2020 Q1 High Yield Quarterly

2020 Q1 High Yield Quarterly

In the first quarter of 2020, the Bloomberg Barclays US Corporate High Yield  Index  (“Index”) return was ‐12.68%, and the CAM High Yield Composite gross total return was ‐10.03%. The S&P 500 stock index return was ‐19.60% (including dividends reinvested) for Q1. The 10 year US  Treasury rate  (“10  year”)  generally drifted lower throughout the quarter finishing at 0.67%, down 1.25% from the beginning of the quarter.

The 10 year did make a record low of 0.54% in early March. That is just one of the many records to take place across markets in 2020. During the quarter, the Index option adjusted spread (“OAS”) widened 544 basis points moving from 336 basis points to 880 basis points. During the first quarter, each quality segment of the High  Yield Market participated in the spread widening as BB rated securities widened  472 basis points, B rated securities widened 532 basis points, and CCC rated securities, widened 836 basis  points.   Take  a  look  at  the  chart  below  from  Bloomberg  to  see  the  eye‐popping  visual  of  the  enormous spread move in the Index. The chart displays data for the past five years. Notice the previous ramp in the Index OAS spread from 2015. That ramp took seven months before reaching the peak and topped out around 850 basis points. The ramp‐up this time around happened inside of five weeks and topped out at 1100 basis points. “It sure was a long year this past month,” is a saying that seems to capture the feelings of many across Wall Street as the first quarter closed.

The  Utility,  Technology,  and  Insurance  sectors  were  the  best  performers  during  the  quarter,  posting  returns of ‐5.06%, ‐5.31%, and ‐5.95%, respectively. On the other hand, Energy, Transportation, and REITs  were  the  worst performing  sectors,  posting  returns  of ‐38.94%, ‐20.90%,  and ‐16.87%, respectively. At the industry level, wireless, supermarkets, pharma, and food/beverage all posted the best  returns.   The  wireless  industry  (‐1.04%)  posted  the  highest  return.   The  lowest  performing  industries during the quarter were oil field services, e&p energy, retail REITs, and leisure. The oil field services industry (‐49.18%) posted the lowest return.

During  the  first  quarter,  the  high  yield primary market posted $81.8 billion  in  issuance.   That  is  the  total issuance including a market that was essentially closed for the month of  March.   Issuance within  Financials was the strongest with almost 23% of the total during the quarter.  The  last  few  days  of  March did see the high yield market begin to open up just a bit for issuance. That was a very encouraging sign to see. We expect that  when  the  issuance  door  opens  some  more,  there  will  likely  be  a  flood  of  companies  coming to  market to fortify their balance sheets.

The  Federal  Reserve  was  very  busy  during  the  quarter.   They  pulled  out  all  the  stops  by  not  only  dropping the Target Rate to an upper bound of 0.25%, but they passed numerous programs (PMCCF, SMCCF, TALF, MMLF, CPFF, etc.) in order to keep the credit markets functioning. While they may run out  of  acronyms  at  some  point,  they  truly  are  injecting  unprecedented  amounts  of  support  in  the  markets. Additionally, after some political wrangling, Congress passed a massive $2 trillion rescue package. The package is very wide reaching and a critical piece of legislation that will go a long way to help support businesses and citizens during such a troubling time.

While Target Rate moves tend to have a more immediate impact on the short end of the yield curve, yields on intermediate Treasuries decreased 125 basis points over the quarter, as the 10‐year Treasury yield  was  at  1.92%  on  December  31st,  and  0.67%  at  the  end  of  the  quarter.   The  5‐year  Treasury  decreased 131 basis points over the quarter, moving from 1.69% on December 31st, to 0.38% at the end of the quarter. Intermediate term yields more often reflect GDP and expectations for future economic growth and inflation rather than actions taken by the FOMC to adjust the Target Rate. There is no doubt that  economic  reports  are  going  to  be  quite  noisy  over  the  balance  of  2020.   However,  the  revised  fourth quarter GDP print was 2.1% (quarter over quarter annualized rate), and the current consensus view of economists suggests a GDP for 2020 around ‐1.3% with inflation expectations around 1.3%.

The global pandemic and crumbling oil prices were the main themes in the quarter leading to markets falling at the fastest pace everi. The energy sector was hit especially hard as crude fell from $60 to $20 a barrel.   The  price  drop  was  due  not  only  to  demand  destruction  caused  by  the  COVID‐19  economic  fallout but also a supply side dispute between Russia and Saudi Arabia. An OPEC meeting broke down when Russia wouldn’t agree to production cuts. In a follow‐up move, Saudi Arabia decided that they would not only increase production but slash their selling price as well. The energy market has been reeling  ever  sinceii.   Within  high  yield,  the  downgrades  have  been  plentiful  and  the  bankruptcies  are  beginning to trickle in.

Being  a  more  conservative  asset  manager,  Cincinnati  Asset Management is structurally underweight CCC and lower rated securities. This positioning has served our  clients  well  so  far  in  2020.   As  noted  above,  our  High Yield Composite gross total return has outperformed  the  Index  over  the  first  quarter  measurement period. With the market so weak during the first quarter, our cash position was a main driver of our  overall performance.  Further,  our  structural  underweight  of  CCC  rated  securities  was  a  benefit.   Additionally, our underweight positioning in the communications sector was a drag on our performance. While  our  overweight  positioning  in  energy  hurt  performance,  our  credit  selections  within  the  midstream industry performed much better than the sector. Unfortunately, our credit selections within the  consumer  cyclical  services,  leisure,  and  auto  industries  hurt  performance.  However,  our  underweight in the transportation sector and our overweight in the consumer non‐cyclical sector were bright spots. Further, our credit selections within the media and healthcare industries were a benefit to performance.

The  Bloomberg  Barclays  US  Corporate  High  Yield  Index  ended  the  first quarter  with  a  yield  of  9.44%.   This yield is an average that is barbelled by the CCC‐rated cohort yielding 17.54% and a BB rated slice yielding 7.24%. Equity volatility, as measured by the Chicago Board Options Exchange Volatility Index (“VIX”), had the proverbial moonshot moving from 14 to a high of 83. For context, the average was 15 over the course of 2019. The first quarter had four issuers default  on  their  debt,  and  the  trailing  twelve  month  default rate was 3.35%iii. Default rates are on the rise and the strategists on Wall Street are already bumping up  their  forecasts.  Fundamentals  of  high  yield  companies have been mostly good and will no doubt be tested as we move through 2020. From a technical perspective, supply is still tracking higher than last year at this time even including the March shutdown of  the  primary  market.   High  yield  has  certainly  had  trouble  this  year;  however  there  are  now  many  more opportunities present in the market than existed just three months ago. For clients that have an investment horizon over a complete market cycle, high yield deserves to be considered in the portfolio allocation.

With the High Yield Market trading at the current elevated spread level, it is important that we exercise discipline and selectivity in our credit choices moving forward. We are very much on the lookout for any pitfalls as well as opportunities for our clients. The market needs to be carefully monitored to evaluate that the given compensation for the perceived level of risk remains appropriate on a security by security basis.  It  is  important  to  focus  on  credit  research  and  buy  bonds  of  corporations  that  can  withstand  economic headwinds and also enjoy improved credit metrics in a stable to improving economy. As always, we will continue our search for value and adjust positions as we uncover compelling situations. Finally, we are very grateful for the trust placed in our team to manage your capital through such an  unprecedented time.

This information is intended solely to report on investment strategies identified by Cincinnati Asset Management. Opinions and estimates offered constitute our judgment and are subject to change without  notice,  as  are  statements  of  financial  market  trends,  which  are  based  on  current  market  conditions. This material is not intended as an offer or solicitation to buy, hold or sell any financial instrument. Fixed income securities may be sensitive to prevailing interest rates. When rates rise the  value  generally  declines.   Past  performance  is  not  a  guarantee  of  future  results.   Gross  of  advisory fee performance does not reflect the deduction of investment advisory fees. Our advisory fees  are  disclosed  in  Form  ADV  Part  2A.   Accounts  managed  through  brokerage  firm  programs  usually will include additional fees. Returns are calculated monthly in U.S. dollars and include reinvestment of dividends and interest. The index is unmanaged and does not take into account fees, expenses, and transaction costs. It is shown for comparative purposes and is based on information generally available to the public from sources believed to be reliable. No representation is made to its accuracy or completeness.

i Wall Street Journal March 24, 2020: “Markets Melt Down at Fastest Pace Ever”

ii Wall Street Journal April 1, 2020: “Price War Batters OPEC’s Weak”

iii JP Morgan April 1, 2020: “Default Monitor”