Market Overview
The ICE BofA US High Yield Index rose 1.09% in the second quarter, with the option-adjusted spread (OAS) widening six basis points (‘bps’), finishing the period at 321 bps. For the quarter, the ICE BofA BB US High Yield Index rose 1.32%, the B US High Yield Index rose 1.03%, and CCC US High Yield Index returned 0.18%.
The second quarter saw $77.9 billion of issuance across 124 issues. This quarter’s issuance was less than the $87.6 billion posted in the first quarter of 2024. During the quarter, refinancing activity (79%) was the main use of proceeds, followed by general corporate purposes (12%), acquisition financing/LBOs (6%), and dividends (3%). In addition to the primary issuance, during the quarter there were $1.8 billion in fallen angels across three issuers, and $5.4 billion in rising stars across four issuers.
Fund flows remained positive in the quarter, totaling $900 million. May and June’s positive flows of $4.1 billion and $1.4 billion, respectively, offset April’s outflow of $4.6 billion. This quarter’s flows were a decrease from the $4.6 billion inflow from the first quarter of 2024.
Default activity slowed in the quarter, following a rather active first quarter 2024. According to JPMorgan, including distressed exchanges, the par weighted high yield bond default rate is 1.7%. A total of $2.4 billion in bonds defaulted during the quarter, a decrease from the first quarter of 2024. In addition, loan defaults and distressed exchanges increased in this quarter. JPMorgan is estimating a 2.0% high yield bond default rate in 2024 and 3.0% in 2025 versus a long-term average 3.2%.
Portfolio Review
The US High Yield strategy (MUTF:LZHYX) gained 1.07% (Institutional shares), net of fees, for the quarter, underperforming the 1.09% return of its benchmark, the ICE BofA US High Yield Index (“the index”).
Overweight exposure to the real estate sector and underweight to the telecommunications and media sectors helped performance. Underweights to the financial services and healthcare sectors hurt relative performance in the period. In addition, the Portfolio’s underweight exposure to the riskiest subset of the market helped relative performance as CCC’s underperformed all rating categories in the quarter. Among individual positions, Nova Chemicals 4.25% due 05/15/2029 (0.91% weighting) moved higher upon reporting strong 1st quarter results. Cloud Software 9.0% due 09/30/2029 (0.58% weighting) rallied on solid first quarter results. On the downside, Hughes Satellite Systems 5.25% due 08/01/2026 (0.34% weighting) fell on disappointing first-quarter earnings, and Scripps Escrow 3.875% due 01/15/2029 (0.65% weighting) was lower as the 2024 outlook for television broadcasters remains challenged.
The Portfolio maintains a higher average credit quality profile than the index, with an overweight to BB credits and underweights to B and CCC credits. The Portfolio’s spread to Treasuries of 277 bps (bps) continues to be lower than the index’s 321 bps. The Portfolio has an effective yield of 7.4% versus 7.9% for the index. The Portfolio’s effective duration of 3.45 is higher than the index’ 3.26.
Outlook
The first two quarters of this year have been marked by ongoing challenges facing the Fed and market participants, as a stronger- than-expected economy, combined with accelerating inflation data, adversely impacted price gains from the fourth quarter of last year. However, during the second quarter, there are signs of a labor market that may be weakening. Moreover, inflation prints that have turned weaker than expected and seems to have resumed a weakening trend that, if continued, could prove to the Fed that meaningful progress has been made on inflation. For example, the unemployment rate has started to tick higher and revisions to headline payroll data shows weakness behind the headline number. In addition, the JOLTS Job Opening and Quits Rate are back to the pre-pandemic trend. Overall, not necessarily an alarm for employment but it could be a sign that the tight labor market experienced in the aftermath of the pandemic is over. The weaker than expected inflation data during the quarter has been a relief to the market as the January and February data showed unexpected reacceleration after six months of welcome deceleration. All that said, the yield differential between 10-year (US10Y) and two-year (US2Y) Treasuries, which finished 2023 at -0.37%, ended the second quarter at 0.36%, or essentially unchanged over the last 6 months. The length of this inversion and continued demand 30-year Treasuries (US30Y) continues to be impressive.
Because the US Treasury Department needs to continue to borrow to finance a spiraling deficit, we expect significant supply of Treasuries going forward putting upward pressure on rates. At the same time, the Fed seems poised to cut interest rates and have begun to taper their balance sheet runoff in Treasuries. These two forces are offsetting technical factors impacting the direction of interest rates. Impressively, long term yields have continued find significant demand considering fears of either accelerating inflation and or heavy US Treasury issuance. Nevertheless, history suggests continued vigilance is warranted to guard against the risk of reaccelerating inflation, particularly given that fiscal stimulus that is still working through economy. Therefore, we continue to believe that the yield curve should steepen and once again be positively sloped. Whether the reshaping is driven from the Fed cutting short term rates or from higher-than-expected inflation combining with an increase in term premium due to increasing Treasury supply, causing Fed to keep rates higher for longer.
Economy Remains Resilient Despite Higher Rates
The Fed held interest rates steady at its May and June policy meetings, but it is clear from its messaging and Summary of Economic Projections (and “Dot Plot”) that the US central bank expects rates will be lowered by only 25 bps during 2024, which is 50 bps lower than they initially forecast. However, given the impressive economic data combining with stubborn inflation, the narrative has become less dovish. Nevertheless, it is our opinion that the Fed is at the end of its monetary tightening cycle and will cut rates more than once this year; however, we expect interest rates will be volatile, as fiscal, and monetary policy forces continue to effect inflation and Treasury supply demand dynamics.
While the Fed remains sharply focused on taming inflation, employment has begun to show signs of deceleration or softening. Although the labor market remains strong despite the higher interest-rate environment, the U-3 Unemployment Rate has ticked higher from 3.8 to 4.1%. and total non-farm job openings, reflecting all jobs available but not filled on the last business day of the month, are now back toward pre-pandemic trends. While the labor force participation rate has been trending higher, it continues to struggle to get to pre-pandemic levels. Our view is that it appears labor is no longer tight and, if inflation comes down sufficiently, the Fed will have a green light to cut rates. We are impressed that the Fed has thus far engineered an aggressive tightening of interest rates without sacrificing employment.
In conclusion, in our view, it seems likely that the Fed is now prepared to start cutting interest rates if sufficient progress has been made to achieve its long-term inflation target of 2%. If the Fed is right, it has been able to orchestrate policy in a manner that has helped drive inflation lower while protecting its employment mandate, and credit markets have responded accordingly. Currently, the risk for market participants is either a recession due to a longer lag from the impact of rising interest rates on the economy or sticky or a reacceleration of inflation. Our view is that, while the probability of recession has grown materially less likely, it is still too early to declare victory. Because this is a presidential election year, we are paying attention to fiscal policy, which could provide a tailwind for economic activity. Of course, this complicates the Fed’s task because inflation could prove stubborn, limiting rate cuts or taking them off the table altogether. Finally, we expect interest rate volatility to remain elevated based on this interaction between fiscal and monetary policy.
Important Information Please consider a fund’s investment objectives, risks, charges, and expenses carefully before investing. For more complete information about The Lazard Funds, Inc. and current performance, you may obtain a prospectus or summary prospectus by calling 800-823-6300 or going to www.lazardassetmanagement.com. Read the prospectus or summary prospectus carefully before you invest. The prospectus and summary prospectus contain investment objectives, risks, charges, expenses, and other information about the Portfolio and The Lazard Funds that may not be detailed in this document. The Lazard Funds are distributed by Lazard Asset Management Securities LLC. Information and opinions presented have been obtained or derived from sources believed by Lazard Asset Management LLC or its affiliates (“Lazard”) to be reliable. Lazard makes no representation as to their accuracy or completeness. All opinions expressed herein are as of the published date and are subject to change. The performance quoted represents past performance. Past performance does not guarantee future results. The current performance may be lower or higher than the performance data quoted. An investor may obtain performance data current to the most recent month-end online at www.lazardassetmanagement.com. The investment return and principal value of the Portfolio will fluctuate; an investor’s shares, when redeemed, may be worth more or less than their original cost. Different share classes may have different returns and different investment minimums. Please click here for standardized returns: https://www.lazardassetmanagement.com/us/en_us/funds/mutual-funds/lazard-us-corporate-income-portfolio/F144/S70/ Allocations and security selection are subject to change. Mention of these securities should not be considered a recommendation or solicitation to purchase or sell the securities. It should not be assumed that any investment in these securities was, or will prove to be, profitable, or that the investment decisions we make in the future will be profitable or equal to the investment performance of securities referenced herein. There is no assurance that any securities referenced herein are currently held in the portfolio or that securities sold have not been repurchased. The securities mentioned may not represent the entire portfolio. An investment in bonds carries risk. If interest rates rise, bond prices usually decline. The longer a bond’s maturity, the greater the impact a change in interest rates can have on its price. If you do not hold a bond until maturity, you may experience a gain or loss when you sell. Bonds also carry the risk of default, which is the risk that the issuer is unable to make further income and principal payments. Other risks, including inflation risk, call risk, and pre-payment risk, also apply. High yield securities (also referred to as “junk bonds”) inherently have a higher degree of market risk, default risk, and credit risk. Credit ratings as assigned by Standard & Poor’s. Bonds rated BBB are investment grade and are defined as having adequate capacity to meet financial commitments, but more subject to adverse economic conditions than bonds rated higher. Bonds rated below BBB are generally referred to as speculative grade securities. Bonds rated BB, B, or CCC are regarded as possessing a speculative capacity to pay debt service because of the existence of negative factors or uncertainties for which there are no compensating positive factors. Ratings from BBB to CCC may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within each of the major rating categories. The ICE BofAML US High Yield Cash Pay Index is a subset of the Bank of America Merrill Lynch US High Yield Master II Index and tracks the performance of US dollar- denominated below-investment grade corporate debt, currently in a coupon paying period, that is publicly issued in the US domestic market. The index is unmanaged and has no fees. One cannot invest directly in an index. Certain information contained herein constitutes “forward-looking statements” which can be identified by the use of forward- looking terminology such as “may,” “will,” “should,” “expect,” “anticipate,” “target,” “intent,” “continue,” or “believe,” or the negatives thereof or other variations thereon or comparable terminology. Due to various risks and uncertainties, actual events may differ materially from those reflected or contemplated in such forward-looking statements. The indices referenced in this document are included merely to show general trends in the market during the periods indicated and are not intended to imply that investments made pursuant to the strategy are or will be comparable to any index in either composition or element of risk. The strategy is not restricted to securities comprising any index. The strategy may use various investment techniques not reflected in an index. The indices referenced herein are unmanaged and have no fees. One cannot invest directly in an index. There is no guarantee that the strategy’s performance will meet or exceed any index. |
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