Polen U.S. Opportunistic High Yield Portfolio Q4 2024 Commentary

Summary

• During the fourth quarter, the Polen Capital U.S. Opportunistic High Yield Composite (the “Composite”) outperformed the ICE BofA U.S. High Yield Index (the “Index”) but underperformed the Credit Suisse Leveraged Loan Index, net of fees.
• Rising yields and spread widening led to mixed results for below investment grade credit. Leveraged loans produced a gain in the fourth quarter and outperformed high yield bonds, which generated a modest gain.
• In Q4, Baffinland Iron Mines Corporation and Assured Partners contributed the most to total returns, while Medical Solutions and Dexko Global were the largest detractors.
• Polen Capital did not make any meaningful changes to portfolio positioning in the fourth quarter. However, we did increase positions in certain existing holdings. Further, we executed relative value sales in positions that had rallied during the quarter.
• As we step into 2025, our primary concerns remain focused on the risks of a potential monetary policy misstep, a softening consumer, widening fiscal deficits, and escalating geopolitical tensions.
• In our view, maintaining patience and avoiding an overreach for yield will enable our portfolios to remain well-positioned to capitalize on compelling opportunities as the cycle matures.

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Commentary

During the quarter, the overall environment was favorable for risk assets. To the delight of investors, the Federal Reserve (the “Fed”) delivered two rate cuts, and market sentiment improved following the outcome of the U.S. presidential election. As a result, high yield spreads reached their tightest levels since 2007. However, toward year end, the Fed’s hawkish tone—prompted by stronger- than-expected economic activity and inflation readings—pushed

U.S. Treasury yields higher and spreads wider. Despite this, in Q4, the ICE BofA U.S. High Yield Index managed to produce a gain of 0.16%. Once again, high yield returns were led by bonds rated CCC and below, which generated a gain of 2.45%. Meanwhile, B- rated issues also eked out a modest gain of 0.34%, but BB-rated bonds incurred a loss of -0.50%, as higher yields more than offset the modest spread tightening experienced by this cohort during the quarter.

Further, in Q4, the top performing sectors were transportation, telecommunications, and media, while the biggest laggards were the utility, real estate, and healthcare sectors. For the full year 2024, the high yield bond index delivered a total return of 8.20%.

Expectations for a “higher for longer” rate environment sustained strong investor appetite for floating rate leveraged loans. Several months of inflows and CLO origination supported a robust bid for leveraged loans.

As of this writing, more than 60% of the loan market is priced above par. In Q4 2024, the Credit Suisse Leveraged Loan Index gained 2.29%, finishing the year with a total return of 9.05%— outperforming its fixed rate peers for the third time in four years. During the quarter, B-rated loans in the index outperformed their BB-rated and CCC-rated counterparts, each producing gains of 2.53%, 2.21%, and 0.25%, respectively. Among loans in Q4 2024, metals/minerals, media/telecommunications, and retail emerged as the best performing sectors.

Turning to new issuance activity, Q4 2024 saw diverging trends between high yield bonds and leveraged loans. While high yield bond issuance slowed, activity in the loan primary market surged. Following strong activity in Q3 2024, high yield bond issuance fell during the quarter, producing the lowest quarterly total of the year. Although refinancing activity remained the largest use of proceeds, M&A-driven issuance as a percentage of total activity increased for the second consecutive quarter. Notably, 2024 primary market issuance for high yield bonds exceeded the combined totals of the preceding two years.

For leveraged loans, new issuance reached record-breaking levels. Q4 2024 was the most active quarter of the year, with December marking the busiest single month on record. To provide context, 2024’s loan primary market activity totaled $1.3 trillion, smashing the previous all-time high of $973.9 billion set in 2017. However, despite the impressive gross total, approximately 88% of this activity was used to refinance or reprice existing debt, leaving net new issuance at relatively low levels.

Finally, while bifurcated default activity persists, it remains in aggregate under control. According to J.P. Morgan data, at the end of Q4 the trailing twelve-month default rates for high yield bonds and leveraged loans (including distressed exchanges) were 1.47% and 4.49%, respectively, representing the widest gap between the two markets since 2000. Excluding distressed exchanges and liability management exercises (LMEs), default rates declined to 0.36% and 1.52%, respectively. This data underscores the prevalence of distressed exchanges and LMEs, particularly in the leveraged loan market. This divergence is likely to persist as elevated rates continue to put pressure on fundamentals among loan issuers.

Portfolio Performance & Attribution

The Polen Capital U.S. Opportunistic High Yield Composite generated a total return of 0.91% gross and 0.80% net of fees during the third quarter. The Composite outperformed the Index by 75 bps gross and 64 bps net of fees. In Q4, U.S. Treasury yields declined. As a result of the Portfolio’s1 shorter duration relative to the Index, the duration effect for the quarter was negative.

However, the Portfolio’s income advantage relative to the Index contributed to relative performance. However, in aggregate, the Portfolio’s reorganized equity positions detracted from absolute and relative returns.

Attribution by rating shows that the quality allocation effect was positive and driven primarily by the Portfolio’s overweight to CCC-rated bonds as well as its underweight to BB-rated bonds.

Conversely, the Portfolio’s aggregate security selection effect by rating was negative. Specifically, the Portfolio’s CCC1-rated positions lagged those of the Indes and detracted from relative performance. This negative effect was partially offset by the positive effect from the Portfolio’s CCC3-rated and CCC2-rated holdings, which outperformed those of the Index.

Turning attention to sector attribution, the sector allocation effect was negative. This negative effect was driven by the Portfolio’s overweight to the Capital Goods and Healthcare sectors. However, these negative effects were partially offset by the positive effect produced by the portfolio’s overweight to the Media sector. Conversely, the sector security selection effect was positive. The Portfolio’s holdings in the Basic Industry and Insurance sectors outperformed those of the Index, contributing to relative performance. However, these positive effects were partially offset by the negative effect produced by the Portfolio’s holdings in the Media sector, which lagged those of the Index.

Notable issuers that contributed to, or detracted from, the Portfolio’s total return for the quarter are set forth below.

Top Contributors

Baffinland Iron Mines Corporation, based on Baffin Island in Nunavut, Canada, is a low-cost producer operating one of the world’s highest-grade iron ore mines. The performance of the company’s 8.75% First Lien Notes due July 2026, held by the Portfolio, was bolstered by positive developments during the quarter regarding the company’s planned expansion. The proposed project, expected to begin in early 2026, aims to roughly triple the mine’s ore output and will require external capital for funding as well as the refinancing of the existing Notes. In Q4, the company announced progress in meeting its goals and timeline for the expansion, driving positive price movement in the Notes.

AssuredPartners, the 11th largest insurance brokerage firm in the U.S., generates $2.9 billion in revenue and ~$1.025 billion in Adjusted EBITDA annually, operating within a highly recurring and relationship-driven commercial insurance market. With a diversified revenue base free from significant customer, producer, or carrier concentration, and strong client retention, the company benefits from its ability to acquire smaller, independent brokers in a fragmented industry. Its EBITDA margins in the low-to-mid 30% range and minimal capital expenditure requirements drive strong cash flows, enabling reinvestment in acquisitions for growth.

Recently, AJ Gallagher announced plans to acquire AssuredPartners for $13.45 billion, causing its 7.5% Senior Notes due 2032 to trade up, reflecting investor expectations that they will be repaid at the make-whole price in H1 2025.

Largest Detractors

Medical Solutions provides workforce solutions to U.S. healthcare facilities, primarily by recruiting and placing travel nurses on approximately 12-week contracts to address fluctuating labor demands. Additionally, the company staffs respiratory technicians, therapists, and medical assistant roles. The Portfolio’s investment in the company’s SOFR + 7.0% Second Lien Term Loan due 2029 declined during the quarter following weaker-than-expected Q3 2024 results amid a challenging market for temporary health care staffing. Despite the macro challenges, the Portfolio continues to hold the Second Lien Term Loan as we believe it offers an attractive risked-adjusted return opportunity.

Dexko Globall is a Michigan-based manufacturer of trailer axles, chassis, suspensions, and components for markets such as industrial trailers, RVs, and utility vehicles. It derives 60% of its revenue from North America and 40% from international markets. The company’s 6.625% Senior Notes due 2029 were a top detractor to returns this quarter. The company’s 2024 year- to-date results fell short of expectations due to weakness in global RV and industrial trailer markets. Despite near-term challenges, we remain optimistic given Dexko’s leading market position, high barriers to entry, strong free cash flow, and excellent management team.

Portfolio Positioning & Activity

In Q4 2024, we did not make any meaningful changes to portfolio positioning. However, we increased our positions in select existing holdings and executed relative value sales on positions that rallied during the quarter.

Outlook

Our view is that the significant rally in equities and leveraged credit during the past two years reflects market participants’ growing belief that the Fed can orchestrate a soft landing.

However, the market’s confidence in this outcome could be disrupted if the Trump administration attempts to remove the Fed chairman prior to the end of his current term in 2026.

Regardless, for now market participants seem to have shifted their attention away from inflationary risks to concerns about the consumer and the economy. However, economic indicators continue to be supportive of markets.

As we enter 2025, our primary concerns include a monetary policy mistake, a weaker consumer, larger fiscal deficits, and growing geopolitical risks.

While the new administration may facilitate business-friendly deregulation and enact tax cuts, the implementation of certain trade policies such as tariffs could have a less favorable impact on the overall U.S. and global economy. With that in mind, as of now, markets seem complacent.

That said, we anticipate a decline in refinancings alongside an increase in net new issuance of high yield bonds and loans, driven by a resurgence in M&A activity amidst a more accommodating regulatory landscape and lower yields. While repricing and refinancing will certainly not vanish, their proportionate share of new issuance should fall.

Within the private equity space, sponsors are likely to pursue exits from portfolio investments due to prolonged holding periods resulting from a slowdown in deal-making in recent years. Many sponsors had heavily leveraged their acquisitions during a low- interest-rate environment but rising rates and falling valuation multiples have now complicated the monetization of these investments. As limited partners grow impatient for returns as their funds’ investment periods end, we expect sponsors to initiate monetization efforts. Despite restrictive monetary policy, a shift toward lower yields is anticipated, supporting these initiatives.

We believe that we are reaching the top of the cycle for the broader high yield and leveraged loan markets. Though spreads are tight, as a long-only fixed income manager, we must nonetheless manage our client portfolios through the cycle.

As a result, today, we are being more cautious and are willing to sacrifice yield for safety. Safety for us means investing in competitively advantaged businesses that generate sustainable free cash flow and offer a reasonable margin of safety. In our view, remaining patient and not overreaching for yield will leave our portfolios well positioned to take advantage of compelling opportunities as the cycle ages.

Sincerely,

Dave Breazzano, Ben Santonelli, and John Sherman

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