"We maintain a constructive outlook on below investment grade corporate credit."- Crescent Capital Group LP
Market in Review
The U.S. high yield asset class continued to grind higher in the third quarter of 2019, delivering a 1.22% return as measured by the ICE BofAML US High Yield Index. For the year to date, U.S. high yield has returned 11.50%, outperforming most other fixed income asset classes, specifically leveraged loans, emerging markets high yield, and European high yield, and only slightly behind U.S. investment grade. Despite the ongoing U.S.-China trade dispute and oil price volatility, the U.S. high yield market continued to be supported by a dovish Federal Reserve, stronger than expected earnings, and decent U.S. macroeconomic data. As a result of constructive market conditions, high yield spreads tightened from 371 basis points to 328 basis points during the quarter. Spread compression was a persistent theme across high yield credit tiers during the quarter, with BB, B, and CCC-credit tier spreads narrowing by 47, 38, and 59 basis points, respectively. The Fed continued easing monetary policy, cutting its federal funds rate target by 25 basis points in both July and in September; notably, these were the first rate cuts since 2008. West Texas Intermediate (WTI) oil prices fell 8% during the quarter, ending at $54.07 a barrel, but the S&P 500 increased 1.70% for the quarter. U.S. Treasury yields fell during the quarter; the 10-year yield decreased by 34 basis points and the 5-year yield decreased by 22 basis points; they ended the quarter at 1.66% and 1.54%, respectively.
In the third quarter of 2019, the Harbor High-Yield Opportunities Fund (Institutional Class) returned 1.62%, outperforming its benchmark, the ICE BofAML US High Yield Index (H0A0), which returned 1.22%.
Similar to the previous quarter, the main driver of outperformance was the Fund’s significant underweight in the Energy sector. Energy was the worst performing sector during the third quarter, with a -4.06% return, while all other sectors delivered positive returns. Additionally, strong security selection within Energy benefited the Fund by avoiding exposure to issuers that were sold off, such as McDermott International and EP Energy. The Fund also exhibited strong security selection in Communication Services and in the consumer goods, leisure, and capital goods industries. Lastly, the overweight to Financials also benefited the Fund. Weak security selection in the Health Care and Technology sectors detracted from relative performance.
In terms of credit quality, the BB-rated credit tier outperformed B and CCC-rated credit tiers during the quarter. Specifically, the BB-rated credit tier returned 2.05%, while the B-rated credit returned 1.22% and CCC-rated credit returned -1.73%. As a result, the Fund benefited from an underweight positioning and strong security selection in the CCC and below credit tier. The Fund also benefited from an overweight positioning in the BB-rated credit tier, which outperformed all other credit tiers. Lastly, strong security selection in the BB and B-rated credit tiers also benefited the Fund.
The Fund maintains a market neutral duration position. We believe the Fed may cut interest rates in the next few quarters as a result of a tightening of credit conditions and signs of slowing economic growth.
The Fund is underweight basic industry, which had a negative impact on performance, Energy (positive impact) and Real Estate (negative impact). We believe these sectors exhibit fundamental challenges and poor relative value. The Fund is overweight media, which had a positive impact, Financials (positive) and consumer goods (positive). We believe these sectors and industries exhibit favorable fundamentals and good relative value.
The Fund is overweight the BB tier (positive impact) and underweight both B (negative impact) and CCC and below (positive). Credit quality exposures are a fallout from our bottom up research process, our view on the relative value offered by different credit rating tiers, and our duration positioning.
The Fund had a 2.3% exposure to investment grade credits, which had a positive impact.
Contributors and Detractors
Contributors to performance during the quarter included Icahn Enterprises, Altice France, and Sprint. Icahn Enterprises bond prices benefited from strong demand for high quality BB-rated paper, as well as quarterly results that were generally in line with expectations. Altice France bonds outperformed due to strong quarterly results, with earnings before interest, tax, depreciation and amoritization (EBITDA) up over 10% both on a sequential and annual basis. Furthermore, subscriber metrics continued to improve across most of the company’s operating regions. As a result, company management provided better than expected forward guidance. Sprint bonds continue to benefit from growing confidence that the company’s planned merger with T-Mobile will receive all required regulatory approvals at both the state and federal levels.
Detractors included Mallinckrodt, Whiting Petroleum, and California Resources. Mallinckrodt bond prices remain under pressure due to continued weakness within the overall pharmaceutical industry, due to increasing scrutiny on drug pricing as well as opioid-related litigation. Furthermore, the company’s bonds were negatively affected by idiosyncratic concerns related to reimbursement risk associated with one of the company’s primary drugs. Whiting Petroleum reported quarterly results that were sharply below expectations, primarily due to lower than anticipated production, in addition to continued weakness across the entire high yield energy sector. California Resources reported quarterly results that were slightly below expectations due to weaker than anticipated commodity price realizations and slower than expected progress at monetizing non-core assets in an effort to bolster liquidity, in addition to continued weakness across the entire high yield energy sector.
Buys and Sells
During the quarter, we added to our existing position in Altice, as our analyst believed the company may continue to see strong operational improvements that could drive spread compression, and that these notes would benefit the most within the company’s capital structure.
We reduced exposure to the Energy sector throughout the quarter, exiting positions in Chesapeake Energy, Denbury Resources, and Oasis Petroleum, as we believe fundamentals within the sector will continue to deteriorate over the coming months as growing demand fears exacerbate already volatile commodity prices. Furthermore, capital markets access is limited for all but the most creditworthy borrowers within the sector, restricting the ability to extend looming debt maturities.
We maintain a constructive outlook on below investment grade corporate credit. Rate concerns have subsided with a dovish pivot in Fed monetary policy, which is a positive development for credit assets. We believe the market is now expecting two additional rate cuts by the Fed by the end of 2019. Fundamentals in the U.S. high yield space remain stable, with minor signs of weakness. Specifically, in the second quarter, leverage ratios decreased to 4.07 times following a small uptick in the first quarter. Leverage ratios still remain below historical averages and have been improving in 11 out of the last 12 quarters. Revenue and EBITDA growth was positive year-over-year but is showing signs of deceleration, in our view. Continued strength in technical factors is supportive of U.S. high yield, we believe, as fund flows have reversed trend since last year and now stand at a positive $13.6 billion year-to-date. At the beginning of the year, many sell-side analysts were forecasting a mid-to-high single digit return in 2019 for U.S. high yield, but some have since upwardly revised their forecasts, noting the improved return profile offered by U.S. high yield after the year-end 2018 spread widening. Major rating agencies project defaults to come in below 3.0% in 2019, well below the historical average of 4.6%.
We do not foresee any major fundamental concerns for the asset class. Risks to our view include unexpected Fed rate actions, a potential peak in corporate earnings growth, oil price volatility, and rising risks of a global trade war. At present, a continuation of the status quo for the U.S. economy seems most likely, in our view. With Gross Domestic Product (GDP) growth of 2.0% to 3.0% per year, we believe there is concern for neither recession nor overheating in the near-term.
Performance data shown represents past performance, which is no guarantee of future results. Current performance may be higher or lower than the past performance data shown. Investment returns and the value of an investment will fluctuate, and an investor's shares, when sold, may be worth more or less than their original cost. You can obtain performance data current to the most recent month-end (available within seven business days after the most recent month-end) by calling 800-422-1050 or visiting harborfunds.com.
Performance figures discussed reflect that of the institutional class shares.
The views expressed herein are those of the portfolio manager at the time of the interview and may not be reflective of their current opinions or future actions. These views are not necessarily those of the fund company and should not be construed as such.
This information should not be considered as a recommendation to purchase or sell a particular security and the holdings or sectors mentioned may change at any time and may not represent current or future investments.