Market Overview
The second quarter saw leveraged credit markets build on the first quarter’s small advance, with the Bloomberg Barclays US Corporate High Yield Index gaining 2.7%.1 The high yield index’s yield to worst established new all-time lows during the quarter, and investors continued to reach deeper down the credit spectrum for yield, boosting the performance of CCC rated bonds relative to higher-quality paper. After a pause earlier in the year, duration again became a tailwind for longer-maturity paper over the past few months as the rate of the 10-year US Treasury drifted from around 1.75% at the beginning of April to near 1.45% at the end of June.2
During the quarter, conditions continued to be very favorable for non-investment grade issuers—and less so for investors—as the trend toward aggressive pricing, tighter spreads and limited covenant protections persisted in the new-issue markets for both high yield bonds and leveraged loans. The first half of 2021 ended with close to $300 billion in high yield issuance, a rate at which the market could easily surpass last year’s record of $450 billion—an enormous amount of additional paper in a $1.3 -$1.4 trillion market.3 The ratings quality of new issues remained high, with the great majority focused on refinancing existing debt, which we consider a good use of proceeds and a sign of market health.4 The quality of new issuance has been one of the bigger surprises of this credit cycle, as high yield issuance quality has yet to display the kind of deterioration we typically would see as we move through the cycle; in contrast, weaker credits and weaker covenants in the recent leveraged loan market have been exposing investors to increased risks.
The average credit quality of the high yield secondary market improved in the second quarter. The rating agencies, which traditionally have been quicker to pull the downgrade trigger on deteriorating credits, have been quick to respond to improving credits in this cycle—in some cases reversing their own recent downgrades. Many issuers have considerable cash on hand to bolster their balance sheets as more normal conditions slowly return, while leverage has improved marginally but remains at levels typically seen after a cathartic cleansing of the credit cycle, when there has been a recession and a recovery. The easy avail-ability of credit has prevented such a purge from occurred in this cycle.
Market technicals have been supportive even though retail high yield mutual fund flows have tailed off this year. Given the massive monetary stimulus that continue worldwide, a significant number of sovereign bonds issued in Europe and Japan still offer negative yields, a startling historical anomaly that has apparently lost its power to shock. This repression of yields—combined with low interest-rate differentials that enable offshore investors to hedge their dollar-based holdings at relatively low cost—has encouraged another reliable source of demand for US paper. With overseas investors somewhat limited in choice of vehicles that may provide positive real rates of return, the demand for leveraged credit from outside the US may prove to be relatively sticky. Demand also has been bolstered by the lack of volatility in the market. Though the Fed announced the winding down of emergency lending facilities initiated during the onset of Covid-19, it and other central banks continue to provide significant general financial system liquidity. Further, many investors seem to believe the Fed would not hesitate to intervene directly in bond markets should conditions demand.
The peak default rate in this high yield market cycle was close to 6% in July 2020, and it was estimated to be below 3% in May and trending lower still.5 Default activity is a lagging indicator; with corporate earnings improving and access to credit markets remaining easy, even unprofitable or marginally profitable companies should be able to avoid default. Distressed credits, meanwhile, are the raw material for future defaults, and we have seen the distress rate decline precipitously to 1.4%, the lowest level since 2015.6 In our judgment, default activity is likely to remain subdued over the next few quarters.
Maintaining a Quality Bias in the Face of Uncompensated Risks
Entering the third quarter, the high yield market appeared priced favorably, with little scope for upside or adequate compensation for risk. The option adjusted spread on the Bloomberg Barclays US Corporate High Yield Index stood at around 270 basis points, not far from its June 2007 trough near 250 basis points. Similarly, spread per turn of leverage—i.e., the ratio of potential return on a bond per unit of risk—ended the quarter at approxi-mately 75 basis points, a far cry from its historical average in the neighborhood of 150 basis points.7
In this environment, we continue to reduce risks that we’re not being adequately compensated to take. We remain biased toward higher credit quality, toward higher attachment points in the capital structure, and toward secured paper and tighter indentures. Due to our bottom-up approach to finding oppor-tunities in both the primary and second high yield markets, we have naturally gravitated toward to a higher quality, more liquid portfolio of bonds issued by companies that have the potential to generate stable and significant free cash flow. While we remain prepared to reallocate capital into other opportunities when the risk compensation dictates, we believe the market isn’t there yet.
Portfolio Review
High Income Fund A Shares (without sales charge*) posted a return of 2.92% in second quarter 2021. While performance was positive across the ratings spectrum, the greatest contribu-tion came from BB issues, given the size of the position in the portfolio. In the falling-interest rate environment of the quarter, longer-duration paper generally outperformed shorter-dated issues. All market sectors to which the portfolio was exposed made positive contributions, led by consumer non-cyclicals and energy; communications and technology were relative laggards. The High Income Fund outperformed the Bloomberg Barclays US Corporate High Yield Index in the period.
Leading contributors in the First Eagle High Income Fund this quarter included Southeastern Grocers Inc. Common Stock USD, EnQuest plc 7.0%, due 4/15/2022, Avation Capital SA 8.25%, due 5/15/2021, Crestwood Midstream Partners LP 6.0%, due 2/1/2029 and Citgo Petroleum Corp. 7.00%, due 6/15/2025.
The common stock of Southeastern Grocers, parent company to a range of supermarket chains in the US region for which it is named, had a very strong 2020 given the demand for consum-ables that accompanied the outbreak of Covid-19. Though it displayed some weakness during the first quarter, it bounced back in the second, as the company has continued to execute on its strategic plan to consolidate stores and use the sales proceeds to make improvements to its remaining portfolio.
UK-based oil exploration and production company EnQuest (LSE:ENQ, Financial) has executed its business plan well over the past several years, reducing debt and lowering operating costs per barrel in an attempt to make the company more resilient against oil price volatility. In June it signed a $750 million senior-secured borrowing base debt facility, the proceeds of which it intends to use to refinance outstanding paper (including the bonds we hold) and to finance the acquisition of a North Sea field announced earlier in 2021. With solid free cash flow expected in 2021, we believe EnQuest should further improve its credit profile as the year progresses.
Avation Capital is the financing subsidiary of Avation PLC, a UK-headquartered commercial passenger aircraft leasing company. The maturity on these notes, which were originally due in May 2021, was extended to 2026, and they carry a coupon of 6.5% plus an additional 1.75% in cash or 2.5% payment-in-kind (PIK), at the company’s option. The PIK flexibility should help Avation preserve capital as it continues to restructure customer leases in the hard-hit aviation industry.
Like most companies in the energy patch, Crestwood—a Houston-based owner and operator of midstream businesses in multiple shale plays in the US—benefitted from the continued rebound in energy prices. In addition, Crestwood recently announced an agreement to sell its Stagecoach Gas Services subsidiary, which is a joint venture with Consolidated Edison, to Kinder Morgan, with closing expected in the third quarter. The company intends to use its share of the sale’s proceeds to repay a credit revolver.
Despite materially weaker earnings due to Covid-19 and weather-related disruptions to its largest refinery in Louisiana, refiner Citgo was able to refinance debt and improve its liquidity posi-tion, leaving it well-positioned for the recovery of oil-product demand, especially gasoline, that followed. Moreover, given this bond issue’s strong asset coverage, it tends to be relatively insu-lated against short-term changes in cash flow.
The leading detractors in the quarter were Ingles Markets, Incorporated 4.0%, due 6/15/2031, Gamestop Corp. 10.00%, due 3/15/2023, At Home Group, Inc. 4.875%, due 7/15/2028, At Home Group, Inc. 7.125%, due 7/15/2029 and United Airlines, Inc. 4.625%, due 4/15/2029.
Headquartered in Asheville, North Carolina, Ingles (IMKTA, Financial) operates nearly 200 supermarkets in the southeast. With a track record of more than 50 years of operation, Ingles focuses on rural communities that typically are underserved by larger grocery competitors like Kroger and Albertsons. Though this bond issue is unsecured, the fact that Ingles owns most of the real estate upon which its stores are located provides the company a degree of optionality should a liquidity event occur.
Though its equity has been buffeted by the shifting winds of Reddit-based enthusiasm, the debt of GameStop (GME, Financial) had been relatively quiet. While some uncertainty exists around the relation-ship between the stock’s market capitalization and the company’s fundamental value, GameStop’s market cap provides manage-ment with balance sheet optionality. In fact, these 2023 notes were redeemed by the company in April using cash on hand.
In June we purchased two new issues from home furnishings retailer At Home Group (HOME, Financial): a 4.875% senior secured bond and a 7.125% unsecured bond. The company, which operates more than 200 stores in 40 states, recently announced that it had reached an agreement to be acquired by a private equity firm.
United Airlines (UAL, Financial) has done a good job of managing its cost structure in what has been a challenging environment for air carriers, and it maintains robust liquidity on its balance sheet. This bond issue is collateralized by parts and certain planes owned by United.
We appreciate your confidence and thank you for your support.
Sincerely,
First Eagle Investment (Trades, Portfolio) Management
- Source: FactSet; data as of June 30, 2021.
- Source: FactSet; data as of June 30, 2021.
- Source: J.P. Morgan; data as of July 1, 2021.
- Source: Morgan Stanley, S&P LCD; data as of July 1, 2021.
- Source: Fitch Ratings; data as of May 31, 2021.
- Source: S&P Global Ratings; data as of April 27, 2021.
- Morgan Stanley Research, Bloomberg, S&P LCD; data as of June 30, 2021.
The performance data quoted herein represents past performance and does not guarantee future results. Market volatility can dramatically im - pact 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. The average annual returns for Class A Shares “with sales charge” of the First Eagle High Income Fund gives effect to the deduction of the maximum sales charge of 4.50%. Past performance data through the most recent month-end is available at www.feim.com or by calling 800.334.2143.
The commentary represents the opinion of the High Yield team portfolio managers as of June 30, 2021, 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 purposes 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 information provided is not to be construed as a recommendation to buy, hold or sell or the solicitation or an offer to buy or sell any fund or security.
