High Yield

Market Commentary

Period ended June 30, 2018
 

MARKET COMMENTARY

The ICE BofAML US High Yield Index returned +1.0% in the second quarter of 2018, edging into positive territory for the year.  While the quarter return was modest, it was among the best performing fixed income asset classes as investment grade credits declined while common government and mortgage indexes were close to flat.  The Federal Reserve Open Market Committee replicated its March interest rate increase with another 25 basis point raise in June.  The Federal Funds Target Rate now stands at 2.0%.  Short rates rose slightly more than long rates, flattening the yield curve which is now quite flat though not inverted.  Lower rated high yield credits absorbed the rate hike while the BB rated cohort saw a modest rise in yields and spreads.  The net effect on the broad high yield market was a modest increase in the yield-to-worst which finished the quarter at 6.54%, and a negligible change in spreads which finished the quarter at 372 basis points. 

Deviations in sector performance were modest during the quarter with about 3 percentage points separating the best- and worst-performing sectors—13 sectors rose while 5 fell.  Energy now comprises about 16% of the index and is not only the largest sector, but was also its top-performer in the quarter.  WTI and Brent crude prices rose +13% and +17% in the quarter, respectively.  Banking was the largest laggard, falling about 1.5% in the quarter despite the rise in interest rates. 

While valuations are not overly exciting, the high yield market continues to demonstrate signs of good health.  There were only 3 defaults across the entire market during the quarter; two in April, one in May, and zero in June—the first month with no defaults since January of 2014.   The trailing 12 month default rate closed just above 2% at quarter end. Revenue and profits continue to grow at a modest yet decidedly positive pace.  The overall market has shrunk as fund flows have been negative, particularly in high yield ETFs, and most new issuance coming to market has been for refinancing.  Leverage has shown nascent signs of rising but this has not worried rating agencies, whose upgrades have considerably outpaced downgrades.  Also, despite lower inventories at primary dealers—the byproduct of a more stringent regulatory environment—liquidity across the market has continued to improve. 

The lowest rated cohort of the investment grade credit market has grown much quicker than the rest of the US credit market and has shown signs of deteriorating credit quality.  While far from inevitable, this has the potential to flood the high yield market with additional supply should there be a large downgrade cycle.  Consequently, we are cautious in both investment grade credits where we have almost no exposure, and also in the BB-rated cohort where we are underweight both the broad and BB/B benchmarks.  Our CCC exposure is also modest, and underweight the broad benchmark, leaving us with a disproportionate exposure to single B credits where nearly half the portfolio is invested. 

We remain focused on credits that our research indicates have strong/quality asset coverage and remain committed to our core competency of focusing on credits of all sizes as well as fallen angels, which are often overlooked by other investors. 

ATTRIBUTION: 2Q 2018

The Hotchkis & Wiley High Yield portfolio (gross and net of management fees) underperformed the broad ICE BofAML US High Yield Index in the second quarter of 2018, and performed in line with the ICE BofAML BB-B US High Yield Constrained Index.  Relative to the broad index, the portfolio’s underweight to CCC-rated credits hurt relative performance as this was the best performing cohort in the market by a wide margin.  The portfolio’s energy credits increased as a group but less than the index’s energy credits, thus credit selection in this sector was negative.  Credit selection in basic industry credits and the underweight exposure to telecommunications also detracted from relative performance.  Positive credit selection in automotive, healthcare, consumer goods, and banking helped relative performance.

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

Fundamentals (3):  We left the fundamentals score unchanged at 3.  The potential for trade wars create some uncertainty but financial leverage remains in check and the default rate including distressed exchanges, is 2.06%--well below historical averages.  Market maturities are well-termed out, with little near-term refinancing pressures.  A paltry 0.3% of the market is trading at distressed levels. 

Technicals (3):  The technicals score remains at 3.  Asset class outflows persist, particularly in the ETF space. However, the soft primary market is down significantly from 2017 offsetting these outflows.  There was $126 billion in new issuance year to date—nearly two-thirds was used for refinancing with less than 20% earmarked for acquisition/LBO financing.  CCC-rated new issuance comprised 13% of the primary market, below the historical average of 16%. 

Valuation (2):  The valuation score remains at 2 though it has improved.  The market’s yield-to-worst is 6.54% 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 because defaults remain subdued.   

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 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 June 30, 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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