First Eagle High Yield Q1 Commentary: Worrisome DevelopmentVW Staff
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 such collateral could be liquidated.
There are risks associated with investing in funds that invest in securities of foreign countries, such as erratic market conditions, economic and political instability and fluctuations in currency exchange rates. Funds whose investments are concentrated in a specific industry or sector may be subject to a higher degree of risk than funds whose investments are diversified and may not be suitable for all investors.
The fund’s investment strategies may result in high turnover rates. This may increase the Fund’s brokerage commission costs, which would reduce performance. Rapid portfolio turnover also exposes shareholders to a higher current realization of short-term gains, which could cause you to pay higher taxes.
The holdings mentioned herein represent the following percentage of the total net assets of the First Eagle High Yield Fund as of March 31, 2014: Kemet Corporation 10.5% 05/01/2018 1.07%, Mood Media Corporation 9.25% 10/15/2020 0.85%, Atlas Energy Holdings Operating Co. Llc 7.75% 01/15/2021 0.89%, Anglogold Ashanti Holdings Plc 8.5% 07/30/2020 0.87%, Acco Brands Corporation 6.75% 04/30/2020 1.35%, Drill Rigs Holding, Inc. 6.5% 10/01/2017 0.93%, Aleris International, Inc. 7.875% 11/01/2020 0.47%, Claire’s Stores, Inc. 9.0% 03/15/2019 0.67%, Magnachip Semiconductor Corporation 6.625% 07/15/2021 0.89%, and Offshore Group Investments Ltd. 7.5% 11/01/2019 1.01%. The portfolio is actively managed and holdings can change at any time. Current and future portfolio holdings are subject to risk.
The commentary represents the opinion of the High Yield Team Portfolio Managers as of March 31, 2014 and is subject to change based on market and other conditions. The opinions expressed are not necessarily those of the firm. These materials are provided for informational purpose only. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. Any statistics contained herein have been obtained from sources believed to be reliable, but the accuracy of this information cannot be guaranteed. The views expressed herein may change at any time subsequent to the date of issue hereof. The information provided is not to be construed as a recommendation or an offer to buy or sell or the solicitation of an offer to buy or sell any fund or security.
A credit rating as represented here is an assessment provided by a nationally recognized statistical rating organization (NRSRO) or credit worthiness of an issuer with respect to debt obligations, including specific securities, money market instruments, or other bonds. Ratings are measured on a scale that generally ranges from AAA (highest) to D (lowest); ratings are subject to change without notice. Not Rated (NR) indicates that the debtor was not rated and should not be interpreted as indicating low quality. For more information on the Standard & Poor’s rating methodology, please visit standardandpoors.com and select “Understanding Ratings” under Rating Resources.
The Barclays Capital U.S. Corporate High Yield Bond Index is comprised of fixed-rate, publicly issued, non-investment grade debt, is unmanaged, with dividends reinvested, and is not available for purchase. The index includes both corporate and non-corporate sectors. The corporate sectors are Industrial, Utility, and Finance, which include both U.S. and non-U.S. corporations. The index is presented here for comparison purposes only. One cannot invest directly in an index.
Investors should consider investment objectives, risks, charges and expenses carefully before investing. The prospectus and summary prospectus contain this and other information about the Funds and may be obtained by asking your financial adviser, visiting our website at www.feim.com or calling us at 800.334.2143. Please read our prospectus carefully before investing. Investments are not FDIC insured or bank guaranteed, and may lose value.