Market Overview
The rally in the high yield market continued in the third quarter of 2016, with metals & mining and energy leading the way. Energy was up 50% from the trough it reached in February of this year. As typically occurs in market rallies, lower-quality issues generally benefited the most. While the spread between single-B’s and triple-C’s tightened substantially, it did not reach the levels seen before the recent period of market weakness—a sign that some degree of risk aversion is still at work in the market.
New issue volumes accelerated throughout the third quarter, with September being the busiest month since April. The issuance was driven primarily by refinancing, and financially motivated issuance (M&A and LBO) remained light. Companies issuing debt appeared to be focused on balance sheet management and on allocating capital more prudently than in the past. As a result, credit underwriting standards within the high yield market remained, in our view, surprisingly adequate. While there was some erosion, it was not to levels seen in past credit cycles. On the other hand, fundamental credit metrics slowly deteriorated in the high yield loan and the investment grade bond markets.
In earlier periods of economic recovery, higher topline growth enabled many companies to invest in their businesses or reduce their debt levels. In the current period of more modest economic growth, cash-flow generation has been less robust and companies have generally been less able to grow into their capital structures. Interest coverage has risen to some extent, but not, as in the past, because many companies have higher revenues and greater free cash flow. Rather, the current increase in interest coverage reflects refinancing activity by companies in a period when global central banks have engineered extremely low yields.
Liquidity is an ongoing concern in the high yield market. In response to the Dodd-Frank Act and the Volcker Rule, banks and brokerages have drastically reduced their activities as market makers and shrunk their inventories of bonds. The resulting decline in market liquidity has increased the potential for spikes in volatility. We believe that the market has been mispricing liquidity—over-pricing it in mid-February when energy and metals & mining bonds yielded close to 20%, and underpricing it in early September, when yields of all sectors fell to 8% or less.
Portfolio Review
The First Eagle High Yield Fund Class I shares returned 4.92% in the third quarter of 2016, compared to 5.55% for the Bloomberg Barclays US Corporate High Yield Index.
The top five contributors to performance were Cloud Peak Energy Resources LLC 8.5% due 12/15/2019, Rex Energy Corporation 1.00% due 10/1/2020, Jupiter Resources, Inc. 8.5% due 10/1/2022, Payless ShoeSource Term Loan 5.00% due 03/11/2021 and Outerwall Inc. 6.0% due 03/15/2019. Many of the quarter’s leading contributors were from the energy sector. Cloud Peak Energy Resources LLC 8.5% due 12/15/2019 rallied strongly in the second half of the period. The company mines coal in the Powder River Basin of Montana and Wyoming, and it sells its coal primarily to electric utilities. Recent EPA regulations have created some pressure on the company, but the larger issue for Cloud Peak has been the decline in natural gas prices. We believe that most of the switching from coal to gas has already occurred, and the recent rally in gas prices has benefited Cloud Peak. Utilities around the country put a premium on fuel diversity, and we believe coal, which currently accounts for almost 30% of electric power generation, will remain in their mix of fuels.
Rex Energy Corporation (REXX, Financial), an oil and gas exploration company with properties concentrated in the Marcellus and Utica shale regions, also benefited from the rally in natural gas. Rex holds leases on good acreage, and it needed to begin production in order to maintain the leaseholds. Seeking to obtain liquidity from alternative sources of capital, it formed joint ventures with certain non-traditional credit investors willing to co-invest and pay a significant portion of the development costs. Rex also engaged in a debt swap that took out a significant portion of its debt and replaced it with an issue paying little cash interest. We believe this gives the company greater flexibility to manage liquidity.
Jupiter Resources, a Canadian gas-oriented exploration and production company involved in Alberta’s Deep Basin, benefited from the rally in gas and the normalization of gas inventory levels. The company’s management has stated categorically that it will not engage in any type of deleveraging or exchange transactions to the detriment of current holders. This gave us comfort that we may benefit without the risk of being pushed down in the capital structure.
The main detractors for the quarter were True Religion Apparel, Inc. First Lien Term Loan 5.875% due 07/30/2019, EnQuest PLC 7.05 due 04/15/2022, DFC Finance Corporation 10.5% due 06/15/2020, Bi-Lo Holdings LLC 8.625% due 09/15/2018 and Shea Homes LP 5.875% due 04/01/2023. The quarter’s detractors represented a range of industries. We believe that True Religion, which produces and sells high-end jeans, will have trouble maintaining its capital structure at its current level of profitability and cash flow generation. Changing consumer attitudes and preferences are proving to be a challenge for the specialty retail segment. The loan recently repriced to a level lower than our valuation of the enterprise. Along with the company and other creditors, we remain focused on maximizing value.
EnQuest (LSE:ENQ, Financial), a UK company that extracts hydrocarbons in the North Sea, was a very strong name for the portfolio for the year but declined in the quarter. Weakness in the bonds reflected concerns about funding for a large project that is expected to commence production in 2017. We believe that EnQuest is able to fully fund the final development of this project, which is expected to signifi-cantly reduce its cash cost per barrel.
Another detractor was DFC Finance Corp. 10.5% due 06/15/2020. The issuer, Dollar Financial, provides financial services to under-banked communities around the world, with large operations in Canada and the UK. The original investment premise was that the Canadian operations alone could support the entire capital structure, but results there have been weaker than expected, and regulatory pressures continue across the globe. As a result, we exited the position during the third quarter.
We appreciate your confidence and thank you for your support.
Sincerely,
First Eagle Investment (Trades, Portfolio) Management, LLC
The commentary represents the opinion of the High Yield Team Portfolio Managers as of September 30, 2016 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 purpose 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 views expressed herein may change at any time subsequent to the date of issue hereof. The information provided is not to be construed as a recommendation or an offer to buy or sell or the solicitation of an offer to buy or sell any fund or security.
