High Yield Fund (HWHIX)

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The performance data quoted represents past performance and does not guarantee future results. Current performance may be lower or higher. Investment return and principal value of the fund will fluctuate, and shares may be worth more or less than their original cost when redeemed. Click quarter-end or month-end to obtain the most recent fund performance. The High Yield Fund imposes a 2.00% redemption fee on shares held for 90 days or less. Performance data does not reflect the redemption fee. If it had, return would be reduced.

Manager 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 leveraged buyout/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 Fund 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.

Mutual fund investing involves risk. Principal loss is possible.  Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities. Investment by the Fund in lower-rated and non-rated securities presents a greater risk of loss to principal and interest than higher-rated securities. The Fund may invest in derivative securities, which derive their performance from the performance of an underlying asset, index, interest rate or currency exchange rate. Derivatives can be volatile and involve various types and degrees of risks. Depending on the characteristics of the particular derivative, it could become illiquid. Investment in Asset Backed and Mortgage Backed Securities include additional risks that investors should be aware of such as credit risk, prepayment risk, possible illiquidity and default, as well as increased susceptibility to adverse economic developments. The Fund may invest in foreign as well as emerging markets which involve greater volatility and political, economic and currency risks and differences in accounting methods.

Fund holdings and/or sector allocations are subject to change and are not buy/sell recommendations. Current and future portfolio holdings are subject to risk. Portfolio managers’ opinions and data included in this commentary are as of 12/31/18 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. Portfolio’s absolute performance may reflect different results. The Fund may not continue to hold the securities mentioned and the Advisor has no obligation to disclose purchases or sales of these securities. Attribution is an analysis of the portfolio's return relative to a selected benchmark, is calculated using trade information and does not reflect the payment of transaction costs, fees and expenses of the Fund. 

Credit Quality weights by rating were derived from the highest bond rating as determined by S&P, Moody's or Fitch. Bond ratings are grades given to bonds that indicate their credit quality as determined by private independent rating services such as Standard & Poor's, Moody's and Fitch. These firms evaluate a bond issuer's financial strength, or its ability to pay a bond's principal and interest in a timely fashion. Ratings are expressed as letters ranging from 'AAA', which is the highest grade, to 'D', which is the lowest grade. In limited situations when none of the three rating agencies have issued a formal rating, the Advisor will classify the security as nonrated.

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.

The average annual total returns for the ICE BofAML US High Yield Index were -4.67%, -2.66%, 7.27%, 3.82% and 10.73% for 4Q18, one-year, three-year, five-year and Since 3/31/09 periods ended December 31, 2018.

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

Glossary of financial terms