Artisan High Income Fund Q2 2024 Commentary

Efficiency Dialogue

Our portfolio carried out in keeping with the ICE BofA US Excessive Yield Index through the quarter. From an asset class perspective, safety choice in company bonds was the biggest constructive contributor. By score, we added worth by safety choice in BB- and B-rated credit score, whereas our obese to CCC detracted from relative returns. Throughout sectors, the biggest constructive contributors included our obese to insurance coverage in addition to safety choice in companies and telecommunications. The biggest sector detractors included safety choice in media and retail.

Investing Surroundings

The excessive yield bond market held comparatively agency through the quarter, as engaging yields supplied an revenue return that offset marginal unfold widening and rising Treasury charges. The ICE BofA US Excessive Yield Index gained 1.0%, bringing year-to-date whole returns to 2.6%. Much like Q1, price volatility proceed to weigh on returns as traders lowered their expectations for Federal Reserve price reductions in 2024. In March, the Fed Funds futures market was pricing between two to a few cuts by the tip of the yr; by the tip of June, traders lowered their expectations to between one and two cuts. This market reassessment contributed to a rise in Treasury yields, with the 10-year Treasury yield ending the quarter up roughly 20bps at 4.4% (although off its peak yield of 4.7% in April).

On the headline degree, unfold motion was comparatively modest through the quarter because the index widened 6bps. Beneath the floor, nonetheless, there’s a rising bifurcation throughout credit score qualities. The BB- and B-rated parts of the index tightened by 5bps and 7bps, respectively, whereas CCCs widened 96bps through the quarter, ensuing within the largest unfold differential between BBs and CCCs since Might 2023. Of specific observe is that the unfold on the BB-rated phase of the index is within the backside decile since 1996 (when ICE started monitoring index unfold information); but at a 53% weight the phase is near an all-time excessive as a proportion of the index and almost 10% above its long-term common. This lends important credence to the worth of energetic credit score investing over passive in at present’s market, as the vast majority of any passive funding in excessive yield would—by design—be directed towards the most costly components of the market, relative to historic spreads.

We observe with curiosity a latest evaluation accomplished by JPMorgan relating to dispersion within the CCC class. Regardless of excessive nominal spreads of 953bps on the total CCC degree, there’s a important quantity of dispersion between greater unfold and decrease unfold points. The evaluation means that roughly 40% of the CCC index trades within 500bps whereas almost one third trades at spreads over 1,000bps—the normal definition of distressed in response to ICE BofA index inclusion guidelines. Our traders know that we’ve got traditionally been obese CCCs with a view that the true threat profile of sure names and sectors within the house—significantly the insurance coverage brokerage phase—just isn’t in line with the extent of default threat implied by a CCC score. This information additional confirms that traders mustn’t view the CCC house as one single, monolithic, “dangerous” entity; there may be substantial dispersion within the CCC class, and no two CCC-rated credit are alike. In the end, we really feel that the CCC market just isn’t a marketplace for “vacationers”—it requires rigorous elementary due diligence and experience to uncover worth.

Whereas price volatility weighed on excessive yield bonds, the leveraged mortgage market continued to carry out, growing its lead over excessive yield year-to-date. The Credit score Suisse Leveraged Mortgage Index returned 1.9% for the quarter bringing its year-to-date return to 4.4%. Over the previous three years, the leveraged mortgage market has outperformed mounted price belongings by an astounding quantity, with an annualized return of 6.0% as in comparison with the excessive yield market at 1.6% and funding grade bonds (as measured by the ICE US Broad Market Index) at -3.0%. Importantly, the leveraged mortgage market has achieved these returns with a lot decrease volatility than excessive yield and funding grade, providing beneficial diversification to portfolios. Certainly, on a longer-term foundation, our mortgage allocation has added important worth and stays an space that we proceed to seek out choose engaging alternatives for our traders.

Much like Q1, major markets continued to fireside on all cylinders. Throughout Q2, the excessive yield market priced over $78 billion in gross issuance whereas leveraged mortgage markets priced $385 billion, with Might and June registering as the 2 highest gross provide months within the historical past of the mortgage market. We observe, nonetheless, that the overwhelming majority of issuance continues to be refinancing/repricing associated—web new credit score creation could be very low, in line with an M&A market that is still effectively under peak volumes, and in response to information from BofA, each the excessive yield and leveraged mortgage index have decreased in par quantity excellent since their 2021/2022 peak. Nonetheless, the significance of selectivity is amplified in environments the place cash flows freely. On condition that many debtors (wholesome or in any other case) have been capable of maintain their enterprise by new issuance/refinancings or cut back their curiosity prices by repricing, underlying weak point or credit score considerations might go unappreciated by the broader market.

Default volumes stay low relative to historical past, although we’re starting to see important dispersion between calculations that focus solely on “laborious defaults”—missed funds or bankruptcies— versus people who embrace distressed exchanges or legal responsibility administration workout routines (LMEs). Knowledge from JPMorgan suggests a major hole in trailing twelve month default charges between the 2 calculations—with the default price for par-weighted “laborious defaults” registering at 1.2% for top yield and 1.1% for loans, versus 1.8% for top yield and three.1% for loans when together with distressed exchanges. The greater than 2% distinction between calculations for leveraged loans is close to a document excessive, effectively above the 25bps common distinction since 2010. We consider this enhance in so-called “creditor on creditor violence” might present selective alternatives to accumulate belongings within the secondary market the place present pricing is reflective of a extreme influence from a possible distressed alternate and we’ve got a differentiated view on potential intermediate-term restoration.

The rise of personal credit score and its influence on credit score markets continues to be extensively debated. We mentioned our views intimately at our latest 2024 Artisan Companions Funding Discussion board, with a view that pricing and phrases throughout private and non-private credit score are successfully converging, and company debtors—not like allocators—don’t essentially view these markets as three distinct buckets; they may merely borrow out there that offers them the perfect deal. We’re seeing these impacts in actual time because the sponsored direct lending market is as soon as once more dealing with stiff competitors from banks within the major excessive yield and mortgage market. Consequently, the illiquidity premium (as measured by spreads) for sponsor-backed direct lending seems to be declining, with latest information from Pitchbook LCD suggesting a cloth discount in spreads for direct lending offers issued within the first half of 2024 versus the second half of 2023.

Portfolio Positioning

From an asset class perspective, our positioning remained comparatively constant over the quarter, with our cut up between bonds and loans at roughly 75%/16%, respectively (with the rest invested primarily in money and money equivalents). Although solely 16% from a headline weight perspective, our mortgage allocation continues to offer a major yield pickup over bonds, with the phase offering potential for engaging returns at present yield ranges. By credit score high quality, our BB publicity elevated barely through the quarter—primarily pushed by upgrades quite than new purchases—whereas our publicity to CCCs declined primarily pushed by the retiring of insurance coverage dealer NFP’s excellent debt following its acquisition by Aon.

The common worth of our portfolio was roughly $90.3 on the finish of June, almost three factors under the excessive yield index. The portfolio’s yield stays comfortably above the benchmark and affords the potential for engaging returns, each in absolute phrases and relative to different asset courses. That is significantly related at a time when the narrative for the broader fairness market continues to be one among focus threat pushed by the Magnificent Seven shares (Apple, Amazon, Alphabet, Meta, Microsoft, Nvidia and Tesla) and an absence of market breadth.

Our largest sector allocations proceed to be insurance coverage brokerage and recreation and journey—particularly, cruise traces. We retain conviction within the close to time period on our cruise traces publicity and would observe that throughout sectors which might be historically considered extra client delicate, this phase nonetheless stays on strong footing. Occupancy charges stay excessive (in extra of 100%), and the hole in pricing between land-based holidays and cruises has widened considerably lately—with cruise traces representing a cut price for the tip client in a time interval the place wallets might turn into extra restrictive.

Within the close to time period, we view the TMT house—know-how, media and telecommunications—as the realm of the market most vulnerable to potential disruption by LMEs. Already in 2024, we’ve got seen a number of high-profile names present process numerous types of LMEs, leading to each the media and telecommunications subsectors of the index lagging behind the remainder of the market. Nevertheless, an increase in LMEs additionally brings the potential for elevated alternatives to buy choose belongings which might be attractively discounted within the secondary market.

Perspective

The primary half of 2024 has introduced elevated rate of interest volatility, an increase in distressed exchanges and “vast open” capital markets, whereas traders proceed to face uncertainties surrounding the economic system, financial coverage and geopolitics. Regardless of all of those headlines, leveraged credit score continues to carry out, buoyed by robust revenue returns and yields which might be engaging relative to historic ranges. We proceed to view excessive yield bonds and leveraged loans as a beneficial part of a diversified portfolio. Whereas the present surroundings just isn’t as goal wealthy because it was a yr in the past from a variety perspective, the potential to generate high-single-digit returns with considerably much less rate of interest threat than funding grade bonds creates a strong complement to a standard asset allocation.

Those that have invested with us for longer time durations know {that a} core tenet of our philosophy is our emphasis on enterprise high quality— firms that exhibit engaging traits equivalent to excessive recurring income, low capex wants, tangible obstacles to entry and in the end a purpose to exist. In at present’s borrower-friendly surroundings the place most issuers have been capable of freely entry capital markets, the significance of this tenet can’t be overstated. We stay discerning patrons of threat, with a excessive rejection price on new issuance. It’s our agency perception that those that follow disciplined and high-conviction credit score investing are rewarded for his or her persistence over the long run.

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