First Eagle High Yield Fund Q2 commentary
The financial markets were buffeted by shifting yield expectations brought upon by May commentary from Fed Chairman Ben Bernanke indicating that further accommodation will be data dependent. While the message was unsurprising, the timing caught most by surprise and resulted in the 10-year treasury yield increasing 86 basis points.1
Volatility also increased across the board as investors digested this “new'” piece of information. High yield wasn’t spared in this broad sell-off as interest rate risk (through declining yields) had crept into the valuation discussion.
Despite this upheaval, we feel the outlook for the high yield market remains constructive. Moreover, in contrast to this recent yield induced sell-off, performance of the high yield market has historically been less correlated with increases in interest rates than other fixed income asset classes, such as investment grade and Treasuries. Generally, high yield, as an asset class, is largely driven by the fundamental credit quality of sub-investment grade borrowers. Accordingly, spreads and prices are ultimately determined by the level and volatility of corporate cash flows as well as the willingness and ability of borrowers to repay their obligations. In our view, these fundamental attributes remain sound as of June 30, 2013.
As many companies continued to focus on managing their balance sheets, default rates remained relatively low. According to Standard & Poor’s (S&P), as of June 30, 2013, the default rate for the last twelve months was 2.5%.2
In addition to the low default rate, the percentage of new issue proceeds used for refinancing is another variable which has historically indicated the relative strength of the high yield market. Year to date as of 6/30/2013, the percentage of new issue proceeds used for refinancing was 63% compared to 33% and 43% in 2007 and 2008, respectively.3
While high yield returns may have been negatively impacted in the near term, the correction we saw in the second quarter of the year produced valuations we feel are more attractive.
Although we are constructive on the high yield market, no investment is without risks. We are cognizant of the gradual deterioration of covenant structures and the resurgence of interest in collateralized loan obligations (CLOs). We feel the CLO demand in 2004, 2005 and 2006 led to a decline in underwriting standards, which eventually spilled over into the high yield market. So far we have not seen the rise in investments in CLOs lead to a steep decline in underwriting standards. Also, given the accommodative credit markets, it was not surprising to see a revival in mergers and acquisitions activity. There were several large deals announced during the first six months of 2013, including Berkshire Hathaway’s purchase of H.J. Heinz for $27 billion, and the $24 billion buyout of Dell Computer. Despite these high profile leveraged buyouts (LBOs), strategic acquisition activity has dominated the M&A landscape as companies seek ways to increase productivity through cost and capacity rationalization. Historically, this type of acquisition activity has generally been neutral to positive for credit quality. In contrast, financially motivated transactions have tended to increase the debt burden of corporations.
Our overweighting in Consumer Cyclical and underweighting in Technology and Financials positively contributed to the portfolio’s performance over the six-month period. In contrast, we were negatively impacted by our weighting in Energy. The shorter duration of the Fund and our bank loan exposure helped to reduce the impact of the sudden increase in yields. We’ve increased our bank loan exposure from 12% at the end 2012 to approximately 22% as of June 30, 2013
The top five contributors to performance for the first six months were Advanced Micro Devices, Inc. (AMD) 6.0% 05/01/15 (+0.18%), The Sheridan Group, Inc. 12.5% 04/15/14 (+0.12%), Offshore Group Investments Ltd. 7.5% 11/01/19 (+0.12%), Marfrig Overseas Ltd. 9.5% 05/04/20 (+0.11%), and Kemet Corporation (KEM) 10.5% 05/01/18 (+0.10%).
The largest detractors from performance for the six-month period were OGX Petroleo E Gas Participacoes S.A. 8.5% 06/01/18 (-0.49%), Mood Media Corporation 9.25% 10/15/20 (-0.16%), OGX Austria GmbH 8.375% 04/01/22 (-0.13%), SandRidge Energy, Inc. 7.5% 02/15/23 (-0.08%) and Frontier Communications Corporation 8.5% 04/15/20 (-0.05%).
We remain focused on credit fundamentals, but will continue to be diligent about monitoring the Fund’s exposure to rising interest rates. Overall, we continue to favor short duration, single B-rated issues, which accounted for about 61% of the Fund in the second quarter compared with approximately 42%4
in the Barclays Capital U.S. Corporate High Yield Index. But as mentioned, we feel valuations are more attractive given the recent correction and we will make gradual shifts in strategy as opportunities present themselves. We appreciate your confidence and thank you for your support.
First Eagle Investment Management, LLC
The performance data quoted herein represents past performance and does not guarantee future results. Market volatility can dramatically impact the fund’s short-term performance. Current performance may be lower or higher than figures shown. The investment return and principal value will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Past performance data through the most recent month end is available at firsteaglefunds.com or by calling 800.334.2143.
Performance figures reflect contractualwaivers and/or expense limitations,withoutwhich totalreturns may have been lower.
Class I Shares require $1MMminimum investment and are offeredwithout sales charge. Performance information is forClass I Shareswithoutthe effect of sales charges and assumes all distributions have been reinvested and if a sales chargewas included valueswould be lower.Had fees not beenwaived and/or expenses reimbursed,the performancewould have been lower.ClassAandCshares have maximum sales charge of4.50%and 1.00%respectively, and 12b-1fees, which reduce performance.The Fund commenced operations in its presentform onDecember 30, 2011, and is successorto another mutualfund pursuantto a reorganizationDecember 30, 2011. Information priortoDecember 30, 2011is forthis predecessorfund. Immediately afterthe reorganization, changes in net asset value oftheClass I shareswere partially impacted by differences in howthe Fund and the predecessorfund price portfolio securities.
*These are the actualfund operating expenses priorto the application offeewaivers and/or expense reimbursements.TheAdviser has contractually agreed to limit operating expenses ofthe Fund to an annualrate of0.80%forI shares,1.25%forAShares, and 2.00%forCShares,with gross operating expenses of1.03%,1.27%, and 2.02%,respectively.This limitation excludes certain expenses as described in the Fees and Expenses section ofthe prospectus.This limitationwill continue until December 31, 2013.The expense limitation may be terminated by theAdviserin future years.
The Fund invests in high yield securities (commonly known as “junk bonds”) which are generally considered speculative because they may be subject to greater levels of interest rate, credit (including issuer default) and liquidity risk than investment grade securities and may be subject to greater volatility. The Fund invests in high yield securities that are non-investment grade. High yield, lower rated securities involve greater price volatility and present greater risks than high rated fixed income securities. High yield securities are rated lower than investment-grade securities because there is a greater possibility that the issuer may be unable to make interest and principal payments on those securities. All investments involve the risk of loss.
Bank loans are often less liquid than other types of debt instruments. There is no assurance that the liquidation of any collateral from a secured bank loan would satisfy the borrower’s obligation, or that such collateral could be liquidated.
Funds that invest in bonds are subject to interest-rate risk and can