High Yield

Market Commentary

Period ended December 31, 2018
 

MARKET COMMENTARY

The ICE BofAML US High Yield Index returned -2.3% in 2018, just the 7th negative return since its 1986 inception; the index had been up +3.5% over the year’s first three quarters before declining -4.7% in Q4.  The Fed raised rates by 25 basis points four times in 2018, moving the Fed Funds target rate from 1.5% to 2.5% over the course of the calendar year.  Treasury rates rose accordingly, more so on the short end of the curve, thus the yield curve flattened.  As of year-end, the yield on the 10-year stood just 20 basis points higher than the yield on the 2-year, an ever so slightly positive sloping curve.  The high yield market’s yield-to-worst rose 2.1% in the year, closing at 8.0%.  The spread over treasuries widened 172 basis points, from 363 at the beginning of the year to 535 at year’s end.  The market’s median spread since 1995 has been about 500 basis points; consequently, the spread went from much tighter than average to slightly wider than average in 2018—from our perspective, a considerably more attractive entry point.  The par-weighted average price of a high yield bond went from more than $100 a year ago to slightly above $92 at the end of 2018.  CCC-rated bonds underperformed the broad market (-4.1% for the year), but interestingly single-B credits held up slightly better than BB’s (-1.5% vs. -2.5%, respectively).  Retail outflows of about $45 billion, including $12 billion of ETF hemorrhaging, pressured the market.  In terms of sectors, energy was the most notable laggard by far1 as crude prices fell 25% from the beginning of the year and more than 40% from October highs. 

Despite the market’s decline, high yield fundamentals remain solid.  The market experienced 29 defaults and 2 distressed exchanges in 2018, representing just over $40 billion in debt.  This translates into a default rate of just 1.87% including distressed exchanges, which is slightly more than half of the market’s long term average of 3.5%.  The average recovery rate in 2018 was 41.7%, almost exactly in line with the long-term historical average of 41.5%.  The percentage of the market trading at distressed levels—less than 50 cents on the dollar—climbed in 2018 but remains a benign 1.6% of all issuance.  A total of $393 billion worth of bonds were upgraded during the year compared to $291 billion that were downgraded, a ratio of 1.35 to 1.  

The new issue market slowed dramatically in 2018; there were $187 billion of new issuance, the lowest total since 2009 and a 43% decline from last year.  During the December selloff, zero new issues priced.  This was the first month with no new issuance since November 2008 during the financial crisis—the only such monthly occurrences since at least 1990.  While smaller, the new issue market remained reasonably well-behaved with just 17% of all new issuance rated CCC, and all but one percentage point of that was used for refinancing.  New issuance earmarked for LBO/acquisition financing rose slightly to 21% of all new issuance, which is close to average. 

While it took a decline in the market to get here, we are more constructive on the high yield market’s forward-looking prospects than we were a year ago due to the improvement in valuation.  The market is also providing pockets of opportunities that we view as especially compelling as an active manager.  As a result, the portfolio exhibits a significant spread advantage—an uncommon opportunity.  Our focus on credits of all sizes, modest overweight in energy, and under the BB-rated cohort have all contributed to the wider-than-market spread, and have us optimistic about the portfolio’s prospects. 

ATTRIBUTION: 2018

The Hotchkis & Wiley High Yield portfolio (gross and net of management fees) underperformed the ICE BofAML US High Yield Index and ICE BofA BB-B Constrained Index in 2018.  The strategy’s emphasis on small and mid cap credits was a headwind as smaller market cap names underperformed the larger, more liquid portion of the high yield market in 2018.  The portfolio’s allocation by credit rating had little relative performance effect versus the broad benchmark, but the portfolio’s 5.5% average allocation to CCC’s hurt performance relative to the BB-B benchmark which has no CCC-rated credits.  The largest detractor to relative performance, irrespective of the benchmark, was the portfolio’s energy credits.  Our exposure is focused on upstream industries that are more attractively valued, yet more exposed to commodity prices.  This hurt performance as crude oil declined.  Positive credit selection in the basic industry, retail, and banking sectors helped offset the energy exposure.

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

Fundamentals (3):  We left the Fundamentals score unchanged at 3.  The default rate remains about half of the historical average, and we expect a benign environment to continue because leverage remains in check and also revenue and earnings are healthy.  Trade war potential keeps the score from rising further, which has the potential to impede economic growth and therefore affect revenue and earnings growth. 

Technicals (3):  The technicals score remains at 3.  The new issue market has softened substantially.  New issuance has been largely for refinancing with LBO issuance relatively contained.  While overall market liquidity remains decent, the asset class has experienced considerable outflows. 

Valuation (3):  We increased the valuation score from 2 to 3.  The market’s yield-to-worst increased to nearly 8% and spreads over treasuries widened to more than 500 basis points—both close to historical averages.  The excess spread, or spread adjusted for unrecovered defaults, remains stable.   

 

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1
The automotive sector had a worse return, but it averaged less than 2% of the market compared to more than 15% for energy.

 

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 December 31, 2018 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.
 

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