High Yield

Market Commentary

Period ended March 31, 2018
 

MARKET COMMENTARY

The ICE BofAML US High Yield Index declined -0.9% in the first quarter of 2018 taking reprieve from its streak of positive performance, which had stood at 8 consecutive calendar quarters.  The Fed raised rates in March in a widely anticipated move, which boosted treasury yields in a fairly uniform manner—short rates increased fractionally more than long rates flattening the yield curve ever so slightly.  At the end of the quarter, the yield-to-worst on the high yield market stood at 6.35%, a 0.51% increase from the beginning of the year.  The high yield market’s spread over treasuries widened by 9 basis points, refusing to absorb the increase in interest rates.  Interestingly, the lowest rated credits (CCC & below) posted a slightly positive return in the quarter while higher rated credits declined the most.  More often than not, lower rated credits underperform when the high yield market falls and outperform when it rises.  Exceptions tend to occur when the market’s decline is due to the increase in interest rates, which transpired this quarter, because higher rated credits are more rate sensitive than lower rated credits. 

All 18 high yield sectors declined in the quarter but the worst-performer declined a rather modest -2.6% (banking).  In last two calendar years, the best-performing sector outperformed the worst-performing sector by 11 and 34 percentage points, respectively, so this quarter’s sector dispersion was quite narrow.  Small and mid cap credits outperformed large cap credits, which tends to be (and was) conducive to our bottom-up credit picking approach. 

The trailing 12 month high yield default rate including distressed exchanges finished the quarter at 2.36% (par-weighted), which is 0.90% higher than it was 3 months ago.  There were a handful of retail and energy defaults during the first quarter, though the largest individual default was in broadcasting (iHeartCommunications).  The default rate is lower than it was a year ago, however, largely due to the decreasing number of defaults in the energy sector.  Credits that trade at or below 50 cents on the dollar represent just 0.5% of high yield credits, suggesting the market is not expecting a notable increase in defaults going forward. 

While the market is tighter than average, fundamentals are reasonable and we have invested in credits that our research indicates have strong/quality asset coverage.  We continue to adhere to our core competency of focusing on credits of all sizes as well as fallen angels, which are often overlooked by other investors. 

ATTRIBUTION: 1Q 2018

The Hotchkis & Wiley High Yield portfolio (gross and net of management fees) outperformed both the ICE BofAML BB-B US High Yield Constrained Index and the broader ICE BofAML US High Yield Index in the first quarter of 2018.  Positive credit selection drove all of the outperformance in the quarter; it was most positive in the basic industry, consumer goods, and healthcare sectors.  Credit selection in technology and services were very small detractors to performance.  Market wide, the disparity in performance from one sector to another was unusually narrow. Consequently, over/underweighting sectors had little effect on performance relative to the benchmark.

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

Fundamentals (3):  We reduced the Fundamentals score from 4 to 3.  Financial leverage remains in check.  The default rate including distressed exchanges, is 2.36% which is an increase from three months ago but below historical averages.  Less than 1% of the market is trading at distressed levels.  Market maturities are well-termed out, with little near-term refinancing pressures.  The potential for trade wars create some uncertainty.

Technicals (3):  The technicals score remains at 3.  The primary market has $73 billion in new issuance year to date—more than 60% of this was used for refinancing with only 14% earmarked for acquisition/LBO financing.  CCC-rated new issuance comprised 12% of the primary market, below the historical median of 16%.  Asset class outflows persist. 

Valuation (2):  The valuation score remains at 2 though it has improved.  The market’s yield-to-worst is 6.35% and spreads over treasuries stand at 372 basis points—a tighter than average market.  Excess spreads, or spreads adjusted for unrecovered defaults, are reasonably close to long term averages.   

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 attribution is based on a representative High Yield portfolio. The performance attribution is an analysis of the portfolio's return relative to the ICE BofAML BB-B US High Yield Constrained 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. 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 March 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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