High Yield

Market Commentary

Period ended December 31, 2019
 

MARKET COMMENTARY

For much of calendar year 2019, the United States engaged in a trade war with its largest global trading partner.  Near the end of the year, the House of Representatives impeached the President for just the third time in history.  High yield credit markets seemed to shrug off the tumultuous political landscape.  After posting a negative return in calendar year 2018 (-2.3%), the ICE BofAML US High Yield Index returned +14.4% in 2019.  The economy has been supportive with real GDP modestly positive, inflation range-bound around 2%, and unemployment at a 50-year low.  Higher rated credits outperformed lower rated credits, large credits outperformed small/mid credits, and the energy sector was a notable laggard. 

The FOMC lowered the Fed Funds target rate by 75 basis points in 2019 via three separate 25 basis point rate cuts during the second half of the year, which decreased the important benchmark rate from 2.50% to 1.75%.  Despite a slight and brief inversion of the 10/2 year yield curve in August, short term treasury yields fell more than long term yields over the course of the year, actually steepening the yield curve ever so slightly.  Yields for the broad high yield market fell by 2.44% and spreads narrowed by 173 basis points.  At year end, the yield-to-worst for the ICE BofAML US High Yield Index was 5.41%, which represented a spread over treasuries of 360 basis points.  Yields and spreads declined less for lower rated issues than for higher rated issues, widening the valuation gap. Yields and spreads also declined less for small/mid cap credits than for large caps, further extending small/mid caps’ yield/spread advantage.  

The high yield market’s default rate, including distressed exchanges, was 2.86% in 2019, an increase of about one percentage point from 2018 but below the long-term average of 3.44%.  The default rate would have been just 1.26% without the energy and metals & mining sectors, which comprised about half of all 2019 defaults by volume.  The default rate for the energy sector was about 11% in 2019, by far the highest among all sectors.  Unsurprisingly, energy was the worst-performing high yield sector by a large margin, returning +5.6% in 2019—all other sectors returned between +13% and +22%. 

Total new issuance in 2019 was $277 billion.  This represents a 48% increase from 2018’s sluggish pace but remains lower than recent history (excluding 2018). More than two-thirds of all issuance was used for refinancing with just 20% earmarked for acquisition financing.  Only 6% of new issuance was CCC-rated, which is well below the 16% historical average—60% of this low rated issuance in 2019 was used for refinancing.  The primary market continues to exhibit a level of conservatism/discipline that we favor.  Nonetheless, rating agencies have become increasingly cautious as downgrades have outpaced upgrades.  In 2019, $316 billion (par) worth of high yield bonds were updated compared to $395 billion that were downgraded—the most lopsided in that direction in three years. 

Overall, high yield valuations appear about average considering the risks at hand.  There seems to be a wide valuation dispersion within the market, which we believe provides a conducive environment for active, bottom-up credit research.  The research has facilitated a portfolio with a considerable spread advantage relative to the market, in part due to our proclivity for small/mid cap credits where spreads widened in 2019 relative to large cap credits.  Accordingly, we remain optimistic about the portfolio’s prospects and look forward to 2020.   

ATTRIBUTION: 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 2019. Credit selection in energy was the largest detractor to relative performance in the period, accounting for roughly half of the underperformance. Exposure in exploration & production as well as oil services credits hurt performance. The portfolio’s penchant for small and mid cap credits worked against it during the year as large credits outperformed small/mid credits by a considerable margin. The portfolio’s small/mid cap bias explains a little more than one-third of the underperformance in the year.  The portfolio’s average credit rating is slightly lower than the index, which detracted from performance modestly.  Higher rated credits are more rate sensitive (i.e. higher duration) and outperformed as interest rates declined.  Positive credit selection in capital goods, leisure, automotive, and technology sectors helped relative performance.   

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

Fundamentals (2): No change.  Growth remains slow but leverage remains flat.  The default rate has been ticking up modestly but remains below average.  Earnings have weakened somewhat and the trade dispute injects volatility into the market.  

Technicals (3):  No change.  Net flows remain decent.  There is strong call and tender activity across the market.  Market liquidity favors higher quality and larger issues.    

Valuation (3):  Wide valuation dispersion creates opportunities for active managers, which is conducive for our investment style.  Yields are below average but the low default environment results in excess spreads that are average.  Spreads are average considering the low rate environment and benign defaults.  The higher quality/duration trade is crowded. 

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, 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