High Yield

Market Commentary

Period ended June 30, 2017

 

MARKET COMMENTARY

The BofA Merrill Lynch US High Yield Index returned +2.1% in the second quarter of 2017 and is now up +4.9% since the beginning of the year.  Higher quality credits performed best, which is moderately atypical in a market rally.  Spreads for the overall market tightened by 15 basis points but spreads on credits rated CCC or below actually widened by 21 basis points.  Every sector but one increased during the quarter, with financial market sectors leading the way.  Energy was the laggard, declining -1.3% during the quarter as oil prices declined 9% and 3 high yield energy issuers defaulted.  A little more than a year ago, spreads for commodity sectors were about 1,000 basis points wider than the market average before almost fully converging with the rest of the market.  After the notable widening during the second quarter, energy spreads are now about 150 basis points wider than the aggregate market. 

The Treasury yield curve flattened during the quarter.  Yields on the 2-year increased, yields on the 5-year were flat, and yields on the 10- and 30-year decreased.  The flattening was of modest magnitude, and the yield curve remains normal/upward sloping.  This is something we monitor closely; however, as an inverted yield curve has preceded all seven recessions of the past 50 years. 

Revenue and EBITDA growth have recovered, and financial leverage remains in check.  Distressed debt accounts for less than 1% of the total high yield market; the default rate is 2%, about half the market’s historical average.  Excluding commodity defaults over the past year, the default rate is under 1%.  The market’s “excess spread”, or spread after adjusting for the default rate environment, is 257 basis points—just 36 basis points below the historical average.  The maturity calendar is termed out well, with little near term refinancing pressures.  The primary/new issue market has been well-behaved.  Most new issuance has been higher quality bonds and the proceeds have been predominantly used for refinancing—LBO activity remains muted. 

We continue to identify interesting opportunities in our areas of expertise—small/mid cap credits and fallen angels.  When markets are tight and the preponderance of investors are focused in relatively narrow group of large cap credits, our core competency is a distinguished advantage.  We are able to identify pockets of opportunities in overlooked segments of the market that are difficult for many large institutional managers to access.  ETFs have essentially no exposure to these market segments.  This has facilitated a 64 basis point spread advantage for the portfolio relative to the broad index, and in our opinion, without assuming undue risk. We will continue to adhere to this core competency and are optimistic about the risk/return prospects of the portfolio as we look forward.  

ATTRIBUTION: 2Q 2017

The Hotchkis & Wiley High Yield portfolio (gross and net of management fees) underperformed the BofA Merrill Lynch US High Yield Index and the BofA Merrill Lynch BB-B US High Yield Constrained Index.  Overall credit selection was decidedly positive but the overweight position in energy credits detracted from relative performance.  The portfolio averaged about 650 basis points overweight energy relative to the broad index—the only negative sector in the market.  Fortunately, positive credit selection in energy offset the majority of the overweight position.  Our positions are focused in credits that have sufficient asset coverage even when using pessimistic assumptions regarding commodity prices.

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

Fundamentals (4):  The fundamentals score remains unchanged at 4.  Revenue growth turned positive and margins have improved, which significantly reduces default risk.  The default rate, including distressed exchanges, fell to 2.0%.  Excluding commodity sectors the default rate is a benign 0.9%.  Leverage has declined and interest coverage has improved.  The maturity calendar is well termed; there is no near-term maturity wall that would pressure refinancing.  

Valuation (2):  We maintained the valuation score at 2.  The yield-to-worst declined to 5.7% and spreads narrowed to 376 basis points—a tight market.  Valuations look more reasonable after adjusting for the low default rate environment.  Excess spreads are only moderately below historical levels.  The narrowing has been led by commodity sectors, which are only slightly wider than the market average.  Other fixed income categories exhibit valuations considerably worse, both in absolute and relative terms.         

Technicals (3):  The technicals score remains unchanged at 3.  The new issue calendar is robust and appears to be loosening slightly.  Low rated new issuance increased from a 12 year low to average levels.  Liquidity across the market has improved over the past year, as bond dealers have increased inventory levels.  Also, rating agency upgrades continue to outpace downgrades.   

Unless otherwise noted, the high yield market or "broad" index refers to the BofA Merrill Lynch 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 BofA Merrill Lynch 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. 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, 2017 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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