“After you throw a few trillion dollars around, people start to believe that it’s all a big joke.”
– Jared Dillian, April 15, 2020
Thoughts on the Market
The COVID-19 pandemic had a dramatic effect on the market in early 2020. Within days of U.S. stocks hitting an all-time high in February, U.S. equity indices began a one-month, 30-40% sell-off, U.S. high grade corporate spreads tripled, and high yield spreads briefly pierced +1000 bp STW. In response, the Fed slashed rates to zero, and the Fed’s latest $3 trillion of QE resulted in an adrenalin shot increase in Fed Credit of $2.5 trillion. This rush of new money led U.S. stocks to recoup most of their losses, or in the case of the Nasdaq 100, hit new highs. However, the global economy remains at a point of heightened/ unchartered economic uncertainty. COVID-19 remains a significant unknown, social unrest and political uncertainty are high and the restart of the global economy a wholly new phenomenon.
Central banks will likely continue with monetary stimulus policies. We are not fans of such massive stimulus programs; we believe trying to anticipate a cyclical correction from a top-down perspective is, at the end of the day, a losing strategy. Fortunately, the bottom-up perspective of our investment process navigates any market environment well as long as it’s successfully implemented. Our rigid margin-of-safety requirements never change. Our relative value methodology across the risk spectrum of credits and that fit our process naturally account for increased economic uncertainty.
The US High Yield market, as represented by the ICE BofAML US High Yield Constrained Index (HUC0) experienced a strong rebound following one of the worst quarters in history, posting a +9.54% total return. The index total return for 1H’20 ended the quarter at -4.84%. As of quarter end, the spread and yield of the US High Yield Market was 649 bps, and 6.86%, which represent moves tighter/lower of 226 bps, and 2.39% during the period.
The Leveraged Loan market also rebounded in 2Q’20 with a total return of +9.78%, ending the quarter with a 1H’20 total return of -4.49%.
From a credit quality perspective, CCCs led the way higher, up +10.81% relative to single Bs and BBs at +9.35% and +9.68%, respectively. However, the significant underperformance of CCC’s in 1Q’20 left their 1H’20 total return lagging at -13.28%, compared to single Bs and BBs at -6.75 and -1.92, respectively.
Investment Grade Credit exhibited strong performance during the second quarter and YTD’20, returning +9.27 and +4.84%, respectively. The 1H’20 return advantage relative to high yield was due to the very strong 1Q’20 return, driven by the collapse of the 5-year UST rate from 1.69%, to 0.38%. The ICE BofA US (IG) Corporate Index (C0A0) ended 2Q’20 with a spread duration of 8.0, compared to just 3.8 for high yield. Big picture, we continue to see IG issuers susceptible to downgrades through the year. Investment grade corporate new issuance has already surpassed last year’s total and is just 7% below the prior annual record of $1.25T in 2017. Barring negative UST rates, IG corporate returns seem challenged at an Index STW and YTW of +155 bps and 2.22%. On the other hand, we look forward to potential relative value opportunities among BBB falling/fallen angels.
Exhibit 1: Returns of Various Assets
Source: JP Morgan, ICE BAML
High Yield Market Commentary
During 2Q’20, the ICE BofA US High Yield Constrained Index (HUC0) total return was +9.54%, while the S&P 500 Index returned +20.54%, and 10-Year US Treasuries +0.68%. Total returns for the first half of 2020 were -4.84% for the HUC0 HY Index, -3.09% for the S&P 500, and a central bank policy-driven +12.85% for 10-Year US Treasuries.
At quarter end, the high yield market, as represented by the ICE BofA US High Yield Constrained Index (HUC0) spread-to-worst (STW) and yield-to-worst (YTW) were +649 bps and 6.86%, and 226 bps and 2.39% tighter/lower during the quarter. Fund flows proved to be a tailwind after dramatically reversing course during the quarter, with $47.3 billion of retail inflows into high yield funds. New issuance resumed and set new records: 2Q’20 new issuance of $145.5B surpassed the previous record of $121.2B in 2Q14, and Jun’20 new issuance of $61.5B also surpassed the previous monthly record in Sep’13.
Source: ICE BAML
Returns for the First State Investments’ High Yield strategy remained solid during 2Q’20. The Broad High Yield strategy returned +10.95%, outperforming its index by 141 bps. The Quality and Select strategies returned +10.15% and +12.24%, outperforming their benchmark indices by 71 and 270 bps for the quarter, respectively. The Short Duration strategy returned +7.24%, underperforming by 117 bps.
High Yield Composite Performance - Annualized
The Inception Date of the FSI High Yield Composites was April 30, 2017. Past Performance is not indicative of future performance. The performance of the BroadHigh Yield Composite is hypothetical, as the assets of the Select High Yield strategy and the Quality High Yield strategy have been combined to create theBroad High Yield strategy. Composite returns do not reflect the deduction of investment advisory fees. A client’s return will be reduced by the investment fees.If a client placed $100,000 under management and a hypothetical gross return of 7% were achieved, the investment assets before fees would have grown to$196,715 in 10 years. However, if an advisory fee of 0.4% were charged, investment assets would have grown to $188,987, or an annual compounded rate of 6.6%. Note: due to rounding percentages may not precisely reflect the absolute figures.
* Index as of quarter end rebalance
Strategy Review
We are the beneficiaries of an investment process that is contrarian by design. When some of our competitors may be stretching for yield at the expense of uncompensated default risk, we believe our investment process should lead us to an underweight in relative credit risk. Over the life of our investment process, we’ve never experienced a meaningful High Yield market correction that wasn’t a net opportunity to increase yields and total return over the longer term, net of any default experience. Therefore, rather than fear market corrections, we view them as net opportunities to position our portfolios for their strongest, absolute total return. As you can see from our performance in the first half of 2020, our investment process has guided us to strong outperformance in the current volatile markets.
With our disciplined process as our foundation, we expect market dynamics will continue to present challenges, but also opportunities for investors. As the overall landscape changes for fixed income investors (e.g., negative yields, increased use of derivatives), we continue to remain confident in both our process and our team’s relentless commitment to execution in all markets. We also believe that the High Yield market is among the most attractive in fixed income, and that we remain able to construct a diversified portfolio that overcompensates us for the risk that we are taking. We believe FSI High Yield is well positioned to produce dependable outperformance versus both peers and the benchmark.
eVestment Performance Rankings
Risk Metrics Since Inception (May 1, 2017)
Peer group percentile rankings are versus eVestment’s US High Yield Fixed Income (for Broad & Select High Yield), Quality High Yield Fixed Income (for Quality High Yield) & Short Duration High Yield FI (for Short Duration High Yield) universes. Data shown includes all results reported in eVestment as of July 17, 2020 and does not reflect any selection by FSI.
Portfolio Positioning
From a sector standpoint, led by our bottom-up relative value analysis, the Broad strategy increased its exposure to Basic Industry and Consumer Goods and reduced exposure to Capital Goods and Telecommunications.
The Broad* strategy is underweight the Automotive, Capital Goods and Financial sectors and is approximately market weight in Retail, where the focus is on higher quality issuers resilient to the impact from the shelter in place polices. We reduced the strategy’s exposure to the Telecommunications sector, from a large overweight to slight overweight, in reaction to the postmerger, relative value of Sprint/T-Mobile.
While our default-adjusted, relative value methodology is indifferent to rating agency metrics, we still track our composite exposures. Underweight exposures to CCCs and BBs were maintained, with a corresponding overweight to Bs. In fact, we increased exposure to Bs slightly during the quarter as we trimmed our CCC exposure.
At quarter end, the Broad high yield strategy had a modest, single-digit % allocation to bank loans. Following the first quarter dislocation we continued to find select loans that fit our investment process and offered attractive relative value.
Outlook
Uncertain and volatile market conditions in the first half of 2020 highlighted our conviction that effective investing in the High Yield sector is first and foremost about risk control. The current market highlights - painfully - that High Yield investing is often more about what you don’t own, rather then what you do. Our investment process requires strict, absolute minimum marginsof- safety, based on real-world asset coverage and free-cash-flow generation. The importance of risk control is paramount in leveraged credit, as the asymmetric return profile is pronounced.
Through the lens of our investment process, value in the High Yield value is attractive, at the same time forward-looking economic uncertainty, and future volatility risk remains high. Our portfolios have slowly repositioned to relatively neutral market risk, after being underweight for much of the first half of 2020, with an emphasis on credits without near-term debt maturities, significant cash and liquidity, and meaningful buffers of free cash flow. This positioning is simply the residual result of implementing our disciplined investment process.
* The Broad High Yield strategy is a hypothetical portfolio, as the assets of the Select High Yield strategy and the Quality High Yield strategy have been combined to create the characteristics of the Broad High Yield strategy.
Broad High Yield
* Index as of quarter end rebalance
Breakdown by Rating
* CC, C, D & NR
Breakdown by Country
Top 10 Issuers
Top 3/Bottom 3 Contribution to Excess Return
* The Broad High Yield Composite is hypothetical, as the assets of the Select High Yield strategy and the Quality High Yield strategy have been combined to create the characteristics of the Broad High Yield strategy. Source: First State Investments. Data as of June 30, 2020
Select High Yield
*Index as of quarter end rebalance
Breakdown by Rating
* CC, C, D & NR
Breakdown by Country
Top 10 Issuers
Top 3/Bottom 3 Contribution to Excess Return
Source: First State Investments. Data as of June 30, 2020
Quality High Yield
* Index as of quarter end rebalance
Breakdown by Rating
* NR & NA
Breakdown by Country
Top 10 Issuers
Top 3/Bottom 3 Contribution to Excess Return
Source: First State Investments. Data as of June 30, 2020
Short Duration High Yield
*Index as of quarter end rebalance
Breakdown by Rating
*NR & NA
Breakdown by Country
Top 10 Issuers
Top 3/Bottom 3 Contribution to Excess Return
Source: First State Investments. Data as of June 30, 2020
Co-Portfolio Managers: High Yield
Matt Philo, CFA
Senior Portfolio Manager, Co-Head of High Yield
Matt joined First State Investments in May 2016. He has 30 years of industry experience.
He was Executive Managing Director & Head of High Yield at MacKay Shields LLC.
He managed the Mainstay High Yield Corporate Bond Fund (MYHIX) from December 2000 through May 2014.
Matt has an MBA in finance from New York University and a BA from University at Albany SUNY. Matt is a CFA Charterholder.
Jason Epstein
Senior Portfolio Manager, Co-Head of High Yield
Jason joined First State Investments in September 2016. He has 18 years of industry experience.
He was a Managing Director with Oak Hill Advisors where he was responsible for managing a team of analysts covering a broad range of sectors.
Prior to Oak Hill, Jason was an analyst within investment banking at Credit Suisse First Boston where he was a member of both the Financial Sponsors and Technology groups.
Jason has a BS in Economics from The Wharton School, University of Pennsylvania.
Important Information:
This material is solely for the attention of institutional, professional, qualified or sophisticated investors and distributors who qualify as qualified purchasers under the Investment Company Act of 1940, as accredited investors under Rule 501 of SEC Regulation D under the US Securities Act of 1933, and as qualified eligible persons as defined under CFTC Regulation 4.7. It is not to be distributed to the general public, private customers or retail investors in any jurisdiction whatsoever.
This presentation is issued by First State Investments (US) LLC (“FSI” or “First State Investments”). The information included within this presentation is furnished on a confidential basis and should not be copied, reproduced or redistributed without the prior written consent of FSI or any of its affiliates.
This document is not an offer for sale of funds to US persons (as such term is used in Regulation S promulgated under the 1933 Act). Fund-specific information has been provided to illustrate First State Investments’ expertise in the strategy. Differences between fund-specific constraints or fees and those of a similarly managed mandate would affect performance results. This material is provided for information purposes only and does not constitute a recommendation, a solicitation, an offer, an advice or an invitation to purchase or sell any fund and should in no case be interpreted as such.
Any investment with First State Investments should form part of a diversified portfolio and be considered a long term investment. Prospective investors should be aware that returns over the short term may not match potential long term returns. Investors should always seek independent financial advice before making any investment decision. The value of an investment and any income from it may go down as well as up. An investor may not get back the amount invested and past performance information is not a guide to future performance, which is not guaranteed.
Certain statements, estimates, and projections in this document may be forward-looking statements. These forward-looking statements are based upon First State Investments’ current assumptions and beliefs, in light of currently available information, but involve known and unknown risks and uncertainties. Actual actions or results may differ materially from those discussed. Actual returns can be affected by many factors, including, but not limited to, inaccurate assumptions, known or unknown risks and uncertainties and other factors that may cause actual results, performance, or achievements to be materially different. Readers are cautioned not to place undue reliance on these forward-looking statements. There is no certainty that current conditions will last, and First State Investments undertakes no obligation to publicly update any forward-looking statement.
PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE PERFORMANCE.
Reference to the names of each company mentioned in this communication is merely for explaining the investment strategy, and should not be construed as investment advice or investment recommendation of those companies. Companies mentioned herein may or may not form part of theholdings of FSI.
The comparative benchmarks or indices referred to herein are for illustrative and comparison purposes only, may not be available for direct investment, are unmanaged, assume reinvestment of income, and have limitations when used for comparison or other purposes because they may have volatility, credit, or other material characteristics (such as number and types of securities) that are different from the funds managed by First State Investments.
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