High Yield

Market Commentary

Period ended September 30, 2018
 

MARKET COMMENTARY

The ICE BofAML US High Yield Index returned +2.4% in the third quarter of 2018, and is now up +2.5% since the beginning of the year.  The FOMC raised the Fed Funds Target Rate by another quarter point to 2.25%, its third such raise of the year.  Consequently, government bonds declined while spread sectors outperformed.  Investment grade corporates were slightly positive (about +1%) and high yield corporates were slightly more positive (+2.4%).  Treasury yields with maturities between 2 and 30 years rose between 20 and 30 basis points, with an ever-so-slight flattening of the yield curve. 

The high yield market absorbed the rate hike and then some, experiencing a decline in the yield-to-worst of 0.24% during the quarter, which finished at 6.30%.  Spreads tightened by 43 basis points, closing the quarter at 329 basis points over comparable duration treasuries.  BB-rated and single B-rated credits performed similarly, while CCC-rated (and below) outperformed slightly—yields declined and spreads narrowed disproportionately for this lowest-rated cohort.  Performance variation among sectors was modest: healthcare returned +3.4%, retail returned +1.1%, and all other sectors where somewhere in between. 

A primary reason for high yield’s outperformance relative to other fixed income asset classes has been the market’s overall health.  Only 2 high yield bonds defaulted in the quarter, following just 3 in the previous quarter—this represents the fewest defaults over a six month period in more than 7 years.  The trailing 12 month default rate, including distressed exchanges, now stands at 2.0% which is well below long term averages.  A meager 0.5% of the market trades at 50% of par or less, implying that the market believes the docile environment will persist.  Recovery rates over the past 12 months averaged 46%, which is also slightly better than long term averages, though the sample size is small due to the low number of defaults.  Rating agencies have agreed with the market’s assessment of tranquility, and have upgraded 5 credits for every 4 they have downgraded.  

The pace of new high yield issuance has been only about 70% of the market’s average over the past 8 years.  The subdued new issue market has been reasonably well-behaved with only 16% of the new issuance this year rated CCC, which is in line with historical averages—about half of this was earmarked for the refinancing of existing debt.  More than 60% of all new issuance was for refinancing, with only 20% used for acquisition/LBO financing.  Revenues have grown and corporate earnings have been strong. 

The market’s valuation is not the most exciting that we have ever observed, which leads us to be laser focused on ensuring sufficient asset coverage even though the market is in good health.  We will continue to look for opportunities in credits of all sizes because we have learned that mispriced opportunities are more prevalent in small and mid caps.  Currently, we are underweight investment grade and BB rated credits as we continue to have concerns about the ballooning of the BBB credit market and its nascent signs of deteriorating quality.   We also have a modest weight in CCCs, so the portfolio continues to be heavily weighted toward single B rated credits.  This, combined with our focus across the cap spectrum has led to a spread advantage1 relative to the broad market of more than 50 basis points. 

ATTRIBUTION: 3Q 2018

The Hotchkis & Wiley High Yield portfolio (gross and net of management fees) underperformed the ICE BofAML US High Yield Index and ICE BofA BB-B Constrained Index in the third quarter.  The two indices performed similarly, and the portfolio lagged both by a modest magnitude.  Overall credit selection was close to neutral relative to either index.  Positive credit selection in the basic industry and healthcare sectors was offset by negative credit selection in energy, particularly in the exploration & production industry.  The underweight exposure in telecommunications was a notable performance detractor as this was among the top-performing sectors in the quarter.

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 2.0%--well below historical averages.  Revenue and earnings have been strong.  Market maturities are well-termed out, with little near-term refinancing pressures.  A paltry 0.5% 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 $168 billion in new issuance year to date—more than 60% was used for refinancing with just 20% earmarked for acquisition/LBO financing.  CCC-rated new issuance comprised 16% of the primary market, in line with historical averages. 

Valuation (2):  The valuation score remains at 2.  The market’s yield-to-worst is 6.3% and spreads over treasuries stand at 328 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.   

 

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1
Spread advantage is based on the option adjusted spread (OAS)

 

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 September 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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