Corporate Credit 2Q 2021
U.S. corporate credit markets rallied across the board in the second quarter, supported by the strong global economic backdrop and falling U.S. Treasury yields. After sharply underperforming in the first quarter, investment grade corporate bonds benefited most from the lower, flatter yield curve as the Bloomberg Barclays U.S. Corporate Investment Grade Index gained 3.55%. High yield bonds added to the first quarter’s gains with the Bloomberg Barclays U.S. Corporate High Yield Bond Index returning 2.74%. Bank loans lagged behind but still ended the quarter in positive territory as the Credit Suisse Leveraged Loan Index gained 1.44%.
Risk assets benefited from the acceleration in the global economic recovery, which was supported by continued progress of the vaccine rollout and the relaxation of quarantine restrictions. In the U.S., monetary and fiscal stimulus acted as tailwinds, as strong economic data and robust corporate earnings showed the extent of the recovery from the pandemic. Inflationary pressures surged during the quarter, as headline consumer prices increased 5.0% year-overyear in May, marking the biggest jump since August 2008. However, the reaction from fixed income markets was subdued as the Federal Reserve (Fed) continued its quantitative easing (QE) program while strongly messaging that inflationary pressures are largely transitory.
U.S. Treasuries partially reversed the first quarter’s selloff and the yield curve flattened over the course of the second quarter. While the yield on the U.S. 5-Year Treasury Note declined 5 basis points, the yield on the 10-Year Note fell 27 basis points as longer duration bonds outperformed. Despite the second quarter retracement, the yield on the 10-Year Note ended the quarter more than 50 basis points above where it started the year.
Corporate credit spreads continued to fall, ending the quarter not far from the all-time lows. High yield bond spreads as measured by the Bloomberg Barclays U.S. Corporate High Yield Bond Index fell roughly 41 basis points, ending the quarter at the lowest level since 2007, while the overall yield on high yield bonds fell to an all-time low near 3.75%. Investment grade corporate bond spreads continued to slowly grind tighter as the spread on the Bloomberg Barclays U.S. Corporate Investment Grade Index ended the quarter near 80 basis points, the tightest level since March 2005.
Corporate issuers continued to take advantage of the attractive funding environment as high yield bond issuance capped off another record quarter and issuance in the first half of the year topped a record-breaking $282 billion. Issuers focused on refinancing existing debt as nearly two-thirds of high yield bond issuance this year has been earmarked for debt repayment and refinancing. Issuance in the investment grade corporate bond market remained robust but fell short of 2020’s record-breaking first half issuance.
Institutional demand remained strong across the corporate credit universe, while retail fund flows favored investment grade corporate bonds. High yield retail fund flows turned positive towards the end of June, but remained negative for the quarter as overall retail fund outflows for the first half of the year topped $12 billion.
Within the high yield bond market, lower quality bonds outperformed but by a much narrower margin than in the first quarter as ‘CCC’s (+3.49%) outperformed ‘B’s (+2.16%) and ‘BB’s (+2.86%). Cyclicals also outperformed with Energy (+6.10%) leading the way on the back of the commodity rally and Utilities (+1.40%) underperforming.
Corporate credit metrics continued to improve as credit rating upgrades have outnumbered downgrades by a 4:1 ratio so far this year and “fallen angels” have been replaced by “rising stars”, credits that have been upgraded from high yield to investment grade. Additionally, defaults continue to decline as the trailing 12-month high yield default rate fell below 6% and many expect it to end the year below 2%.
Performance and Attribution Summary
High Yield Bond
The Aristotle High Yield Bond Composite returned 2.19% gross of fees (2.14% net of fees) in the second quarter, underperforming the 2.57% return of the ICE BofA BB-B U.S. Cash Pay High Yield Constrained Index.1 Sector rotation was the primary detractor from relative performance.
Sector rotation detracted from relative performance led by the allocation to bank loans and cash. Industry allocation also detracted from relative performance led by underweights in Energy and Food, Beverage & Tobacco, which was partially offset by the positive effect of an overweight in Technology and an underweight in Pharmaceuticals. Additionally, security selection marginally detracted from performance led by holdings in Energy and Pipelines & Distributors. This was partially offset by positive selection in Building Materials & Home Construction and Technology.
|Top Five Contributors||Top Five Detractors|
|Bausch Health||Occidental Petroleum|
|QTS Realty Trust||Kraft Heinz|
|U.S. Concrete||Penn National Gaming|
|Lions Gate Capital||AmeriGas|
1The primary composite benchmark changed from the FTSE BB/B Excluding B/CCC Splits Index to the ICE BofA BB-B U.S. Cash Pay High Yield Constrained Index effective September 30, 2020
Investment Grade Corporate
The Aristotle Investment Grade Corporate Bond Composite returned 3.58% gross of fees (3.52% net of fees) in the second quarter, nearly in line with the 3.55% return of the Bloomberg Barclays U.S. Corporate Investment Grade Index. Security selection was the primary driver of relative performance, while duration and yield curve positioning was the primary detractor from relative performance.
Security selection contributed to relative performance led by holdings in Banking and Technology, which was only partially offset by negative selection in Insurance and Utilities. Additionally, industry allocation contributed to relative performance led by overweights in Pipelines & Distributors and Real Estate Investment Trusts (REITs) & Real Estate-Related. This was partially offset by the negative effect of underweights in Aerospace & Defense and Energy.
The portfolio’s short duration positioning detracted from relative performance, although its impact was partially offset by the positive effect of an overweight in ‘BBB’-rated credits. Sector rotation detracted slightly from relative performance led by the allocation to cash.
|Top Five Contributors||Top Five Detractors|
|Corning||Southern California Edison|
|Enterprise Products||Marathon Petroleum|
The Aristotle Strategic Credit Composite returned 1.91% gross of fees (1.91% net of fees2) in the second quarter, performing in line with the 1.91% return of the blended benchmark of one-third Bloomberg Barclays U.S. High Yield Ba/B 2% Issuer Cap Index, one-third Bloomberg Barclays U.S. Intermediate Corporate Index and one-third Credit Suisse Leveraged Loan Index. Security selection was the primary detractor from relative performance, while sector rotation was the primary driver of relative performance.
Security selection detracted from relative performance led by holdings in Energy and Pipelines & Distributors, which was partially offset by positive selection in Banking & Transportation. Industry allocation had an overall neutral effect on relative performance as the positive effect of an overweight in Pipelines & Distributors and an underweight in Utilities was largely offset by the negative effect of underweights in Industrials and Diversified Manufacturing & Construction Machinery.
Sector rotation contributed to relative performance led by an overweight in high yield bonds and an underweight in bank loans, while the allocation to cash detracted from relative performance.
|Top Five Contributors||Top Five Detractors|
|Wells Fargo||Sally Capital|
|United Airlines||Kennedy Wilson|
2As of June 30, 2021, 96% of the Composite consisted of a non-fee paying account.
Outlook and Strategy
Our outlook for corporate credit markets heading into the second half of 2021 remains much the same; we believe strong global economic growth should continue to be supportive of markets but several risks, led by the specter of inflation, remain on the horizon.
The U.S. led the global economic recovery in the first half of 2021 as the economy benefited from an accelerated pace of vaccinations, additional fiscal stimulus and continued easy policy from the Fed. We do not expect to see the same rate of growth in the latter part of the year and believe growth has now peaked in the U.S. While Europe has the potential to pick up some slack, the lack of coordinated monetary and fiscal policy will keep the region from seeing the same sharp increase in growth that the U.S. experienced, and we therefore believe global growth has peaked for the current cycle.
After the volatile steepening of the U.S. yield curve in the first quarter, the subsequent stabilization and reversal in yields during the second quarter caught many by surprise. We believe technical factors have played a significant role in the reversal and will continue to drive core fixed income markets. While the supply of Treasuries should pick up from the lower-than-expected pace over the past few months, there has been unrelenting institutional demand for fixed income as the Fed continues with its QE program, foreign investors turn to U.S. fixed income for yield and select fully funded corporate pensions seek to lock in gains and add duration.
With corporate credit spreads ending the quarter not far off the historic tights, overall valuations are not as attractive as they were at the beginning of the year. However, the technical backdrop should remain supportive, as we expect a slowdown in new-issue supply in the second half of the year. We believe a lot of corporate issuance was front-loaded this year as companies worried about higher interest rates. Issuance on the back of an increase in mergers and acquisitions (M&A) and leveraged buy-outs (LBOs) will be the wild card in the latter part of the year.
In our view, overall inflation risks remain elevated and will continue to be the biggest concern for fixed income markets. We have been watching inflation measures closely and positioning our portfolios for the possibility of higher inflation by adding credits of companies we believe will either not be affected by or will benefit from higher inflation. This is very much a name-by-name process; we are focusing on companies with pricing power and solid management teams that have control over their margins while avoiding companies that are unable to absorb higher costs.
High Yield Bond Positioning
Adjustments to our high yield bond portfolios consisted largely of tweaking existing positions. Overall, we rotated further into cyclical “reopening” trades across industries. We continue to hold a duration underweight in our full duration portfolios and believe shorter duration credits should outperform as we expect interest rates to rise again in the second half of the year.
We continued to reduce the weight of investment grade corporate bonds we opportunistically added over the past year. We also marginally increased our exposure to ‘B’-rated credits. We further increased our exposure to cyclicals, reducing an underweight in Energy while selectively increasing exposure to Travel & Leisure. At the end of the quarter, we held overweights in Building Materials & Home Construction, Media & Entertainment and Transportation alongside underweights in Energy, Telecommunications and Food, Beverage & Tobacco.
Investment Grade Corporate Positioning
In our investment grade corporate bond portfolios, we further rotated into cyclicals while marginally reducing our overall duration positioning. We have also rotated into subordinated Banking securities for yield pick-up.
We favor Financials (Banking, Insurance, REITs), cyclicals (Transportation, Pipelines) and select Utilities. We further reduced our allocation to Healthcare, as we believe spreads are quite tight after benefiting from the shutdown in 2020. We also continue to hold underweights in Pharmaceuticals and Food, Beverage & Tobacco.
Strategic Credit Positioning
As with our other strategies, we only made marginal changes to positioning in our Strategic Credit portfolios. We slightly increased the allocation to high yield bonds, while further reducing exposure to investment grade corporate bonds and holding exposure to bank loans nearly constant. As a result we slightly decreased duration but to a much smaller extent than we did in the first quarter.
We hold an underweight in bank loans as short-term interest rates in the U.S. remain pinned to near the historic lows and the Fed shows few signs of abruptly shifting its current easy monetary policy stance. Additionally, as strong growth continues in the U.S., we expect to see a pick-up in LBOs and an increase in the number of lower quality issuers in the bank loan market.
As of June 30, the strategy was composed of 23.2% investment grade corporate bonds, 67.3% high yield bonds and 8.6% bank loans. Roughly 0.9% was held in cash. At the end of the quarter, we held overweights in REITs & Real Estate-Related, Retailers & Restaurants and Transportation alongside underweights in Healthcare, Technology and Food, Beverage & Tobacco.
The opinions expressed herein are those of Aristotle Credit Partners, LLC (Aristotle Credit) and are subject to change without notice. Past performance is not a guarantee or indicator of future results. This material is not financial advice or an offer to buy or sell any product. You should not assume that any of the securities transactions, sectors or holdings discussed in this report are or will be profitable, or that recommendations Aristotle Credit makes in the future will be profitable or equal the performance of the securities listed in this report. The portfolio characteristics shown relate to the Aristotle Credit High Yield Bond strategy, the Aristotle Credit Investment Grade Corporate Bond strategy and the Aristotle Credit Strategic Credit strategy. Not every client’s account will have these characteristics. Aristotle Credit reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. There is no assurance that any securities discussed herein will remain in an account’s portfolio at the time you receive this report or that securities sold have not been repurchased. The securities discussed may not represent an account’s entire portfolio and, in the aggregate, may represent only a small percentage of an account’s portfolio holdings. For a full list of all recommendations made by Aristotle Credit during the last 12 months, please contact us at (949) 681-2100. This is not a recommendation to buy or sell a particular security.
Returns are presented gross and net of investment advisory fees and include the reinvestment of all income. Gross returns will be reduced by fees and other expenses that may be incurred in the management of the account. For example, a 0.5% annual fee deducted quarterly (0.125%) from an account with a ten-year annualized growth rate of 5.0% will produce a net result of 4.4%. Actual performance results will vary from this example.
The Bloomberg Barclays U.S. Corporate Investment Grade Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes securities publicly issued by U.S. and non-U.S. industrial, utility and financial issuers that are all U.S. dollar denominated. The Bloomberg Barclays U.S. Corporate Investment Grade Index is a component of the Bloomberg Barclays U.S. Credit Index. The Bloomberg Barclays U.S. Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Barclays EM country definition, are excluded. The ICE Bank of America (ICE BofA) BB-B U.S. Cash Pay High Yield Constrained Index measures the performance of the U.S. dollar-denominated BB-rated and B-rated corporate debt issued in the U.S. domestic market, a fixed coupon schedule and a minimum amount outstanding of $100 million, issued publicly. Allocations to an individual issuer in the Index will not exceed 2%. The Credit Suisse Leveraged Loan Index is a marketweighted index designed to track the performance of the investable universe of the U.S. dollar-denominated leveraged loan market. The Bloomberg Barclays U.S. High Yield Ba/B 2% Issuer Cap Index is an issuer-constrained version of the U.S. Corporate High Yield Index that measures the market of U.S. dollar-denominated, non-investment grade, fixed-rate, taxable corporate bonds rated Ba/B. The Index limits the maximum exposure to any one issuer to 2%. The Bloomberg Barclays U.S. Intermediate Corporate Index is designed to measure the performance of U.S. corporate bonds that have a maturity of greater than or equal to one year and less than 10 years. The Index includes investment grade, fixed-rate, taxable, U.S. dollar-denominated debt with $250 million or more par amount outstanding, issued by U.S. and non-U.S. industrial, utility and financial institutions. The volatility (beta) of the Composites may be greater or less than the indices. It is not possible to invest directly in these indices. Composite and index returns reflect the reinvestment of income.
Aristotle Credit Partners, LLC is an independent registered investment adviser under the Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about Aristotle Credit, including our investment strategies, fees and objectives, can be found in our Form ADV Part 2, which is available upon request. ACP-2107-21