Commentary

Corporate Credit 3Q 2024

Summary

U.S. corporate credit markets delivered strong performance in the third quarter, as U.S. yields declined sharply and corporate credit spreads tightened. The Bloomberg U.S. Aggregate Bond Index returned 5.20% during the quarter, as the year-to-date return climbed into positive territory at 4.45%. Similarly, after underperforming in the first half, investment grade corporate bonds outperformed both high yield bonds and bank loans, as the Bloomberg U.S. Corporate Bond Index returned 5.84% for the quarter and 5.32% for the year-to-date period. The Bloomberg U.S. Corporate High Yield Bond Index added to gains from the first half of the year, with a total return of 5.28% for the quarter and 8.00% for the year-to-date period. After outperforming in the first six months of the year, bank loans trailed with the decline in front-end yields, as the Credit Suisse Leveraged Loan Index gained 2.08% during the quarter and 6.61% in the first nine months of the year.

U.S. equity markets rallied to new all-time highs in the third quarter, with the S&P 500 Index generating a total return of 5.89% during the period, taking the year-to-date total return to 22.08%. The Federal Reserve’s (Fed) dovish pivot in July and subsequent 50-basis-point cut in September, as well as increased expectations for an economic soft-landing, drove strong risk sentiment during the quarter. Additionally, a weaker U.S. dollar and lower crude oil prices were supportive. Nonetheless, the equity rally was not without a few bumps in the road, including a sharp selloff in early August following the Bank of Japan’s decision to hike its policy rate to the highest level in 15 years at 0.25%, which sparked a violent unwind in carry trades. Nonetheless, the selloff quickly reversed in the following days and was fully erased by the end of the month.

U.S. economic data showed continued robust growth, declining inflation and a solid, yet slowing, labor market. Second quarter U.S. GDP surprised to the upside at an annualized rate of 3% driven by strong consumer spending. In slight contrast, U.S. labor market data were mixed. In July and August, non-farm payrolls missed expectations, and the Bureau of Labor Statistics (BLS) revised labor market data for the annual period ending March, which was lower by 818,000 jobs. However, the September payrolls showed the strongest job growth in six months, quelling fears of a rapidly slowing labor market. The unemployment rate also dipped to 4.1% in September after peaking at 4.2% in August. Additionally, the August CPI report revealed the annual inflation rate slowing for the fifth consecutive month to 2.5%, the lowest rate in over three years.

After leaving rates unchanged for the eighth consecutive meeting in July, the Fed announced a 50-basis-point cut in September, taking the benchmark rate to a range of 4.75% to 5.00%, the lowest since May 2023. The combination of slowing labor market data in July and August, as well as the continued decline in the annual inflation rate, prompted the Fed’s decision to begin its long-awaited cutting cycle. While a cut in September was well-signaled, the exact magnitude was uncertain. The larger-than-expected cut helped increase market expectations of a more accommodative Fed going forward. By the end of the quarter, interest rate futures priced in an additional 50 basis points of cuts expected before year-end. However, with the next FOMC meeting occurring the day after the November election, political uncertainty may steal the spotlight before then.

Market Environment

U.S. Treasuries rallied across the board during the quarter, as the Fed’s rate cut led to a sharp bull steepening of the yield curve. The yield on the U.S. 2-year note fell roughly 98 basis points, reaching the lowest in over a year, while the yield on the U.S. 10-year note fell around 42 basis points. With the September rate cut, the spread between the yield on 2-year and 10-year notes reversed its inversion for the first time in over two years, ending the longest period of inversion in history.

Strong technicals continued to drive spread compression during the period. High yield bond spreads tightened roughly 10 basis points, ending the quarter below 300 basis points, as measured by the Bloomberg U.S. Corporate High Yield Bond Index. While spreads narrowed across all rating categories, the most pronounced compression occurred in CCC-rated bonds. Investment grade corporate bond spreads also narrowed further, declining roughly 5 basis points to below 90 basis points by quarter-end, as measured by the Bloomberg U.S. Corporate Bond Index.

Leveraged finance issuers took advantage of favorable market conditions and strong primary markets, as refinancing continued to drive the bulk of issuance. While high yield bond supply was slightly lower than the previous quarter, it topped $74 billion in the third quarter, an increase of nearly 90% compared to the third quarter of 2023. Leveraged loan issuance also continued at a strong pace, with supply topping $205 billion in the quarter, an increase of nearly 70% compared to the same period in 2023. Supply in the investment grade corporate bond issuance also remained robust with third-quarter issuance topping $360 billion, bringing year-to-date issuance above $1 trillion, ahead of 2023’s torrid pace of supply.

High yield bond fund inflows continued at a steady pace during the quarter, while leveraged loan funds experienced outflows ahead of the September rate cut. High yield bond inflows topped $15 billion, the largest quarterly total of the year. Conversely, leveraged loan funds outflows totaled more than $2 billion, driven by an outflow of roughly $5 billion in August.

Within the high yield bond market, lower-quality bonds gained most in the quarter, as CCC-rated bonds (+10.2%) significantly outperformed B’s (+4.5%) and BB’s (+4.3%). From an industry perspective, within the Bloomberg U.S. Corporate High Yield Bond Index, Telecommunications (+13.4%) and Cable & Satellite (+12.0%) outperformed, while Energy (+2.1%), and Automotive & Captive Finance (+2.4%) underperformed but still generated positive total returns. The top-performing sectors during the quarter were the worst-performing sectors in the first half, as sentiment improved, and lower-priced bonds rallied.

Distressed exchanges were the primary driver of default and distressed exchange activity during the quarter. The 12-month trailing, par-weighted U.S. high yield default rate, including distressed exchanges, declined roughly 15 basis points to end the quarter at 1.64% (0.94%, excluding distressed exchanges), around 180 basis points below its long-term historical average. Meanwhile, the loan par-weighted default rate, including distressed exchanges, rose roughly 60 basis points to end September at 3.70% (1.28%, excluding distressed exchanges), approximately 60 basis points above the long-term historical average but nearly 100 basis points below the long-term average excluding distressed exchange

Performance and Attribution Summary

High Yield Bond

The Aristotle High Yield Bond Composite returned 3.59% gross of fees (3.53% net of fees) in the third quarter, underperforming the 4.39% return of the ICE BofA BB-B U.S. Cash Pay High Yield Constrained Index. Security selection was the primary detractor from relative performance. Industry allocation and sector rotation also detracted from relative performance, with no offsetting contributors.

Security selection detracted from relative performance led by holdings in Finance Companies and Transportation. This was partially offset by selection in Energy and Cable & Satellite. Industry allocation also detracted from relative performance led by an overweight in Energy and an underweight in Telecommunications. This was partially offset by an underweight in Technology and an overweight in Utilities. Additionally, sector rotation detracted from relative performance led by the allocation to cash, which was partially offset by the allocation to investment grade corporate bonds.

Top Five Contributors Top Five Detractors
Charter CommunicationsUnited Airlines
New Fortress EnergyJetBlue Airlines
Allegheny TechnologiesAir Canada
Walgreens Boots AllianceLevel 3 Financing
O-I GlassResolute Investment Managers
*Bold securities held in representative account

Short Duration High Yield Bond

The Aristotle Short Duration High Yield Bond Composite returned 2.66% pure gross of fees (2.53% net of fees) in the third quarter, underperforming the 3.19% return of the ICE BofA 1-3 Year BB-B U.S. Cash Pay Fixed Maturity High Yield Constrained Index. Security selection was the primary detractor from relative performance. Industry allocation and sector rotation also detracted from performance, with no offsetting contributors.

Security selection detracted from relative performance led by holdings in Pharmaceuticals and Chemicals. This was partially offset by selection in Diversified Manufacturing & Construction Machinery and Pipelines & Distributors. Industry allocation also detracted from relative performance led by an overweight in Pipelines & Distributors and an underweight in Media & Entertainment. This was partially offset by overweights in Pharmaceuticals and Real Estate Investment Trusts (REITs) & Real Estate-Related. Additionally, sector rotation detracted marginally from performance led by the allocation to cash, with no offsetting contributors.

Top Five Contributors Top Five Detractors
New Fortress EnergyBausch Health
AlbertsonsZayo Capital
American AirlinesNavient
Tri Point GroupE.W. Scripps
Griffon CorpCommunity Health Systems
*Bold securities held in representative account

Outlook

We maintain a positive outlook for U.S. corporate credit markets, which we believe will continue to benefit from strong fundamentals, supportive technicals, a resilient U.S. economy and lower interest rates. We believe the current risk-on environment could extend through year-end, as all-in yields remain relatively attractive compared to historical levels. As we move into the final quarter of the year, our focus continues to be on higher-quality credits in sectors we believe will benefit from strong tailwinds.

From a macroeconomic standpoint, divergence remains the key theme, with the U.S. outperforming on a relative basis due to robust growth and a resilient labor market. Despite fears of an economic slowdown in the U.S., strong earnings and corporate fundamentals continue to bolster investor confidence. In contrast, Europe and China continue to underperform due to structural challenges. China’s recent stimulus measures have sparked a rally in local equity markets, but the country’s economic recovery remains hindered by the ongoing real estate debt overhang, a structural issue that will likely persist. In Europe, growth continues to disappoint, and the economies of the continent are seeing diverging fortunes, with France showing relative resilience and Germany potentially slipping into a technical recession. Given this backdrop, we maintain domestic (U.S.) focus.

The rapid reaction of interest rate markets to the Fed’s dovish pivot saw markets get ahead of the September rate cut. With 2-year yields historically leading the Fed, we would not be surprised to see two additional 25-basis-point cuts before year-end. But given this scenario is largely priced in, yields may be rangebound over the next few months, barring any major downside surprises in the labor market that accelerate the Fed’s cutting cycle. Furthermore, longer-end rates bottomed out during the week before the September Fed meeting and continued to rise through quarter-end. We believe the price action reflects longer-term concerns over U.S. deficits, as well as the possibility that rate cuts could reignite inflationary pressures or the risk of rising geopolitical tensions, which could disrupt supply chains once again.

Even if the Fed moves slower than expected, we believe high yield bond markets should continue to benefit from strong fundamentals and favorable technical conditions. Second-quarter earnings for high yield issuers showed strong quarter-over-quarter EBITDA growth with only marginal increases in leverage, which we believe gave investors confidence to add risk in high yield. We did not anticipate the extent of the rebound in lower-quality and lower-dollar-priced bonds, particularly in distressed and special situations, which we believe was driven primarily by strong technical factors. Additionally, the high yield bond universe continues to shrink as companies pay down liabilities or refinance into private debt, which should continue to limit supply and market growth. While primary markets remain open, inflows from retail and institutional funds also continue to offset new supply.

For higher-quality high yield bonds, much of the duration tailwind from lower rates may have passed for the year. However, we believe attractive all-in yields, along with a positive economic backdrop, will remain supportive. However, potential downside risks include heightened geopolitical tensions, a resurgence in inflationary pressures, downside labor market surprises and sector-specific regulatory challenges after the election. As always, we remain committed to a disciplined, active investment approach, focusing on rigorous fundamental credit analysis to navigate the evolving credit market landscape and seeking to generate consistent, attractive risk-adjusted returns over the long-run.

High Yield Bond Positioning

In our high yield bond portfolios, we continue to focus on higher-quality credits in the short-to-intermediate part of the curve. Our average credit quality remains aligned with the benchmark, and our duration exposure relative to the benchmark remains largely unchanged. We continue to focus on sectors with strong fundamentals and issuers we believe should benefit from specific tailwinds, allowing resilience throughout the economic cycle.

During the quarter we reduced exposure to BBB-rated corporate bonds as longer duration securities rallied, focusing on our core allocations to BB and B-rated credits. As technicals, rather than fundamental credit analysis, drive price action and spreads sit at historically tight levels, we expect a more pronounced differentiation between higher and lower quality credits in the coming year, as current valuations in the lower-quality space appear stretched. While lower rates and strong fundamentals should underpin markets more broadly, we remain cautious on some of the lower-quality credits in industries facing secular decline that outperformed in the third quarter, especially given current valuations. Additionally, while many lower-quality companies with more floating rate debt in their capital structure should benefit from lower benchmark rates, we expect liability-management exercises (LME’s) will continue to be a major theme, as issuers attempt to use strong sentiment to resolve some of the thornier debt burdens, adding complexity to investing in this segment of the market.

From a credit selection and industry perspective, we remain focused on companies we believe will benefit from longer-term secular tailwinds. During the quarter, we reduced our underweight in Cable & Satellite, driven by positive credit-specific developments. We maintained an underweight in Telecommunications and added an underweight in Healthcare, where we see potential regulatory headwinds in the coming year. We maintained our overweights in Retailers & Restaurants and Transportation, targeting companies we believe can benefit from a resilient U.S. consumer. Additionally, we reduced our overweight in Energy, focusing on credits we believe can benefit from rising demand for data center power, driven by Artificial Intelligence (AI). At the end of the quarter, we held overweights in Energy, Transportation and Retailers & Restaurants alongside underweights in Technology, Telecommunications and Healthcare.

Disclosures

All investments carry a certain degree of risk, including the possible loss of principal. Investments are also subject to political, market, currency and regulatory risks or economic developments. There are risks specifically associated with fixed income investments such as interest rate risk and credit risk. Bond values fluctuate in price in response to market conditions. Typically, when interest rates rise, there is a corresponding decline in bond values. This risk may be more pronounced for bonds with longer-term maturities. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. High yield securities are generally rated lower than investment grade securities and may be subject to greater market fluctuations, increased price volatility, risk of issuer default, less liquidity, or loss of income and principal compared to investment grade securities.

The material is provided for informational and/or educational purposes only and is not intended to be and should not be construed as investment, legal or tax advice and/or a legal opinion. Investors should consult their financial and tax adviser before making investments. The opinions referenced are as of the date of publication, may be modified due to changes in the market or economic conditions, and may not necessarily come to pass. Information and data presented has been developed internally and/or obtained from sources believed to be reliable. Aristotle Credit does not guarantee the accuracy, adequacy or completeness of such information.

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 and the Aristotle Credit Short Duration High Yield Bond 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.

Past performance is not indicative of future results. Performance results for periods greater than one year have been annualized. Composite returns are preliminary pending final account reconciliation.

High Yield Bond Returns: Composite and benchmark returns reflect the reinvestment of income. Composite 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. Net returns are presented net of actual investment advisory fees and after the deduction of all trading expenses.

Short Duration High Yield Bond Returns – Pure Gross: Pure gross returns do not reflect the deduction of any trading costs, fees or expenses. Pure gross returns prior to September 2017 reflect the deduction of transaction costs. Model Net Performance: Starting from September 2017, composite returns are presented pure gross and net of the highest wrap fee stated. Performance for periods prior to September 2017 are presented pure gross and net of actual investment advisory fees.

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-2410-1

Performance Disclosures

Sources: SS&C Advent; ICE BofA

*Composite returns are preliminary pending final account reconciliation.

**2014 is a partial-year period of nine months, representing data from April 1, 2014 to December 31, 2014.

***2009 is a partial-year period of ten months, representing data from March 1, 2009 to December 31, 2009.

Past performance is not indicative of future results. Composite 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. Net returns are presented net of actual investment advisory fees and after the deduction of all trading expenses. The Aristotle High Yield Bond strategy has an inception date of April 1, 2014; however, the strategy initially began at Douglas Lopez’s predecessor firm. A supplemental performance track record from March 1, 2009 to December 31, 2013 (Mr. Lopez’s departure from the firm) is provided. The returns are based on a separate account from the strategy while it was being managed at Doug Lopez’s predecessor firm and performance results are based on custodian data. During this time, Mr. Lopez had primary responsibility for managing the account. Please refer to disclosures at the end of this document.

Sources: SS&C Advent; ICE BofA

*Composite returns are preliminary pending final account reconciliation.

**2014 is a partial-year period of nine months, representing data from April 1, 2014 to December 31, 2014.

Past performance is not indicative of future results. Composite and benchmark returns reflect the reinvestment of income. Pure Gross: Pure gross returns do not reflect the deduction of any trading costs, fees or expenses. Pure gross returns prior to September 2017 reflect the deduction of transaction costs. Model Net Performance: Starting from September 2017, composite returns are presented pure gross and net of the highest wrap fee stated. Performance for periods prior to September 2017 are presented pure gross and net of actual investment advisory fees. Please refer to disclosures at the end of this document.

Index Disclosures

The Bloomberg U.S. Aggregate Bond Index is a broad base, market capitalization-weighted bond market index representing intermediate term investment grade bonds traded in the United States. The Index is frequently used as a stand-in for measuring the performance of the U.S. bond market. In addition to investment grade corporate debt, the Index tracks government debt, mortgage-backed securities (MBS) and asset-backed securities (ABS) to simulate the universe of investable bonds that meet certain criteria. In order to be included in the Index, bonds must be of investment grade or higher, have an outstanding par value of at least $100 million and have at least one year until maturity. The Bloomberg U.S. Corporate Bond 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 U.S. Corporate Bond Index is a component of the Bloomberg U.S. Credit Bond Index. The Bloomberg U.S. Corporate High Yield Bond Index measures the U.S. dollar-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 Bloomberg EM country definition, are excluded. The S&P 500 Index is the Standard & Poor’s Composite Index and is a widely recognized, unmanaged index of common stock prices. It is market cap weighted and includes 500 leading companies, capturing approximately 80% coverage of available market capitalization. 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 market-weighted index designed to track the performance of the investable universe of the U.S. dollar-denominated leveraged loan market. The ICE Bank of America (ICE BofA) 1-3 Year BB-B U.S. Cash Pay Fixed Maturity High Yield Constrained Index tracks the performance of the U.S. dollar-denominated below investment grade corporate debt, currently in a coupon paying period, that is publicly issued in the U.S. domestic market; including 144A securities, both with and without registration rights. Qualifying securities must have risk exposure to countries are members of the FX-G10, Western Europe, or territories of the United States and Western Europe. The FX-G10 includes all Euro members: the United States, Japan, the United Kingdom, Canada, Australia, New Zealand, Switzerland, Norway and Sweden. Qualifying securities include only those rated BB1 through B3. Perpetual securities are not included as all securities must have a fixed final maturity date. All final maturity dates must range between one and three years. It is a capitalization-weighted index, constrained to 2% maximum weighting per issuer. The Consumer Price Index is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. 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.