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Still Runway for High-Yield and Bank Loan Funds

Cara Esser, CFA

Cara Scatizzi: Hi, I am Cara Scatizzi, a closed-end fund analyst at Morningstar. I am joined today by T.J. Settel, a portfolio manager at Western Asset.

T.J. specializes in bank loans and high-yield bonds. Thanks for joining me T.J.

T.J. Settel: Thank you, Cara.

Scatizzi: TJ, what's been going in the bank loan and high-yield bond market?

Settel: Well, it's kind of interesting times right now. We're in a period right now where we had great returns over the past two years, and people are kind of questioning what the returns are going to look like for the next six to 12 months.

We right now are still in favor of the asset class. We're looking at some of the strength that's in the asset class such as the economy that we think continues to improve. Corporate fundamentals that continue to improve. Valuations that we still think offer attractive valuations, and default rates that are going to continue to go down. So we're still in favor of the asset class.

Scatizzi: What did the first quarter look like for this asset class?

Settel: Well, year-to-date high yield is up about 5.5%, which has been a very strong return. We were looking for about 8% to 10% return for the year. So we're more than half way through what our target is, but for the remainder of the year if you get 4.5%, 5% that's still going to look at versus other asset classes, and loans are up about 3.3%, which is right on schedule for our full-year target return of about 6% to 8%.

Scatizzi: And you said that you still see value in both the bank loan and the high-yield market. Where specifically do you see some of those valuable opportunities?

Settel: So we still like the lower end of the credit spectrum. So, CCCs are still fairly attractive. Not nearly as attractive as they were two to three years ago, but they still offer some value.

We still like the upgrade candidates; we still think that there's going to be continued M&A and takeout of high-yield names and that those names that are taken out will continue to trade up.

Within the bank loan space, we're finding more value in the new-issue calendar versus the secondary calendar where you are getting about LIBOR plus 4.50 with a one and a quarter floor, and a nice dollar discount, and then you have obviously the floating rate of interest.

Scatizzi: And can you tell us a little about the close-end funds that Western Asset manages?

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Settel: Sure. We launched one last year called HYI. That's the ticker symbol, obviously. What's unique about that firm, which we like, it had a 15 year fixed maturity. It tends to focus on the lower part of the quality spectrum. It's trading at a 4.5% discount right now, which is usually attractive. It's got a 9.2% distribution yield right now.

We also have HIO, which is a traditional high-yield fund trading at a 1% discount right now with about 8.3% distribution yield.

Then we also have a leverage fund, HIX, which is at 5.2% premium because of the leverage, but that's distributing over 10% right now.

Scatizzi: Where do you think that the bank loan in the high yield market will be headed in the next few months?

Settel: That's a great question. I think that's the question everyone wants to get answered. We get back to fundamentals again, and we're going through first quarter earnings right now and it looks very, very strong. Again, it's surprising to the upside. We're seeing revenue growth for most of our companies. Importantly, most of our companies are not guiding towards any kind of earnings warnings for the foreseeable future. Even with commodity prices rising, they think for the most part that could be absorbed.

We continue to see record profitability for most of our companies. We continue to see very large amounts of free cash flow being generated. We continue to see that liquidity on the balance sheet is very, very strong, access to capital is very, very strong. So, this year high yield has done close to $100 billion in issuance loans, have done over $100 billion of issuance, that's a very strong number, and we're well on pace between two asset classes north of $400 billion being issued.

Maturity schedule is actually much less of an issue than it was a couple of years ago, so if we were here in 2008 and you looked out to 2014, we would see over $500 billion that was due between 2008 and 2014. If you look till today, there is about $200 billion that's due, and including less than $30 billion that is due over the next 12 months, so the maturity schedules are very favorable. And defaults continue to go down. We're on pace for less than 1% default, which is very, very low, and this is a second straight month where we had no defaults at all in the marketplace.

So, if you put that altogether, and you say, valuations right now within high yields, you're getting Treasuries plus 500, loans is about the same LIBOR plus 500, you say where should I trade? You could argue that we should be able to tighten by at least another 100 basis points over the next 12 months in both asset classes. So, we think that there is still some value within the marketplace.

Scatizzi: T.J. a lot of people are concerned about rising interest rates. How do you think that would affect both the bank loan and the high yield market?

Settel: It's a great question and it's one of the primary concerns we hear from investors as well. If you step back and think about high-yield and bank loans, bank loans are easier, their floating rate of interest, and so they should do quite well in the rising interest rate environment as long as we don't get a spike in interest rates.

Let me just say for the record that Western Asset actually thinks the Fed is going to remain accommodative for quite a while, and so we're not expecting a spike in interest rates. But if you look back in time and you look at high yield, for example, if you compare it versus where Treasuries are trading right now, high yield's trading at 150% premium to the 10-year Treasury right now, which is fairly wide versus history, and it's also trading at a spread north of 500, which is again wide of history.

So, it's very easy to see that high yield can withstand some type of rising interest rate, maybe 100 basis points, before it would affect the asset class. So again, we don't think that there is going to be a spike in inflation or in interest rates, and so high yield and bank loans should do very well in that environment.

Also, I'll point out that a lot of times inflation for corporations and for their balance sheet and for their earnings is fairly good in the short term because revenues rise and costs stay fairly sticky, so we think in the short-term it could be good for high yield.

Scatizzi: Well, thanks for joining me today, TJ, I really appreciate it.

Settel: Sure. Thank you.