“It is not the responsibility of the Federal Reserve – nor would it be appropriate – to protect lenders and investors from the consequences of their financial decisions”
Dr. Ben Bernanke, August 17, 2007

“Without big banks, socialism would be impossible.”
Vladimir Lenin, October 14, 1917

Thoughts on the Market

The U.S. High Yield market, as represented by the ICE BofAML US High Yield Constrained Index (HUC0) posted a +2.6% Q4’19 total return (‘TR’), and a +14.4% total return for the full-year 2019. The strong 2019 represented the fourth best annual return since the post-GFC recovery in 2009; modestly trailing the +17.5%, +15.6% and +15.1% total returns of 2016, 2012 and 2010, respectively.

In the fixed income markets during Q4’19, a prominent trend reversal was the sell-off in U.S. Treasuries. Exhibit 1, below highlights modest weakness in the UST 10-Year, which reflects a 25 bp increase in yield. Investment Grade corporates (‘IG’), as represented by the ICE BofAML US Corporate Index (C0A0) proved extremely resilient in the face of higher rates: the +1.15% total return included +21 bps of positive price return, despite its 7.51 spread duration.

The STW of the C0A0 Index tightened 21 bps during the quarter, to a STW of +99 bps, versus a post-GFC tight of +88 bps on Feb. 2, 2018. U.S. and Emerging Market equities traded higher throughout the quarter, seemingly boosted by any and all accommodative monetary actions, or statements by the GCBs. From the perspective of a 30+ year veteran, (and long ago, value equity PM) there seems to be two simple ingredients to ever higher, record-high, stock markets: ► unlimited money printing, and ► unlimited conviction that game theory favors a no-pricetoo-high wager on the GCB-put. A Brave New World?

Meanwhile, U.S. High Yield (‘HY’) presented a very interesting dichotomy in October and November, relative to the “one-way, up” equity markets. The U.S. Broad High Yield market, as represented by the ICE BofAML US High Yield Constrained Index (HUC0) experienced -52 bp in price decline during Oct-Nov, but posted a solid +2.61% total return for Q4’19; after a 157 bp price increase in December, and 166 bps of income for the quarter. Interestingly, while CCC U.S. High Yield (HUC3) posted the strongest, +3.43% total return of the three, rating-based tranches during 4Q’19, it was achieved after -331 bp in price decline during Oct-Nov, a +464 bp price rally in December, and 225 bps of income, for the quarter.

Exhibit 1: Returns of Various Assets

Source: JP Morgan, ICE BAML

Finally, European High Yield (HE00) and EM High Yield Corporates (EMHB) were spared the Oct-Nov price weakness of U.S. High Yield (HUC0). EM High Yield Corporates posted a stand-out +4.15% total return in Q4’19, to only trail U.S. High Yield by -92 bps in 2019. European High Yield noticeably lagged U.S. High Yield by -63 bps in Q4’19, and -315 bps for all of 2019. However, most of the European High Yield lag is due to income returns ~60% below U.S. High Yield (-59 bps in Q4’19, and -258 bps in 2019). ‘NIRP’ hasn’t been kind to average coupons of EU HY.

High Yield Market Commentary

The U.S. High Yield market , as represented by the ICE BofAML US High Yield Constrained Index (HUC0) posted a +2.6% Q4’19 total return, and +14.4% full-year 2019 total return. The strong 2019 represented the fourth best annual return since the post-GFC recovery in 2009; modestly trailing the +17.5%, +15.6% and +15.1% total returns of 2016, 2012 and 2010, respectively.

For the overall High Yield market, accounting for the relative weights of industry sectors:

The strongest performing industry sectors in Q4’19 were Energy, Healthcare, and Telecommunications. The weakest performing sectors for the overall market were Leisure, Hotels, and Media.

The strongest performing industry sectors for all of 2019 were Healthcare, Telecommunications, and Cable TV. The weakest performing sectors for the overall market were Airlines, Entertainment, and Publishing.

For 4Q’19, the BB, Single-B and CCC & Below rated tranches improved in performance as average rating declined, with total returns of +2.39% for BB, +2.89% for Single-B and +3.43% for CCC & Below.

The inverse relationship was evident for full year 2019, with total returns of +15.74% for BB, +14.26% for Single-B and a distant +9.46% for CCC & Below. The CCC & Below tranche was barely price return positive for 2019, with 95% of its total return from income.

Summary:

HUC0 Index characteristics at the end of Q3’19, Q4’19, & Jan. 23, ‘20:

As of September 30, 2019:
Yield-to-worst of 5.87%, spread-to-worst of +420 bps, duration-to- worst of 3.3, and average price of 99.16

As of December 31, 2019:
Yield-to-worst of 5.41%, spread-to-worst of +372 bps, duration-to-worst of 3.0, and average price of 100.74

As of Monday, January 27, 2020:
Yield-to-worst of 5.70%, spread-to-worst of +422 bps, duration-to-worst of 3.2, and average price of 99.97

High Yield Composite Performance - Annualized

The Inception Date of the FSI High Yield Composites was May 1, 2017. Past Performance is not indicative of future performance. The performance of 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 Broad 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

Portfolio Positioning

The industry sectors producing the biggest impacts within our High Yield Composites are often very different than the overall market, due to our individual credit overweight’s and cumulative bond picking results.

For our Broad High Yield composite, the industry sectors making the strongest contributions to portfolio performance for Q4’19 were Services, (e.g. see: GEO Group in “Broad HY, Positive Contributors”), Consumer Products, (e.g. see: Vista Outdoor in “Broad HY, Positive Contributors”) and Energy, (e.g. see: Laredo Petroleum in “Broad HY, Positive Contributors”).

Conversely, the sectors making the weakest contributions to performance for Q4’19 included Metals/Mining Ex-SteelRetail, (e.g. see: GrubHub in “Broad HY, Negative Contributors”) and Financial (due to our 5.1% underweight relative to the index).

For our Broad High Yield composite during all of 2019, the industry sectors making the strongest contributions to portfolio performance, were Energy, Consumer Products and Telecommunications. Energy performance was the result of superior security selection in E&P, and a combination of solid security selection and a meaningful underweight in Energy Services. Telecommunications performance benefited from four holdings, in particular: a global communications satellite operator; structurally senior debt at an underleveraged subsidiary of CenturyLink; an asset rich wireless provider based in Chicago; one of the largest high yield issuers that we expect to successfully merge with T-Mobile US.

Conversely, the sectors making the weakest contributions to performance for all of 2019, included Financial (due to our avg. 5.9% underweight relative to the index), Retail, (e.g. see: GrubHub in “Broad HY, Negative Contributors”) and Utility.

Our team became relatively active in the portfolios during the second half of the year as the U.S. high yield market was “sneaky” soft from July-November; with each month experiencing small benchmark index price declines. November was a particularly busy month with a heavy bias toward net buying. We bought only a few new issues during Q4’19, and one of those was a new issue Term Loan. We added four new Term Loan holdings as weakness in that market segment presented select buying opportunities. Our E&P exposure was actively traded based on relative value, and net exposure increased, as bond prices lagged the run-up in WTI crude prices during November-December. Other notable trends included a concerted effort to decrease, and exit exposure to select Metals/Mining credits; while increasing our weights in some of our Telecommunications holdings. As always, all of our portfolio changes were simply the result of our team letting our investment process highlight potential portfolio changes, and then, agreeing on the proper course to maintain optimal, default-adjusted portfolios.

Big picture, our investment process currently leads us to be overweight Consumer Products, Energy-E&P (largely offset by underweights in Energy Services), and Pharmaceuticals (largely offset by an underweight in Healthcare Facilities). Our constant, and largest sector underweights remains Financial. Our other meaningful underweight is Media, which includes Advertising, Cable TV and Media Content.

All four of our High Yield Composites outperformed their benchmark indexes during Q4’19. Broad High Yield, Select High Yield, and Quality High Yield have also outperformed in 2019 and Since Inception. Just 3-months from our 3-year, performance milestone, these Core Composites are in the first or second-decile of their respective eVestment peer groups; see Chart, below.

Short Duration High Yield has modestly lagged (-4 bp) its benchmark index Since Inception, however we are satisfied with performance given the strategy’s emphasis on relative safety and low volatility. Additionally, Short Duration High Yield is a respectable 30th percentile in its eVestment peer group, Since Inception.

As Co-Heads of the First State Investments High Yield Group, we want to take this opportunity to thank all of our Team partners for driving our Group’s performance, with unusual diligence, cheerfulness and COMPLETE commitment to our investment process. Ours is truly a Team effort, and we’ve never worked with as talented and cohesive a Team of investment professionals.

eVestment High Yield Peer Group Percentile Rankings

PostScript: Our “Swan Song” Analysis of Global Central Banks:

Note to Reader: If you’ve lost interest in the repetitive activities of Global Central Banks, please skip ahead to “High Yield Market Commentary.”

We reluctantly share out thoughts regarding the highest profile, macro dynamic during the quarter. We’ll preface our comments by admitting our views are based on common sense, rather than first-hand, knowledge, or even expertise regarding the latest area of increased GCB mania. As backdrop, the Fed officially began cutting the discount rate on July 31st, having verbally performed its 180° dovish U-turn in mid-January, a full year prior to this investor letter.

At market close on Friday, Sep. 13, 2019: the High Yield Index offered a 5.82% YTW and +397 bp STW, trading towards the tight end of its STW range; the NASDAQ 100 had been trading “range bound” since the end of April; interestingly, the 10-Yr UST bond’s yield had increased from its 2019 low of 1.46%, to 1.90% in just the previous 8 trading days, (an ~4 pt. decline). Still, just another week during the great bull market.

The following week, the typically sedate “repo rate” shook the foundation of the financial markets when it soared from ~2%, to as high as 9%, on Sep. 17th. The repo market has most commonly served as a source of liquidity for large, universal banks to finance trading and speculative investment positions. Turmoil in the multi-trillion dollar repo markets amounts to one massive and non-transparent uncertainty.

All most investors know, for sure, is that dysfunctional repo markets were at the center of the GFC and the Lehman bankruptcy; along with isolated financial scandals such as Refco & MF Global. After the 2010’s “Decade of Debt,” today’s repo markets are larger and more global; including China and offshore financial centers (e.g. Cayman, Luxembourg, Singapore etc.).

The Fed is reported to have now funneled $500 billion into the repo market, to control repo rates and the availability of repo liquidity. The Fed’s support, in the form of daily and longer-term repo loans, and outright purchases of Treasury bills, does not seem outsized in size or scope, in the context of the broader GCB monetary stimulus of the past decade.

What does seems significant, to us, is the rapid response by the Fed, coupled with reports that the Fed is considering lending directly to smaller “financial institutions” and hedge funds. We view the following as the significant takeaways from this latest liquidity incident:

  • the universal banks that control, and own the GCBs have effectively bypassed the need for Government approvals of financial bailouts,
  • as is typical, U.S. legislation such as the “Dodd-Frank Wall Street Reform and Consumer Protection Act” was also drafted, and amended to expand the Fed’s autonomy, and scope of monetary policy implementation, and,
  • the past decade has been a favorable environment for bank lobbyists to utilize political clout to systematically amend other regulatory impediments to full GCB autonomy.

Is a fully independent GCB system a net positive, or net negative, at this point, in this monetary cycle?

Our Conclusion: a net positive, given we see no possible unwinding of the great monetary experiment that defined the Decade of Debt. The good news? This evolution of a GCB system with full autonomy of unilateral action should render future analysis of that system an exercise in redundancy, to which neither the writers, nor readers of our future high yield commentaries need be subjected.

Fortunately, the macro backdrop of an ever expanding global money supply plays no meaningful role in the disciplined implementation of our investment process. Fortunately, because investment strategies that rely on top-down predictions of the next economic recession, and/or credit crunch have been brutal reminders that “being early is a lot like being wrong.”

“Swan Song” GCB Summary: In our opinion, global financial markets have remained resilient at relatively lofty levels due to the actions and statements of the GCBs. Our long-held view has been that the massive monetary stimulus of the past decade cannot be reversed; only accelerated. GCBs will not voluntarily stop “QE” (encompassing financial asset purchases, negative interest rates etc.) until, 1) The GCBs, themselves decide to reset the global fiat currency system, and clear the decks, so to speak, (Gold, anyone?), or 2) The GCB system loses control of interest rates, inflation, and by definition, the global economy. Given those alternative options, the current status quo qualifies as the solid ground.

ANALYSIS: “EASY ANSWERS” – WHY HIGH YIELD? WHY NOW?

It wouldn’t be a New Year if market pundits and credit strategists weren’t taking pot-shots at Long-only, High Yield! Meanwhile, it’s relatively rare that the higher fee, higher risk, Private Credit Fund strategies are even mentioned: almost ALL of which have transitioned from reasonable, higher risk/higher return, illiquid credit alternatives, to, in our opinion, unreasonable risk/return propositions for investors; while the private credit fund managers continue to benefit from high management fees, on leveraged funds, with multi-year, lock-up terms. What could go wrong when $1 trillion is pushed into an asset class of small, private loans with zero secondary market liquidity, that, in our opinion utilize rather aggressive leverage?!

As of Monday, January 27, 2020 the HUC0 HY Index Offered:
Yield-to-worst of 5.70%, spread-to-worst of +422 bps, duration-to-worst of 3.2, average price of 99.97

Contrary to most market commentary perspective, High Yield history didn’t begin in 2019. During 2018, the same index traded tighter than +350 STW in January, April, June and October, with a STW low of +327 bps. In October, 2017 the same index’s STW was +352 bps; and in June 2014, +354 bps.

At the REAL credit cycle peaks, the low in STW was +251 bps in June, 2007, and the tight in STW was +244 bps in October, 1997; both still fresh, in memory.

So today, how can we defend our views that, Our High Yield composites are not only attractive in the absolute, but offer the best relative value in all of Fixed Income? Simply and Methodically:

The Current High Yield Market allows us to own a diversified portfolio, holding only credits that “fit our processand offer interest rate spread premiums that overcompensate for our estimate of every credit’s annual default risk. “Never buy credit risk at the wrong price.”

Yes, UST rates are low. We can’t control that, but we don’t need to. We need only care about interest rate spreads. Why? Because credit default rates are absolute, as are the interest rate spreads that protect us against each credit’s estimated annual default risk. UST rates are a random variable, unrelated to the default-adjusted, relative value assessments of our investment process.

In addition:
We employ no leverage.
We offer attractive running yields.

Income return accounted for 48% of U.S. High Yield’s 2019 TR of +14.41%. By way of comparison, income return accounted for 30% of U.S. High Grade’s 2019 TR of 14.23%. As of January 27th, the current yield (avg. coupon/avg. price) of the U.S. High Yield Index (HUC0) was a robust 6.3%, versus the U.S. High Grade Index (C0A0) current yield of 3.7%. This +2.6% High Yield, income advantage represents a notable “wind at our backs” as high yield managers.

Most Importantly: we do not fear corrections or outright down cycles because our investment process forces us to be CONTRARIAN investors. We expect to be underweight credit risk relative to the benchmark index and our peer competitors in market corrections. As a result, we have invariably been in a relative risk position that leads us to welcome the resultant opportunities to increase our portfolios’ YTW and total-return upside.

The Case for High Yield is that simple, and Simple is Good.

Analysis: Why High Yield? Why Now?

 


Excutive Summary 

The full “Analysis: Why High Yield? Why Now?” endeavors to defend our consistent views of recent Quarters:

► We continue to view our High Yield composites as attractive in the absolute, and the best relative value in all of Fixed Income.

► Our High Yield Composites all present spread premiums that comfortably overcompensate for our estimates of annual default risk, for every portfolio holding.

► We don’t fear market volatility or downside corrections; we calmly welcome the opportunities they present.

This Credit Cycle in Numbers:

Since 2009: non-financial US corporate debt has increased by +$4.3trln, representing +66% of its initial size; on both measures, new records relative to the two previous credit cycle peaks in 2000, and 2008. Among the top contributors of overall debt growth in recent years:

1. The Leveraged Loan Market has increased in size by 70-75% since the end of 2013, recently surpassing the size of the U.S. HY Market. We believe the overall risk of the loan market has increased this cycle as a result of: rapid growth, the prevalence of Loan-Only financings, and weaker, “covenant light” protections.

2. The explosive growth of the Private Debt Market has likely cannibalized some corporate issuer demand from the high yield market; especially financings for LBOs. BofA estimates the private debt market is now approaching the size of the U.S. high yield market at $1 trillion; having grown by over 70% over the past three years alone. Meanwhile, the private debt markets offer virtually zero secondary market liquidity.

3. BBB Corporates, the lowest-rated segment of U.S. investment grade corporates, increased to record size during this credit cycle: in the absolute ($2.3trln), as a percent of IG (60%), and as a percentage of HY (220%).

Summary Case for U.S. High Yield:

As a result of the dramatic growth of other risk credit markets, we observe the High Yield market has been spared its typical influx of the weakest quality new issuance during this great credit boom. In fact, public High Yield is the only U.S. credit sector with a negative growth rate over the past three years, (and six years). Importantly, we observe that the average credit quality of the High Yield market is meaningfully stronger than historic credit cycle norms.

The High Yield Market, as represented by the ICE BofAML US High Yield Constrained Index (HUC0), offers a Spread to Worst (STW) of +422 bp as of January 27, 2020. For context, the current STW is just 2 bp below the median STW since the inception of our HY Composites, including the late-2018 sell-off to a +548 bp STW.

TRUE: In our judgment, and from the perspective of our disciplined investment process, the current HY market leads to optimal, High Yield Composite portfolios representing the most attractive, relative value in all of Fixed Income.

VALUATION: our High Yield Composites all present spread premiums that comfortably overcompensate for our estimates of annual default risk, of every portfolio holding,

INCOME YIELD ADVANTAGE, over most other liquid, fixed income alternatives; providing an attractive, default adjusted “wind at our back.”

SIMPLE IS GOOD: our portfolios employ no leverage and typically present solid trading liquidity.

The CONTRARIAN RISK ROTATION: Most importantly, our disciplined investment process forces us to be Contrarian “lenders” relative to the short-term, and long-term credit cycle. We capitalize “Contrarian” because we believe it represents THE Critical, Differentiating Advantage of our Investment Process: relative to other high yield managers, and relative to most of the “illiquid” investment strategies, (that populate like deer during every bull market in credit). It’s also the reason we can say, “We don’t fear market volatility or downside corrections; to the contrary, we calmly welcome the opportunities they present.”

Portfolio Commentary

Broad High Yield

* Index as of quarter end rebalance

*CC, C, D & NR

* The Broad High Yield strategy is a hypothetical portfolio. 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.

Sector & Issuer

Positive Contributors (top three):


GEO Group (GEO):
“GEO” (a real estate investment trust “REIT” that manages secure institutions, ICE processing centers, and community reentry facilities around the globe), reported solid 3Q’19 earnings, and modestly increased forward guidance for full year, 2019. Compared to the previous year, fiscal 2019 revenues, adj. EBITDA and adj. funds from operations are now projected to increase 7%, 9% and 10%, respectively. The company generates predictable and substantial discretionary free cash flow, maintains strong liquidity and has modest debt maturities before 2024.

Laredo Petroleum (LPI): Laredo Petroleum outperformed after reporting strong 3Q19 results that beat expectations and guiding FCF generation going forward. Further, the company announced two small bolt-on acquisitions, one in Howard County and the second around Laredo’s existing footprint. The expansions addressed investor concern regarding inventory runway (2+ years of tier 1 well locations added), and are set to accelerate the company’s oil cut as a percentage of production from low 30% to greater than 40% which was taken positively by credit investors as the inventory and high gas production have been investor overhangs on the name historically.

Vista Outdoor (VSTO): Vista Outdoor outperformed during the quarter as the earnings story seemed to stabilize, and investors put more weight in the company’s asset value. VSTO is progressing on their margin improvement plan and should continue to improve if/when tariffs roll off as part of any US/China trade deal. Leverage remains high in the business, however we believe that the asset value in the remaining businesses well covers the debt, and the possible catalyst of a deleveraging asset sale continues to make these bonds attractive.

Negative Contributors (bottom three):

GrubHub (GRUB): GrubHub bonds sold-off after reporting disappointing 3Q19 results. Competitive dynamics deteriorated sharply during the 3rd quarter, with competition no longer simply moderating GrubHub’s strong top-line growth, but rather starting to erode the company’s existing customer base. As a result, the company decided to pursue a change in strategy, namely an aggressive growth plan that will significantly pressure near-term EBITDA and FCF. Our comfort with the credit stemmed from its profitable, measured approach to growth and we no longer felt comfortable underwriting the risk once the company decided to pursue the strategy of its irrational peers. Industry consolidation could help drive improved competitive dynamics, but M&A may not benefit GrubHub bondholders given its competitors’ weak balance sheets and weak Change of Control language in GrubHub bonds.

California Resources (CRC): California Resources underperformed after the state of California announced that it would block new fracking and steam-injected oil well drilling permits pending a scientific review against the dangers of these activities on local populace. This represents a stark 180 from Governor Newsom’s previously stated position that he would not (and did not have the power to) outright ban fracking/steam injection. While California Resources stated that they do not use well completions linked to the moratorium, a crux of California Resources’ deleveraging story is a sale of an overriding royalty interest in its current acreage, and this moratorium will likely make such a sale less attractive to buyers and delay needed debt retirement going forward. We sold our position in California Resources following the announcement as we view further regulatory escalation as likely, creating a disproportional amount of tail default risk.

Intelsat (INTEL): Intelsat underperformed during the fourth quarter after the FCC changed course and decided to hold a public auction for C-Band spectrum, as opposed to letting the satellite companies of the C-Band Alliance (“CBA”) perform a private auction. The market was anticipating a private auction by the CBA which would have resulted in higher proceeds, but after public pushback from Louisiana Senator John Kennedy, the FCC proceeded with a public auction. Additionally, prominent members of Congress have pushed for at least 50% of proceeds to be given to the US Treasury for rural infrastructure buildout, further reducing proceeds to Intelsat. We believe the move down in bonds was overdone and remain optimistic that despite an FCC run auction and pushback from Congress on allocation of proceeds, Intelsat will be appropriately compensated for relinquishing their spectrum.

Note: Securities discussed are the largest positive and negative contributors for the specific High Yield strategy.

Select High Yield

* Index as of quarter end rebalance

*CC, C, D & NR

Sector & Issuer

Positive Contributors (top three):


GEO Group (GEO):
“GEO” (a real estate investment trust “REIT” that manages secure institutions, ICE processing centers, and community reentry facilities around the globe), reported solid 3Q’19 earnings, and modestly increased forward guidance for full year, 2019. Compared to the previous year, fiscal 2019 revenues, adj. EBITDA and adj. funds from operations are now projected to increase 7%, 9% and 10%, respectively. The company generates predictable and substantial discretionary free cash flow, maintains strong liquidity and has modest debt maturities before 2024.

Laredo Petroleum (LPI): Laredo Petroleum outperformed after reporting strong 3Q19 results that beat expectations andguiding FCF generation going forward. Further, the company announced two small bolt-on acquisitions, one in Howard County and the second around Laredo’s existing footprint. The expansions addressed investor concern regarding inventory runway (2+ years of tier 1 well locations added), and are set to accelerate the company’s oil cut as a percentage of production from low 30% to greater than 40% which was taken positively by credit investors as the inventory and high gas production have been investor overhangs on the name historically.

Icahn Enterprises (IEP): Icahn Enterprises Holdings L.P. (95% owned by Carl Icahn), owns interests in subsidiary companies with both private and public company investments. Public market investments are currently valued well in in excess of 2x net holding company debt; other private subsidiary investments (primarily Icahn Automotive) provide additional, substantial asset coverage. Investment fund performance was weak in 3Q’19, primarily due to a net short positioning; however, not a meaningfully negative for its public bonds. Current capital markets have been providing the opportunity to call, and refinance near-term, higher coupon debt.

Negative Contributors (bottom three):

Intelsat (INTEL): Intelsat underperformed during the fourth quarter after the FCC changed course and decided to hold a public auction for C-Band spectrum, as opposed to letting the satellite companies of the C-Band Alliance (“CBA”) perform a private auction. The market was anticipating a private auction by the CBA which would have resulted in higher proceeds, but after public pushback from Louisiana Senator John Kennedy, the FCC proceeded with a public auction. Additionally, prominent members of Congress have pushed for at least 50% of proceeds to be given to the US Treasury for rural infrastructure buildout, further reducing proceeds to Intelsat. We believe the move down in bonds was overdone and remain optimistic that despite an FCC run auction and pushback from Congress on allocation of proceeds, Intelsat will be appropriately compensated for relinquishing their spectrum.

GrubHub (GRUB): GrubHub bonds sold-off after reporting disappointing 3Q19 results. Competitive dynamics deteriorated sharply during the 3rd quarter, with competition no longer simply moderating GrubHub’s strong top-line growth, but rather starting to erode the company’s existing customer base. As a result, the company decided to pursue a change in strategy, namely an aggressive growth plan that will significantly pressure near-term EBITDA and FCF. Our comfort with the credit stemmed from its profitable, measured approach to growth and we no longer felt comfortable underwriting the risk once the company decided to pursue the strategy of its irrational peers. Industry consolidation could help drive improved competitive dynamics, but M&A may not benefit GrubHub bondholders given its competitors’ weak balance sheets and weak Change of Control language in GrubHub bonds.

California Resources (CRC): California Resources underperformed after the state of California announced that it would block new fracking and steam-injected oil well drilling permits pending a scientific review against the dangers of these activities on local populace. This represents a stark 180 from Governor Newsom’s previously stated position that he would not (and did not have the power to) outright ban fracking/steam injection. While California Resources stated that they do not use well completions linked to the moratorium, a crux of California Resources’ deleveraging story is a sale of an overriding royalty interest in its current acreage, and this moratorium will likely make such a sale less attractive to buyers and delay needed debt retirement going forward. We sold our position in California Resources following the announcement as we view further regulatory escalation as likely, creating a disproportional amount of tail default risk.

Note: Securities discussed are the largest positive and negative contributors for the specific High Yield strategy.

Quality High Yield

* Index as of quarter end rebalance

*NR & NA

Sector & Issuer

Positive Contributors (top three):


Horizon Pharma (HZNP):
HZNP’s strong performance over the quarter was mainly led by the FDA Advisory Committee’s unanimous support for its Thyroid Eye Disease (TED) drug Teprotumumab. Tepro, which is the second big drug in the company’s orphan and rheumatology portfolio, could see peak sales of >$700mn (per company’s projections) resulting in >50% top-line growth. With a conservatively leveraged balance sheet, strong cash flow generation and no imminent litigation risk, HZNP continues to perform well among pharmaceutical peers.

GEO Group (GEO): “GEO” (a real estate investment trust “REIT” that manages secure institutions, ICE processing centers, and community reentry facilities around the globe), reported solid 3Q’19 earnings, and modestly increased forward guidance for full year, 2019. Compared to the previous year, fiscal 2019 revenues, adj. EBITDA and adj. funds from operations are now projected to increase 7%, 9% and 10%, respectively. The company generates predictable and substantial discretionary free cash flow, maintains strong liquidity and has modest debt maturities before 2024.

Icahn Enterprises (IEP): Icahn Enterprises Holdings L.P. (95% owned by Carl Icahn), owns interests in subsidiary companies with both private and public company investments. Public market investments are currently valued well in in excess of 2x net holding company debt; other private subsidiary investments (primarily Icahn Automotive) provide additional, substantial asset coverage. Investment fund performance was weak in 3Q’19, primarily due to a net short positioning; however, not a meaningfully negative for its public bonds. Current capital markets have been providing the opportunity to call, and refinance near-term, higher coupon debt.

Negative Contributors (bottom three):

GrubHub (GRUB): GrubHub bonds sold-off after reporting disappointing 3Q19 results. Competitive dynamics deteriorated sharply during the 3rd quarter, with competition no longer simply moderating GrubHub’s strong top-line growth, but rather starting to erode the company’s existing customer base. As a result, the company decided to pursue a change in strategy, namely an aggressive growth plan that will significantly pressure near-term EBITDA and FCF. Our comfort with the credit stemmed from its profitable, measured approach to growth and we no longer felt comfortable underwriting the risk once the company decided to pursue the strategy of its irrational peers. Industry consolidation could help drive improved competitive dynamics, but M&A may not benefit GrubHub bondholders given its competitors’ weak balance sheets and weak Change of Control language in GrubHub bonds.

California Resources (CRC): California Resources underperformed after the state of California announced that it would block new fracking and steam-injected oil well drilling permits pending a scientific review against the dangers of these activities on local populace. This represents a stark 180 from Governor Newsom’s previously stated position that he would not (and did not have the power to) outright ban fracking/steam injection. While California Resources stated that they do not use well completions linked to the moratorium, a crux of California Resources’ deleveraging story is a sale of an overriding royalty interest in its current acreage, and this moratorium will likely make such a sale less attractive to buyers and delay needed debt retirement going forward. We sold our position in California Resources following the announcement as we view further regulatory escalation as likely, creating a disproportional amount of tail default risk.

ORBCOMM (ORBC): Orbcomm underperformed in the fourth quarter following mixed 4Q results and 2020 guidance as a result of the slowdown in the North America transport market, namely industrial trucking. As a provider of satellite IoT solutions for transport containers, Orbcomm saw orders slow as companies pushed-out their container orders following large declines in volume. The Orbcomm bond is a small, illiquid issue with only one market-maker who was a seller which led to it getting marked down. Fundamentals remain intact and Orbcomm still expects revenue and EBITDA growth through 2020 from new order wins in other end markets including maritime shipping, heavy equipment, and government.

Note: Securities discussed are the largest positive and negative contributors for the specific High Yield strategy.

Short Duration High Yield

* Index as of quarter end rebalance

*NR & NA

Sector & Issuer

Positive Contributors (top three):


GEO Group (GEO):
“GEO” (a real estate investment trust “REIT” that manages secure institutions, ICE processing centers, and community reentry facilities around the globe), reported solid 3Q’19 earnings, and modestly increased forward guidance for full year, 2019. Compared to the previous year, fiscal 2019 revenues, adj. EBITDA and adj. funds from operations are now projected to increase 7%, 9% and 10%, respectively. The company generates predictable and substantial discretionary free cash flow, maintains strong liquidity and has modest debt maturities before 2024.

Bausch Health (BHCCN): Bausch health reported another quarter of strong results that beat street estimates for revenue and EBITDA in November. In addition to these strong results, the company reported that it has resolved the 2015 US securities class action suit related to the sharp drop in the then Valeant’s stock price. The debt-funded c. $1.2bn settlement, while large and leveraging, resolved one of the largest unknown litigation liabilities faced by BHCCN (it remains free of the opioid and generic drug pricing litigations faced by most pharmaceutical peers). The company issued $2.5bn of new notes, using half of the proceeds to fund the settlement and the remainder to partially redeem 2023 notes.

Laredo Petroleum (LPI): Laredo Petroleum outperformed after reporting strong 3Q19 results that beat expectations and guiding FCF generation going forward. Further, the company announced two small bolt-on acquisitions, one in Howard County and the second around Laredo’s existing footprint. The expansions addressed investor concern regarding inventory runway (2+ years of tier 1 well locations added), and are set to accelerate the company’s oil cut as a percentage of production from low 30% to greater than 40% which was taken positively by credit investors as the inventory and high gas production have been investor overhangs on the name historically.

Negative Contributors (bottom three):

California Resources (CRC): California Resources underperformed after the state of California announced that it would block new fracking and steam-injected oil well drilling permits pending a scientific review against the dangers of these activities on local populace. This represents a stark 180 from Governor Newsom’s previously stated position that he would not (and did not have the power to) outright ban fracking/steam injection. While California Resources stated that they do not use well completions linked to the moratorium, a crux of California Resources’ deleveraging story is a sale of an overriding royalty interest in its current acreage, and this moratorium will likely make such a sale less attractive to buyers and delay needed debt retirement going forward. We sold our position in California Resources following the announcement as we view further regulatory escalation as likely, creating a disproportional amount of tail default risk.

ORBCOMM (ORBC): Orbcomm underperformed in the fourth quarter following mixed 4Q results and 2020 guidance as a result of the slowdown in the North America transport market, namely industrial trucking. As a provider of satellite IoT solutions for transport containers, Orbcomm saw orders slow as companies pushed-out their container orders following large declines in volume. The Orbcomm bond is a small, illiquid issue with only one market-maker who was a seller which led to it getting marked down. Fundamentals remain intact and Orbcomm still expects revenue and EBITDA growth through 2020 from new order wins in other end markets including maritime shipping, heavy equipment, and government.

Oasis Petroleum (OAS): Oasis Petroleum underperformed after investor concerns arose that Bakken crude and natural gas differentials would drag on 3Q19 hydrocarbon price realizations as offtake capacity remained challenged in the basin, especially on the gas side. This came following results from Northern Oil and Gas (which has a meaningful portion of its minority working interests in Oasis wells) reporting weak realizations and delays/well shut-ins during 3Q19 related to heavy rain forcing production halts. We sold Oasis bonds ahead of earnings on this news to remove the risk related to the basin exposure, which we saw as downside skewed.

Note: Securities discussed are the largest positive and negative contributors for the specific High Yield strategy.

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.

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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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