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Fixed-Income Insights

Here are Lord Abbett’s insights on current trends in the U.S. high-yield market—and how a disciplined investment process can mitigate the latest storm.

With most high-yield indexes down more than 2%, last week was a rough one for the U.S. high-yield bond market. While the decision by Third Avenue Management (Third Avenue) to liquidate its Focused Credit Fund garnered all the headlines, there were many other factors contributing to the volatility. As a result, we have received a number of questions from investors in our leveraged credit products. With yields on the benchmark BofA Merrill Lynch U.S. High Yield Constrained Index (High Yield Index) approaching 9%, we are seeing a number of compelling total return opportunities. Herein, we attempt to answer some of the most important questions, and also to add our thoughts on how Lord Abbett plans to capitalize on the current dislocations in the credit markets:

1) What exactly happened in the high-yield market last week?

In many ways, last week’s activity was much like many other weeks we have seen this year, in which the market was being led lower by the energy and metals and mining sectors. OPEC’s decision not to reduce crude oil supply on Friday, December 4, caused another drop in oil prices, with the benchmark West Texas Intermediate (WTI) grade falling to a multiyear low of less than $36 per barrel at one point during the week. In addition, the market is on pins and needles while waiting for the first rate increase from the U.S. Federal Reserve (Fed) in nine years. (The Fed’s decision is expected on December 16.)

By the time the Third Avenue news started to circulate on Thursday, December 10, trading conditions were already quite choppy. While the initial headlines on Third Avenue made it appear that it was a conventional high-yield fund that had ceased redemptions, many financial publications this weekend have correctly stated that the Focused Credit Fund’s strategy was more akin to that of a hedge fund investing in distressed debt. Meanwhile, all of this has occurred in December, which is not the optimal month to be in search of liquidity in the high-yield market.

2) How much exposure does Lord Abbett have to ‘CCC’ rated issuers in its high-yield mutual fund?

The exposure to ‘CCC’ rated issues is around 12% (as of December 11, 2015) on a market-value basis, which is slightly underweight relative to the Fund’s benchmark, the High Yield Index. By contrast, the Third Avenue fund was reported to have 89% of its assets in credits rated below single ‘B’, according to Morningstar.

3) What percentage of Lord Abbett’s Fund is invested in the top 10 holdings?

The top 10 holdings (issues) currently comprise only 6.9% of the Fund as of December 11, 2015; the top 10 issuers, only 11%. (See more on our risk limits below.)

4) Which aspects of Lord Abbett’s investment process have allowed Lord Abbett to outperform in such a volatile market this year?

There are several elements that have enhanced the Fund’s returns and allowed us to meet the liquidity demands of our clients, such as:

  • Risk limits on position sizing—We have limits on the amount the Fund can overweight an issuer based upon its credit rating. This leads to a more diversified portfolio, as opposed to some of the highly concentrated strategies that have run into trouble recently. This also leads to smaller position sizes, which makes it more efficient to exit an underperforming credit.
  • Analytical process—Our approach features a blend of top-down macro views combined with rigorous bottom-up analysis from our credit analysts. This has allowed the Fund to generate strong returns in both up and down credit markets. For example, our macro insights have allowed us to navigate the volatility in the oil patch quite well over the last year, which has been a key contributor to our outperformance.
  • Liquidity—This is an integral part of our process, and is a key consideration in the development of any new investment strategy at Lord Abbett. Within our high-yield Fund, we target a 3% cash holding to manage daily liquidity needs. As part of our philosophy, the Fund does not carry significant overweights to ‘CCC’ rated credits. This is the least liquid portion of the high-yield market, which many of our peers are learning the hard way right now. We do maintain out-of-index positions in leveraged loans and equities, which allows us to seek out pockets of liquidity in other asset classes when liquidity in the high-yield market is challenging. As of December 11, 2015, the Fund had approximately 8% in equities and convertible debt securities. If we need to quickly raise cash and/or de-risk the Fund, we can do it much more efficiently in the equity market than we could if we were heavily weighted in ‘CCC’ credits.

5) What is the role of equities in a high-yield portfolio?

It’s important to note that Lord Abbett believes that portfolio design is integral to the investment management process. The design of our high-yield strategy allows us to invest in other asset classes, such as leveraged loans and equities. This allows us to take advantage of pockets of liquidity in other markets when it is challenging to trade high yield. We use equities to enhance the Fund’s exposure to investment themes that we may not be able to get access to in the credit markets. We also believe that risk/reward is much more favorable in the equity markets than in ‘CCC’ credits, especially when one factors in trading liquidity. This has held true in 2015 (through December 11), with the S&P 500® Index down 0.27% and the BofA Merrill Lynch CCC & Lower U.S. High Yield Index down more than 14%.

6) What are Lord Abbett’s thoughts on the energy sector?

While we expect commodity prices to remain under pressure in the near term, we do believe that the supply/demand equation should come into balance in late 2016. More than 1,000 drilling rigs have been taken offline in the United States over the past year. The pipeline and oil field services subsectors remain two of the Fund’s largest underweights. The Fund has a small overweight in refining, as well as in exploration and production, where we are seeing a number of attractive total return opportunities.

7) Where are we in the credit cycle?

That’s the big question, one worthy of an entire research report. (As a matter of fact, we will be publishing an in-depth report on the credit cycle early in 2016.)  For now, we will give you the short answer, which was summed up quite well by my colleague Steve Rocco, Partner and lead Portfolio Manager for our high-yield strategies, in a strategy discussion last week. While we are in the late stages of the credit cycle, we are mid-cycle in terms of U.S. economic expansion. In other words, we think the current credit cycle can play out for a few more years. The credit cycle is never truly “over” until the economy enters recession, which is not our base case for 2016. In fact, to exit the high-yield market at current valuations, one would have to be of the mind that we are heading into a recession and that the spreads on the high-yield index will soon be trading at a spread above 1,000 basis points (bps) over U.S. Treasuries. If not, we would argue that investors should at least have some exposure to the asset class. As of the close on December 12, 2015, spreads on the high-yield index are more than 700 bps, roughly 100 bps above their long-term average and, year to date, 200 bps wider. Valuations in the leveraged loan market are also quite compelling right now.

We have said for some time that the credit cycle is fairly long in the tooth and the Fed’s “liftoff” would lead to meaningful volatility in the credit markets. This has played out in the leveraged credit markets over the last few months. While this market is very challenging, the ensuing performance dispersion helps highlight the benefits of a consistent and disciplined investment process rather than making outsized bets on particular sectors or rating categories. Today’s volatility also presents a number of opportunities for those asset managers that were well positioned going into this environment, and can approach new opportunities from a position of strength. We look forward to capitalizing on these opportunities, and will strive to continue to deliver strong risk-adjusted returns for all clients in our leveraged credit strategies.

8) How could the U.S. Federal Reserve’s anticipated rate hike on December 16 play into all this?

We honestly do not spend much time discussing the when or if of Fed policy in our more recent strategy meetings. Our thoughts are in line with the consensus regarding the timing and magnitude of the Fed’s tightening campaign in 2016. We continue to believe that it will be a challenge for the Fed to orchestrate a graceful exit, which is part of the reason we have been defensively positioned over the past few months.

 

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