1.4% (healthcare) to +5.2% (insurance).  Spreads for the energy sector widened to 717 basis points at quarter-end, 315 basis points wider than the overall market. 

The high yield market’s default rate, including distressed exchanges, finished the quarter at 2.8% which is slightly below the long-term average of 3.5%.  Year-to-date, there have been 25 high yield bond defaults or distressed exchanges, 14 of which were energy credits.  The energy sector default rate is about 11%, so the high yield market’s default rate excluding energy is a modest 1.2%.  A mere 2.4% of the market trades at less than 50% of par value, and just 5.2% trades at less than 70% of par value.  Roughly 40% of these distressed-priced credits are in the energy sector. 

After slowing a bit in calendar year 2018, the new issue market has picked up to levels about average with the past decade.  About two-thirds of new issuance has been used for refinancing, slightly higher than average, while less than 20% has been used for acquisition financing.  Less than 10% of new issuance has been CCC rated, and the bulk of that issuance was for refinancing.  All in all, the primary market remains well-behaved. 

Our view of the overall high yield market remains relatively average.  Fundamentals have weakened slightly, while technicals and valuations remain average.  We maintain our focus across high yield credits of all sizes, which has helped facilitate a spread advantage relative to the broad benchmark of more than 100 basis points and we remain optimistic about the portfolio’s prospects going forward. 

ATTRIBUTION: 3Q 2019

The Hotchkis & Wiley High Yield portfolio (gross and net of management fees) underperformed the ICE BofAML US High Yield Index and ICE BofAML BB-B US High Yield Constrained Index in the third quarter.  The portfolio’s overweight in small and mid cap credits was a performance detractor in the quarter as larger cap credits outperformed.  Credit selection in energy was a notable detractor, particularly in exploration & production and oilfield service credits.  Credit selection in healthcare and basic industry were more modest detractors.  Positive credit selection in the automotive and leisure sectors helped relative performance. 

OUTLOOK (Scoring Scale: 1 = Very Negative . . . . 5 = Very Positive)

Fundamentals (2): We reduced the fundamentals score from 3 to 2.  The default rate remains below average but has been ticking up modestly.  Leverage ratios are about flat, but earnings appear to be weakening slightly.  The broadening trade dispute has the potential to impede economic growth and affect revenue and earnings growth further. 

Technicals (3):  We reduced the technicals score from 4 to 3.  Net flows into the asset class remain decent.  There is strong call and tender activity in the market, but the liquidity picture is mixed.  The new issue market is about average compared with the last decade. 

Valuation (3):  No change.  Positive excess spreads (due to low defaults) offsets low yields.  Spreads are about average, though wide dispersion allows for opportunities for active credit pickers. 

Unless otherwise noted, the "high yield" or "broad" market refers to the ICE BofAML US High Yield Index.
 
Composite performance for the strategy is located on the Performance tab. Returns discussed can differ from actual portfolio returns due to guideline restrictions, cash flow, tax and other relevant considerations. Portfolio characteristics and attribution based on representative High Yield portfolio. The performance attribution is an analysis of the portfolio's return relative to the ICE BofAML US High Yield Index and is calculated using trade information and does not reflect cash flow transactions and the payment of transaction costs, fees and expenses. Absolute performance for the portfolio may reflect different results. No assurance is made that any securities identified, or all investment decisions by H&W were or will be profitable. The High Yield strategy may prevent or limit investment in major bonds in the ICE BofAML US High Yield Index and ICE BofAML BB-B US High Yield Constrained indices and returns may not be correlated to the indices. Quarterly characteristics and portfolio holdings are available on the Characteristics and Literature tabs. Portfolio information is subject to the firm’s portfolio holdings disclosure policy.
 
The commentary is for information purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy, or investment product.  Portfolio managers’ opinions and data included in this commentary are as of September 30, 2019 and are subject to change without notice.  Any forecasts made cannot be guaranteed.  Information obtained from independent sources is considered reliable, but H&W cannot guarantee its accuracy or completeness. Investing in high yield securities is subject to certain risks, including market, credit, liquidity, issuer, interest-rate, inflation, and derivatives risks.  Lower-rated and non-rated securities involve greater risk than higher-rated securities.  High yield bonds and other asset classes have different risk-return profiles, which should be considered when investing.  All investments contain risk and may lose value.
 
Past performance is no guarantee of future results.
 

The ICE BofAML index data referenced is the property of ICE Data Indices, LLC (“ICE BofAML”) and/or its licensors and has been licensed for use by Hotchkis & Wiley. ICE BofAML and its licensors accept no liability in connection with its use. See Index definitions for full disclaimer.

Index definitions