Aristotle Capital Corporate Credit Q4 2023 Commentary

Summary

U.S. corporate credit markets ended the year on a strong note, as U.S. yields fell sharply and credit spreads narrowed to near the tightest levels of the year. The Bloomberg U.S. Aggregate Bond Index posted its first positive annual return since 2020, gaining 6.82% in the fourth quarter and 5.53% for the year. After underperforming for much of the year, investment grade corporate bonds outperformed both high yield bonds and bank loans during the fourth quarter. The Bloomberg U.S. Corporate Bond Index returned 8.50% during the quarter, bringing its year-to-date return to 8.52%. High yield bonds also rallied into the end of the year, gaining 7.16% for the quarter and 13.44% for the year, as measured by the Bloomberg U.S. Corporate High Yield Bond Index. After leading the way earlier in the year, bank loans lagged in the fourth quarter as the Credit Suisse Leveraged Loan Index returned 2.85% during the quarter and posted a full-year return of 13.04%.

Equities rebounded into the end of the year, as the S&P 500 (SP500, SPX) notched its strongest quarterly gain since the fourth quarter of 2021, gaining 11.69% for the quarter and 26.29% for the year. Risk assets benefited as financial conditions eased significantly in the U.S. over the final two months of the year, with the macroeconomic narrative shifting to expectations of a “soft landing.” Softer energy prices and a weaker dollar were supportive of risk sentiment, as West Texas Intermediate (‘WTI’) crude oil fell more than 20% and the U.S. Dollar Index declined 3.6%. Data released during the quarter showed U.S. economic growth had accelerated in the third quarter, with real GDP rising at an annual rate of 4.9%-the fastest pace of growth in nearly two years. The labor market also remained tight with the unemployment rate holding at 3.7% in December. Meanwhile, inflation continued its downward trend, as the headline Consumer Price Index (CPI) fell from an annualized pace of 3.7% in September to 3.1% in November.

The Fed held its benchmark rate at a range of 5.25% to 5.50% for the third consecutive meeting in December, as expected. However, the updated Summary of Economic Projections (‘SEP’) signaled the committee expects 75 basis points of rate cuts in 2024 and a median year-end 2024 Fed funds rate projection of 4.6%, down from 5.1% in September. As such, Chair Jerome Powell stated the central bank’s policy rate is likely at or near its peak for the tightening cycle, as recent indicators have suggested inflation is falling amidst slower economic growth, moderating job gains and low unemployment.

Market Environment

U.S. Treasuries rallied across the curve in the fourth quarter, with the bulk of the move happening in the final two months of the year. The yield on the U.S. 10-year note (US10Y) ground more than 30 basis points higher in October, then fell more than 100 basis points over the next two months, ending the quarter roughly 69 basis points lower. The yield on the U.S. 2-year note (US2Y) also ended the quarter much lower, falling nearly 79 basis points, as the yield spread between the 2-year and 10-year notes narrowed roughly 10 basis points during the quarter.

Credit spreads fell sharply during the quarter, as both high yield and investment grade corporate spreads ended the year at the tights. Mirroring the pattern in U.S. yields, high yield bond spreads widened roughly 40 basis points in October, only to fall more than 100 basis points between November and December, ending the quarter roughly 71 basis points lower, as measured by the Bloomberg U.S. Corporate High Yield Bond Index. Investment grade corporate bond spreads followed a similar pattern, tightening roughly 22 basis points, as measured by the Bloomberg U.S. Corporate Bond Index.

Following a very slow first half of the year, high yield bond and leveraged loan issuance picked up for the second consecutive quarter. High yield bond supply totaled close to $176 billion in 2023, an increase of roughly 65% compared to the prior year. Nonetheless, the continued flow of rising stars, high yield credits that have been upgraded to investment grade, combined with lower supply, provided technical support as the overall size of the high yield bond secondary markets decreased during the year. Leveraged loan fourth-quarter issuance totaled roughly $112 billion, bringing full-year issuance to roughly $370 billion, a 47% increase compared to 2022. Investment grade corporate bond supply continued apace with year-to-date total volumes topping $1.4 billion, in line with 2022, but still below historical averages.

With strong risk sentiment through the end of the year, inflows into high yield bond and leveraged loan funds partially reversed net outflows from earlier in the year. High yield bond inflows totaled more than $5 billion in the fourth quarter, which helped reduce the total outflow for the year to nearly $7 billion, well below the full-year outflow of nearly $49 billion in 2022. Leveraged loan fund retail demand was less pronounced, with inflows totaling less than $1 billion during the period, as the full-year outflow for 2023 topped $17 billion, which was roughly $5 billion more than last year’s outflow. Additionally, collateralized loan obligation (‘CLO’) demand picked up during the quarter, as CLO volume totaled nearly $139 billion in 2023 compared to just over $152 billion in 2022. Investment grade corporate bond funds saw solid retail demand continue with inflows of more than $16 billion in the fourth quarter and $88 billion for the full year.

Within the high yield bond market in the final quarter of the year, there was little performance dispersion between lower-quality and higher-quality bonds, as ‘BBs (+7.36%) outperformed ‘B’s (+7.01%) and ‘CCC’s (+6.91%). However, ‘CCC’s significantly outperformed for the full year, topping ‘B’s by roughly 6.07% and ‘BB’s by 8.25%. From an industry perspective, within the Bloomberg U.S. High Yield Bond Index, Brokerage & Asset Management (+11.80%) outperformed, while Transportation (+4.12%) underperformed.

Defaults and distressed exchanges rebounded, as high yield bond and leveraged loan default rates approached the highs from earlier in the year. The 12-month trailing, par-weighted U.S. high yield default rate, including distressed exchanges, increased roughly 73 basis points to end the quarter at 2.84% (2.08%, excluding distressed exchanges), below its long-term historical average. Meanwhile, the loan par-weighted default rate, including distressed exchanges, rose roughly 49 basis points to end September at 3.15% (2.10%, excluding distressed exchanges), near its long-term historical average.

Performance and Attribution Summary

High Yield Bond

The Aristotle High Yield Bond Composite returned 6.08% gross of fees (6.01% net of fees) in the fourth quarter, underperforming the 7.12% return of the ICE BofA BB-B U.S. Cash Pay High Yield Constrained Index. Sector rotation was the primary detractor from relative performance. Industry allocation and sector rotation also detracted modestly from relative performance.

Sector rotation detracted from relative performance led by the allocation to cash. The allocations to investment grade corporate bonds and bank loans also detracted from relative performance, with no offsetting contributors. Industry allocation also detracted from relative performance led by overweights in Transportation and Energy. This was partially offset by an underweight in Technology and an overweight in Banking. Additionally, security selection detracted from relative performance led by holdings in Finance Companies and Cable & Satellite. This was partially offset by selection in Diversified Manufacturing & Construction Machinery and Telecommunications.

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Investment Grade Corporate

The Aristotle Investment Grade Corporate Bond Composite returned 8.66% gross of fees (8.61% net of fees) in the fourth quarter, outperforming the 8.50% return of the Bloomberg U.S. Corporate Bond Index. Security selection was the primary contributor to relative performance, while sector rotation detracted from relative performance.

Security selection contributed to relative performance led by holdings in Technology and Retailers & Restaurants. This was partially offset by selection in Insurance and Transportation. Industry allocation also contributed modestly to relative performance led by an overweight in Real Estate Investment Trusts (REITs) & Real Estate-Related and an underweight in Pharmaceuticals. This was partially offset by an underweight in Telecommunications and an overweight in Utilities. Sector rotation detracted from relative performance led by the allocation to cash, with no offsetting contributors. A modest duration underweight also detracted from relative performance, with no offsetting contributors.

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Outlook

In recent months, we witnessed a significant shift in the macroeconomic landscape, characterized by lower inflation, robust growth, sturdy employment and a more dovish Fed. This substantially increased expectations for a potential “soft landing” in 2024. U.S. corporate credit markets experienced a robust rally into year-end, against a backdrop of solid corporate balance sheets, favorable technical factors and a resilient economic environment. Despite less favorable valuations post-rally, we maintain the belief that there is still a compelling case for holding U.S. corporate credit, given relatively appealing income opportunities and solid fundamentals.

Between the third quarter’s close and year-end, notable changes unfolded in interest rate market expectations for 2024. From concerns about increased U.S. Treasury supply in September, the narrative shifted to optimism around future Fed rate cuts by December. The turning point emerged in early November, following the U.S. Treasury’s tamer-than-expected quarterly refunding announcement and Fed Chair Powell’s dovish shift in response to softening inflation data.

As stated at the end of the third quarter, we thought U.S. yields had likely topped out in the near term as we headed into the fourth quarter. However, we did not anticipate the magnitude of the rate reversal in November and December, which we believe was likely exacerbated by positioning and technical factors. However, the same risks we acknowledged at the end of the third quarter remain, including the Fed’s commitment to quantitative tightening (‘QT’), growing U.S. deficits and potentially lower foreign demand for U.S. Treasuries. Consequently, with interest rate futures markets pricing in roughly 150 basis points in Fed cuts for 2024 following the sharp decline in yields in the fourth quarter, we anticipate longer-end U.S. yields to be rangebound with a bias to the topside heading into the new year.

With the improvement in U.S. economic data and the Fed’s dovish rhetoric, previously widespread fears of a looming recession have all but disappeared. In our opinion, the U.S. consumer remains in good shape while fiscal stimulus will continue to trickle into the economy as we enter an election year. Nonetheless, with market expectations pricing in what we see as a “Goldilocks” scenario, we believe it is prudent to monitor the incoming economic data for signs of slowing growth or more persistent inflation.

In light of the impact of the recent rally on valuations, at the moment, we believe there is limited opportunity for credit spreads to compress further from their current tight levels relative to history. Technical factors will remain supportive, as we expect new issue activity to remain subdued, rising stars in the high yield market to increase and demand to remain strong due to elevated all-in yields. Barring a more significant economic slowdown than we are anticipating, fundamentals are expected to remain healthy, maintaining moderate leverage, solid interest coverage and still modest default activity. That being said, the impact of higher rates is expected to be felt more in 2024 as certain issuers, notably in lower-quality segments of the market, confront the need to refinance debt at much higher interest rates. Nonetheless, we believe companies with sound capital structures in the higher-quality segment of the markets should be able to withstand higher rates, presenting an opportunity for income and positive total returns, particularly in the short to intermediate part of the yield curve.

High Yield Bond Positioning

In our high yield bond portfolios, we continue to favor higher-quality credits while focusing more on bottom-up security selection heading into 2024. From an industry perspective, we are continuing to look for more idiosyncratic themes with expectations for more differentiated performance across credits and industries in the new year.

While maintaining a bias toward higher quality, our primary focus will be on bottom-up security selection in 2024. We continue to hold a modest duration underweight relative to the benchmark and see attractive opportunities in the belly of the yield curve, as we see the yield curve steepening over 2024. Additionally, we expect fundamentals to remain resilient and the default rate to remain modest, and we believe riskier issuers are more likely to seek funding in the private markets. This will be a theme we will continue to monitor and explore further in the new year.

Industry-wise, we prefer those with a domestic focus and credits that have been prudent in managing their balance sheets to withstand persistent higher rates. We continue to overweight Energy and idiosyncratic themes in Retailers & Restaurants, while remaining cautious on Cable & Satellite and Telecom, where we believe business models are facing significant risks. At the end of the quarter, we held overweights in Energy, Transportation and Retailers & Restaurants alongside underweights in Technology, Telecommunications and Cable & Satellite.

Investment Grade Corporate Positioning

In our investment grade corporate bond portfolios, we maintain a neutral stance on duration relative to the benchmark, while increasing exposure to higher-quality credits. From an industry perspective, we reduced exposure to more cyclical industries and higher beta credits.

From a duration perspective, we maintained a neutral stance relative to the benchmark during the quarter. We continued to reduce exposure to split-rated/crossover credits (BBB/BB) while making more nuanced changes in higher quality tiers. As we believe quality continues to improve within ‘BBB’-rated credits, we have increased exposure in the shorter end of the curve, while increasing exposure to the longer end within ‘A’-rated credits.

From an industry perspective, we began to reduce higher beta names in industries such as Energy, while increasing exposure to higher-quality, less cyclical segments of the market, including Utilities. At the end of the quarter, we held overweights in Utilities, Insurance and REITs & Real Estate-Related alongside underweights in Banking, Healthcare and Technology.

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 Investment Grade Corporate 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. 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. 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-2401-4 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, Bloomberg *Composite returns are preliminary pending final account reconciliation. **2014 is a partial-year period of eight months, representing data from May 1, 2014 to December 31, 2014. ***2009 is a partial-year period of four months, representing data from September 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 primary benchmark was retroactively changed from Bloomberg U.S. Credit Bond Index to Bloomberg U.S. Corporate Bond Index effective March 31, 2017. The Aristotle Investment Grade Corporate Bond strategy has an inception date of May 1, 2014; however, the strategy initially began at Terence Reidt’s predecessor firm. A supplemental performance track record from September 1, 2009 to December 31, 2013 (Mr. Reidt’s departure from the firm) is provided. The returns are based on a separate account from the strategy while it was being managed at Terence Reidt’s predecessor firm and performance results are based on custodian data. During this time, Mr. Reidt had primary responsibility for managing the account. 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. 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 WTI Crude Oil Index is a major trading classification of sweet light crude oil that serves as a major benchmark price for oil consumed in the United States. The U.S. Dollar Index (DXY) is a measure of the value of the U.S. dollar relative to the value of a basket of currencies of the majority of the United States’ most significant trading partners. 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.

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