High yield bond performance got off to a strong start in the first quarter, benefiting from a relatively benign economic and interest rate environment. There was a surprisingly muted response following the political upheaval in the Ukraine. A dip in new issuance also lent technical support to the market and bolstered demand for those deals that did get completed.
Since the start of the year high yield spreads have tracked equities, tightening 24 basis points (bps) over Treasuries during the quarter.1 Average yields declined 34 bps.2 Nevertheless, we saw $2.5 billion in inflows to high yield mutual funds. Demand for leveraged loans has remained extremely strong, with a string of inflows that has persisted for 94 consecutive weeks.3
Deal quality has weakened for leveraged loans – a reflection of the strong demand for floating rate debt amidst a cloudy outlook for interest rates. Approximately half the proceeds of new loan issuance has been for shareholder-friendly activity, such as leveraged buyouts or dividends, while the balance has been for refinancing purposes. Quality in the high yield market has been marginally better, with about 55% of issuance slated to fund re-financings.4 We are constantly comparing this credit cycle with those of the past for clues to help determine how much risk to prudently assume. Credit cycles are all similar in many respects, but differ in ways such as length, intensity, and degree of valuation distortion. Issuers and underwriters are consistently attempting to weaken provisions in the indenture to capture value from lenders. One worrying trend we have seen that is new in this cycle is the lowered level of financial disclosure that some companies seek to provide. We have seen deals in which companies are not required to hold quarterly calls, or provide Management Discussion and Analysis with results. This lowered level of information, along with very primitive financial disclosure, may make it difficult to follow and assess how well companies are performing.
Another worrisome development has been a general weakening in debt covenants, which are designed to protect investors from a sudden deterioration in an issuer’s financial outlook. So-called “covenant-lite” loans represented 57% of total bank loan issuance in 20135 and now account for almost half of the bank loan market. In the high yield bond market, issuers have sought to weaken call protection by shortening the call period, adding special call provisions, or increasing the amount of debt that they can redeem through an equity issuance.
To be sure, default rates are near historic lows at between 1% and 2%6 over the last 12 months, and overall spreads remain attractive at 368 basis points above Treasuries7 . Still we continue to closely watch for signs of deteriorating credit quality.
The Fund returned 2.58% year-to-date for Class I shares as of March 31, 2014. 8 Our results were hurt somewhat by our under-exposure to BB-rated credits. These outperformed in the first quarter, rebounding from the second half of 2013 despite the implementation of the long-awaited tapering of extraordinary Fed accommodation.
We remain focused on credit fundamentals, rather than having a definitive view about the direction of Treasury yields. We have brought our BB exposure up to 37% of the portfolio, as the compression in credit spreads reduces our incentive to reach lower in the credit spectrum for additional yield (and risk). Accordingly, our B exposure has declined from 53% to 49% of assets. We believe that our remaining bias toward B credits, along with our 17% weighting in loans, will help preserve our portfolio in the event that Treasury yields do indeed rise.
First Eagle’s top five contributors
The top five contributors to performance were KEMET Corporation (NYSE:KEM) 10.5% 05/01/2018 (+0.09%), Mood Media Corp (TSE:MM) (LON:MM) 9.25% 10/15/2020 (+0.08%), Atlas Energy LP (NYSE:ATLS) 7.75% 01/15/2021 (+0.08%), AngloGold Ashanti Limited (ADR) (NYSE:AU) 8.5% 07/30/2020 (+0.07%) and ACCO Brands Corporation (NYSE:ACCO) 6.75% 04/30/2020 (+0.07%).
First Eagle’s top five detractors
The top five detractors were Drill Rigs Holding, Inc. 6.5% 10/01/2017 (-0.02%), Aleris Corp (NYSE:ARS) 7.875% 11/01/2020 (-0.01%), Claire’s Stores, Inc. 9.0% 03/15/2019 (-0.00%), Magnachip Semiconductor Corp (NYSE:MX) 6.625% 07/15/2021 (-0.00%) and Offshore Group Investments Ltd. 7.5% 11/01/2019 (-0.00%).
We continue to believe the default outlook is benign, helped in part by a dearth of significant maturities in the high yield debt market over the next few years. As long as interest rates remain repressed, high yield will continue to look attractive to those seeking to balance current return and exposure to duration risk. However, we will be cautious in the face of weakening fundamentals and will modify portfolio risk accordingly.
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 www.feim.com or by calling 800.334.2143.
The annual expense ratio is based on expenses incurred by the fund, as stated in the most recent prospectus.
Had fees not been waived and/or expenses reimbursed in the past, returns would have been lower. Class I Shares require $1MM minimum investment, and are offered without sales charge. Performance information is for Class I Shares without the effect of sales charges and assumes all distributions have been reinvested and if a sales charge was included values would be lower. Class A and C shares have maximum sales charge of 4.50% and 1.00% respectively, and 12b-1 fees, which reduce performance. The Fund commenced operations in its present form on December 30, 2011, and is successor to another mutual fund pursuant to a reorganization December 30, 2011. Information prior to December 30, 2011 is for this predecessor fund. Immediately after the reorganization, changes in net asset value of the Class I shares were partially impacted by differences in how the Fund and the predecessor fund price portfolio securities.
Funds that invest in bonds are subject to interest-rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk, in which the bond issuer may fail to pay interest and principal in a timely manner, or that negative perception of the issuer’s ability to make such payments may cause the price of that bond to decline.
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