Aristotle Capital Management Corporate Credit Q1 2022 Commentary
Jay Yuno/E+ via Getty Images
Summary
U.S. corporate credit markets declined sharply in the first quarter amidst a large backup in interest rates as bank loans significantly outperformed high yield bonds and investment grade corporate bonds in the first quarter. Bank loans returned -0.10% during the period as measured by the Credit Suisse Leveraged Loan Index. High yield bonds faced their worst quarter since the first quarter of 2020 and returned -4.84% as measured by the Bloomberg U.S. Corporate High Yield Bond Index. Investment grade corporate bonds underperformed amidst a rout in longer duration assets and returned -7.69%, the worst quarterly return since 2008, as measured by the Bloomberg U.S. Corporate Bond Index.
U.S. equities fell as the S&P 500 Index returned -4.60% during the period. The decline was driven by several factors including an aggressive hawkish pivot from global central banks led by the Federal Reserve (FED), persistent inflationary pressures and a spike in geopolitical tensions emerging from Russia’s invasion of Ukraine in February. U.S. economic data painted a mixed picture as the labor market continued to improve while inflation continued to rise. The unemployment rate fell to 3.8% in February, its lowest level since February 2020, while inflation accelerated further from already elevated levels as the February Consumer Price Index (CPI) rose by 7.9% year-over-year, the fastest annual pace in nearly 40 years. At its March meeting, the Fed voted to raise the target for the benchmark federal funds rate by 25 basis points, the first increase since 2018. The Fed reiterated additional interest rate hikes will be needed, and it will accelerate the pace of tapering, reducing its holdings of Treasuries, agency debt and agency mortgage-backed securities (MBS). Geopolitical tensions also rose significantly with Russia’s invasion of Ukraine, further clouding the global economic outlook and sparking a broad-based rally in commodities. On the COVID-19 front, while trends continued to improve in the U.S., a resurgence in China toward the end of the quarter led to regional lockdowns and added further uncertainty to the global growth outlook.
Market Environment
U.S. Treasury yields rose sharply in the first quarter with the front end of the curve leading the way, resulting in significant bear flattening. The yield on the U.S. 2-Year note climbed roughly 160 basis points during the period, while the yield on the U.S. 10-Year note rose roughly 83 basis points. The curve flattened further and threatened inversion beyond the 2-Year point toward the end of the quarter as the Treasury market rapidly repriced the Fed’s tightening cycle. Longer duration bonds underperformed as the Bloomberg U.S. Aggregate Bond Index fell 5.93%, its largest quarterly decline in more than 40 years.
Alongside the selloff in risk assets, corporate credit spreads widened modestly but ended the quarter well off their widest levels seen in early March. High yield bond spreads widened roughly 38 basis points but ended the quarter more than 80 basis points below the March high as measured by the Bloomberg U.S. Corporate High Yield Bond Index. Investment grade corporate bond spreads also widened roughly 22 basis points as measured by the Bloomberg U.S. Corporate Bond Index.
High yield bond issuance slowed markedly in the first quarter with issuance totaling roughly $43 billion, the lowest first quarter total since 2016, as borrowers were cautious amidst the market turmoil and sharp backup in yields. Investment grade corporate bond issuance topped $450 billion in the first quarter with issuance rebounding in March, as monthly supply topped $230 billion. Additionally, leveraged loan supply totaled close to $110 billion in the first quarter, a modest slowdown compared to last year’s pace.
On the demand side, investors continued to favor bank loan funds over high yield bond and investment grade corporate bond funds amidst robust demand for floating-rate instruments. U.S. leveraged loan funds experienced inflows of nearly $20 billion in the first quarter, while U.S. high yield bond funds experienced outflows of nearly $25 billion and investment grade corporate bond funds experienced outflows of more than $10 billion.
Within the high yield bond market, the riskier segments outperformed as ‘B’s (-3.53%) and ‘CCC’s (-3.88%) outperformed ‘BB’s (-5.94%) with higher quality bonds bearing more interest rate risk than the lower quality segments of the market. From an industry perspective, Energy (-2.60%) outperformed led by the rally in commodities, while Communications (-6.60%) trailed the broader high yield bond market. Default activity remained very low by historical standards with only $1.6 billion of actual defaults during the quarter as the 12-month trailing, par-weighted U.S. high-yield default rate fell to a record low of 0.23% at the end of March.
Performance and Attribution Summary
High Yield Bond
The Aristotle High Yield Bond Composite returned -3.44% gross of fees (-3.49% net of fees) in the first quarter, outperforming the -4.58% return of the ICE BofA BB-B U.S. Cash Pay High Yield Constrained Index.
Security selection contributed to relative performance led by holdings in Media & Entertainment and Retailers & Restaurants. This was partially offset by security selection in Industrials and Telecommunications. Sector rotation also contributed to relative performance led by the allocation to bank loans, which was only partially offset by the allocation to investment grade corporate bonds. Additionally, industry allocation contributed modestly to performance led by an underweight in Food, Beverage & Tobacco and an overweight in Transportation. This was partially offset by overweights in Insurance and Retailers & Restaurants.
| Top Five Contributors | Top Five Detractors |
|---|---|
| Kraft Heinz (KHC) | PBF Energy (PBF) |
| Quad/Graphics (QUAD) | Dell (DELL) |
| Altice (ATUS) | WW International (WW) |
| Tenneco (TEN) | Rent-A-Center (RCII) |
| Gray Television (GTN) | MetLife (MET) |
Investment Grade Corporate
The Aristotle Investment Grade Corporate Bond Composite returned -7.34% gross of fees (-7.41% net of fees) in the first quarter, outperforming the -7.69% return of the Bloomberg U.S. Corporate Bond Index. Sector rotation was the primary contributor to relative performance, while security selection was the primary detractor from relative performance.
The allocation to cash and an underweight in the long end of the yield curve relative to the benchmark contributed to relative performance, while yield curve positioning detracted from relative performance. Industry allocation had a neutral effect on relative performance as an underweight in Industrials and an overweight in Transportation were largely offset by an overweight in Insurance and an underweight in Pharmaceuticals.
Security selection detracted from relative performance led by holdings in Transportation and Insurance. This was partially offset by security selection in Banking and Real Estate Investment Trusts (REITs) & Real Estate-Related.
| Top Five Contributors | Top Five Detractors |
|---|---|
| Wells Fargo (WFC) | MetLife (MET) |
| Verizon (VZ) | United Airlines (UAL) |
| MPT Operating | Ally Financial (ALLY) |
| Prudential Financial (PRU) | Discovery Communications |
| Alexandria Real Estate (ARE) | Brown & Brown (BRO) |
Strategic Credit
The Aristotle Strategic Credit Composite returned -3.44% gross of fees (-3.49% net of fees1) in the first quarter, compared to the -3.45% return of the blended benchmark of one-third Bloomberg U.S. High Yield Ba/B 2% Issuer Capped Bond Index, one-third Bloomberg U.S. Intermediate Corporate Bond Index and one-third Credit Suisse Leveraged Loan Index. Security selection was the primary contributor to relative performance, while sector rotation was the primary detractor from relative performance.
Security selection contributed to relative performance led by holdings in Media & Entertainment and Automotive & Captive Finance. This was partially offset by security selection in Consumer Products and Diversified Manufacturing & Construction Machinery. Industry allocation also contributed modestly to performance led by overweights in Energy and Lodging & Leisure. This was partially offset by overweights in Automotive & Captive Finance and Retailers & Restaurants.
Sector rotation detracted from relative performance led by an underweight in bank loans, which was partially offset by an underweight in investment grade corporate bonds.
| Top Five Contributors | Top Five Detractors |
|---|---|
| Tenneco (TEN) | Wells Fargo (WFC) |
| Carpenter Technology (CRS) | Lumen Technologies (LUMN) |
| CSC Holdings | Air Lease (AL) |
| Murphy Oil (MUR) | Dell (DELL) |
| Antero Resources (AR) | United Airlines (UAL) |
Outlook
We believe three major themes have shaped the performance of corporate credit markets thus far in 2022: A more hawkish Fed, more persistent and higher-than-expected inflation and increased geopolitical risk resulting from Russia’s invasion of Ukraine. Despite the increase in uncertainty generated by these three themes, we continue to believe there are opportunities in U.S. corporate credit markets and maintain a positive outlook, especially for shorter duration high yield bonds.
The overall global macroeconomic backdrop has become significantly cloudier than it was at the end of 2021. While the Fed telegraphed tighter policy toward the end of last year, the Fed’s hawkishness so far in 2022 has caught the market by surprise and led to a rapid selloff, concentrated in the front end of the yield curve. With the Fed signaling quantitative tightening will begin in June, we believe there is the potential for the yield curve to steepen given the backdrop of a still strong economy and the extent of the repricing that has already occurred in the front end of the yield curve.
We also believe inflation risks could prove to be more stubborn than originally forecasted toward the end of last year. The impact of the war in Ukraine on commodity prices is just one example of how exogenous shocks have only magnified issues that could lead to stickier inflation. We believe consumers are already beginning to adapt their behavior to higher inflation, and the resulting rise in consumer inflation expectations could lead to more endemic inflation. In our opinion, there is a possibility that companies could eventually face a slowdown in topline demand as consumers’ discretionary income comes under pressure. For companies, the resulting pressure on margins and pricing power could push them to seek topline growth through more leveraged, shareholder-friendly policies.
High yield supply decreased more than we originally expected in the first quarter, and we believe issuance may continue to fall below expectations over the next few quarters. In our opinion, the opportunistic refinancing window for corporates is closed, thus the issuance that does occur this year could be used to fund share repurchases and mergers and acquisitions (M&A). We believe a shift from refinancing-related issuance to M&A and share repurchase-related issuance would be negative for credit market fundamentals. In the investment grade market, we also expect issuance to slow down, which would be positive on the margin for the supply/demand picture.
We believe overall risk, from geopolitical to credit risk, has increased significantly over the past three months. While we see these risks persisting in the coming quarters, we believe the best strategy to protect against these risks is to focus on credit fundamentals and segments of the market that, in our opinion, have already priced in what we believe to be a significant amount of risk, while seeking to avoid the segments of the market that could succumb to less balance sheet-friendly activities.
High Yield Bond Positioning
In our high yield bond portfolios, we continue to favor short duration high yield bonds, especially after the rapid repricing of the 2- to 3-year segment of the yield curve over the past quarter. From an industry perspective, we adjusted our portfolios to add exposure to companies that focus on providing consumer experiences rather than consumer goods.
While duration and interest rates are typically inversely correlated, duration has increased for many high yield bond benchmarks over the past quarter despite the large backup in U.S. yields. Before the increase in interest rates, many bonds had been trading to their call date but as interest rates have increased, these bonds are now trading to their maturity date. We believe most of this adjustment has already happened, and we continue to hold a duration underweight relative to the benchmark in our high yield bond portfolios.
With the reopening of the economy, we also believe there is pent-up demand for consumer experiences (e.g., travel and concerts), which could benefit companies in certain industries. Despite rising input costs, we believe some of the areas that may benefit are concert and event providers, conference-oriented lodging providers and airlines. As a result, we increased exposure to these areas, holding overweights in Media & Entertainment, Transportation and Lodging & Leisure alongside underweights in Technology, Telecommunications and Healthcare.
Investment Grade Corporate Positioning
In our investment grade corporate bond portfolios, we continue to favor credit risk over interest rate risk and remain overweight ‘BBB’-rated credits and underweight duration relative to the benchmark. From an industry perspective, we only modestly adjusted exposure during the quarter.
The sharp backup in interest rates in the first quarter led to historically large drawdowns for longer duration, higher quality segments of the fixed income market. We believe a steeper yield curve could lead to further losses in this segment of the market, and we seek to maintain an underweight in duration. Despite the duration underweight in our investment grade corporate bond portfolios, the overweight in ‘BBB’-rated credits has helped keep the effective yield in our investment grade corporate bond portfolios above that of their respective benchmarks. Nonetheless, the overweight in ‘BBB’-rated credits weighed on performance in the first quarter as the credit spread on ‘BBB’-rated credits widened more than that of the higher quality tiers in the investment grade corporate bond universe.
Within our investment grade corporate bond portfolios, we added an overweight in Media & Entertainment driven by idiosyncratic factors. Otherwise, industry-level exposure was quite similar compared to exposure at the end of 2021. At the end of the quarter, we held overweights in Insurance, Transportation and Brokerage & Asset Management alongside underweights in Banking, Pharmaceuticals and Retailers & Restaurants.
Strategic Credit Positioning
In our strategic credit portfolios, we increased an overweight in high yield bonds while further increasing underweights in bank loans and investment grade corporate bonds. We also maintained a duration underweight relative to the blended benchmark as we have over the past several quarters.
Despite the relative outperformance of bank loans during the quarter, the deterioration in the backdrop for risk assets has led us to hold off on increasing exposure to bank loans, as we believe bank loans hold significantly more liquidity risk and credit risk than other segments of the corporate credit market. Instead, we increased our exposure to shorter duration, higher quality high yield bonds while reducing hybrid investment grade corporate bond exposure in our strategic credit portfolios.
As of March 31, the strategy was composed of 71.4% high yield bonds, 18.4% investment grade corporate bonds and 6.4% bank loans. Roughly 3.8% was held in cash. We held overweights in Lodging & Leisure, Energy and Transportation alongside underweights in Technology, Banking and Healthcare.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.