High Yield

Market Commentary

Period ended June 30, 2019
 

MARKET COMMENTARY

The ICE BofAML US High Yield Index returned +2.6% in the second quarter of 2019 and is now up +10.2% since the beginning of the year.  An increasingly dovish tone from the US Federal Reserve contributed to a positive high yield market, as Chairman Jay Powell indicated a readiness to lower interest rates for the first time in more than a decade. The Federal Funds futures market is pricing in a high likelihood of a rate cut during the Fed’s next meeting, and both long and short term rates fell accordingly.  The very short end of the yield curve remains inverted, but the 2/10 year curve is upward sloping and steepened further during the quarter.  The yield-to-worst for investment grade and high yield credits declined 0.5% and 0.4%, respectively.  Spreads remained remarkably stable during the quarter.  Two notable exceptions to the modest decline in yields and stagnant spreads were CCC-rated bonds and the energy sector, which are not mutually exclusive.  The lowest rated high yield cohort returned just +0.6% in the quarter, lagging the index by 2 percentage points, as its YTW increased slightly and its spread over treasuries widened by about 60 basis points.  High yield energy credits returned -0.8% in the quarter, with energy YTW increasing by 0.2% and spreads widening by more than 70 basis points. 

Geopolitical tensions seemed to subside, as the US reached a deal with Mexico to halt proposed tariffs, and US-China trade talks resumed, buoying markets further.  All sectors except energy (-0.8%) were positive in the quarter, with insurance, retail, transportation, and banking leading the way.  The high yield default environment remains benign relative to average.  The default rate, including distressed exchanges, is 1.55% which is less than half of the 20-year average.  This is down 0.34% since the beginning of the year and down 0.50% year-over-year.  During the first half of 2019, 13 high yield bonds defaulted and 2 went through a distressed exchanged, for a total par value of about $14 billion ($8 billion occurred during the second quarter).  The market’s average post-default recovery rate stands at 36%, slightly less than the long-term average of 41%.  This is a bit misleading, however, considering that defaults have been few and far between.  About one-third of this year’s default activity was in the energy sector.  Less than 1% of the market trades for under 50% of par value and less than 5% trades for under 70% of par value, reflecting the market’s view that fundamentals remain sound. 

The new issue market has picked up from 2018’s slowdown, and remains on a pace slightly lighter than average for the past decade.  About two-thirds of all issuance has been for refinancing and less than 20% for LBO/acquisition activity.  Just 10% of new issuance was CCC-rated debt and more than two-thirds of that was for refinancing. 

Overall, our view of the high yield market remains relatively unchanged.  Fundamentals are solid and the new issue market well-behaved, which appears to be appropriately reflected in valuations.  We maintain our focus across high yield credits of all sizes, which has helped facilitate a ~75 basis point spread advantage relative to the broad benchmark and we remain optimistic about the portfolio’s prospects going forward. 

ATTRIBUTION: 2Q 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 the second quarter.  The portfolio’s overweight in small and mid cap credits was a performance detractor in the quarter as larger cap credits outperformed.  Credit selection in basic industry and consumer goods also hurt relative performance, along with the underweight allocation to telecommunications.  Positive credit selection in the automotive, capital goods, and energy sectors helped relative performance in the quarter. 

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

Fundamentals (3):  No change.  Defaults remain well below average.  We expect a benign environment to continue because leverage remains in check and because revenue and earnings are reasonable.  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 (4):  Increased from 3 to 4.  The new issue market remains about average and asset class fund flows are strong.  There is also strong call and tender activity and overall market liquidity remains decent. 

Valuation (3):  No change.  Valuations remains appropriate considering the market’s decreased leverage and overall health.  The excess spread, or spread adjusted for unrecovered defaults, remains stable. 

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 June 30, 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