The iMGP High Income Alternatives Fund gained 2.18% in the quarter, compared to the 1.83% gain for the Bloomberg Barclays US Aggregate Bond Index (Agg) and 2.75% gain for high-yield bonds (BofA Merrill Lynch US High-Yield Cash Pay Index). For the first half of 2021, the fund gained 4.34%, compared to returns of -1.60% and 3.59% for the Agg and high-yield, respectively.
Past performance does not guarantee future results. Index performance is not illustrative of fund performance. An investment cannot be made directly in an index. Short-term performance in particular is not a good indication of the fund’s future performance, and an investment should not be made based solely on returns. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance of the fund may be lower or higher than the performance quoted. To obtain the performance of the funds as of the most recently completed calendar month, please visit www.imgpfunds.com. Investment performance reflects fee waivers in effect. In the absence of such waivers, total return would be reduced.
Quarterly Review
The High Income Alternatives Fund climbed by almost 2.2% during the second quarter of the year, continuing a strong stretch of absolute and relative performance following the pandemic-driven dislocation of credit and equity markets in March 2020. Even after lapping the strong recovery of Q2 2020 (+10.14%), the fund’s trailing one-year performance (ending June 30, 2021) is up 16.07%, far surpassing the Agg’s -0.33% return, and also edging out the high-yield index’s 15.48% gain.
In what was a positive second quarter across the domestic credit markets, inflation concerns seem front of mind for investors. Although the Fed acknowledged that recent inflation numbers were higher than expected, they still believe the latest increases are transitory. Looking ahead, the Fed estimates that inflation will revert to their target of around 2% by 2022, suggesting that they believe inflation will subside from current levels. Against this backdrop, we saw the 10-Year Treasury yield decline. After hitting an all-time low of 0.51% in the summer of 2020, yields reached 1.74% at the beginning of quarter before ending the three-month period at 1.47%.
Going forward, a key initial input to the credit markets will be the Fed’s ability to effectively take their foot off the gas of accommodative policies in the form of tapering their asset-buying programs. The second step will be their decision around increasing interest rates. In the meantime, our credit managers currently believe the credit markets offer relatively attractive opportunities given the still-supportive Fed but continue to be very selective amid rising valuations. As a reminder, the credit managers are flexible both in their sector allocations as well as risk level. If they believe it to be prudent, they will rotate “up-in-quality” to more conservative exposures while waiting for more attractive risk-adjusted opportunities. Meanwhile, Neuberger Berman has continued to perform well (up over 8% year to date and over 19% the last year). The strategy has been collecting attractive premiums as options markets continue to earn back losses suffered early last year through rich pricing of implied volatility, with the VIX just recently getting back to the neighborhood of its pre-pandemic levels.
As a reminder, the fund is intended to be a complement to traditional fixed-income allocations, seeking long-term returns that are significantly higher than core fixed-income with a low correlation to core bonds and less interest-rate sensitivity, but almost certainly higher volatility. Over the long term, we believe returns will be comparable to high-yield bonds, but with lower volatility and downside risk because of the diversified sources of return and manager flexibility.
Performance of Managers
During the quarter, all three managers produced positive performance. Neuberger Berman returned 3.57%, Guggenheim gained 2.02%, and Brown Brothers Harriman was up 1.87%. (These returns are net of the management fees that each sub-advisor charges the fund.)
Manager Commentaries
Brown Brothers Harriman
The BBH sleeve had a strong second quarter performance of 1.97%. At the half-way point in 2021, the sleeve has already returned 4.28% and our disciplined strategy of seeking returns from credit selection rather than interest rates movement continues to be a differentiated approach to fixed income. Similar to last quarter, our performance this period was achieved with very little movement in overall credit spreads as BBB and BB rated bond spreads tightened just 11bps and 27bps, respectively, and the BBH sleeve maintained its low 2.1-year duration exposure.
Meanwhile, the 10-year US Treasury yield rallied 27bps from the March high of 1.74% to end the quarter at 1.47% as the market continues to debate the strength of the U.S. economic rebound and the potential for above trend inflation. The move down in interest rates was not enough to bring the performance of the Agg out of negative territory for the first half and trailing one year.
Our investing focus in the quarter was in off-the-run and niche sectors of the securitized asset-backed securities (ABS), floating-rate loan and bonds markets, where narrowing pockets of opportunity still reside today. The further tightening of credit spreads throughout the quarter has broad-market valuations now approaching extreme levels in both low spreads, yields and lack of volatility. The situation remains challenging for investors today, but still manageable for the BBH sleeve. The sleeve has a yield of 4.4% and we are optimistic that our investments will continue to perform well in 2021.
We ended the second quarter in much the same situation as the prior quarter. Valuations remain expensive for the majority of market sectors and our focus remains on locating those new, niche, or recovering credit investments that differentiate our process and performance from competitors. We do not know when valuations may cheapen, so we continue to be disciplined about the durability of investments and the prices paid to enter into positions. The importance of investment income or carry, and patience, is rising as the pace of potential capital appreciation slows. We remain steadfast in our approach and are comfortable in the sleeve’s positioning heading into the second half of the year.
Guggenheim
Although U.S. vaccinations have slowed, relaxed social distancing measures and increased consumer comfort is prompting a rapid reopening of the service sector. While total vaccination rates are not sufficient for herd immunity, take up has been higher for the most vulnerable, which should limit hospitalizations and deaths and keep reopening intact. Fiscal policy has driven strong gains in personal income, and household net worth has been boosted further by stock market gains and surging home prices. With consumer savings the past year over $2.3 trillion in excess of normal levels, consumption growth will be strong even as fiscal support fades. Real GDP growth will get a further boost from a continuation of housing market strength supported by low inventories and low borrowing costs, and with rising business investment as inventories are replenished and firms respond to the strong demand outlook. We expect over 7% real GDP growth in the U.S. this year, and over 3% next year.
The pace of job gains has disappointed in recent months, with COVID fears, school closures, and unemployment benefits all possible causes. All three issues will fade by the fall, allowing more rapid job growth and lower unemployment. We expect volatile inflation readings in the near term due to supply chain backlogs in the manufacturing sector and price adjustments as consumption shifts from goods to services. We expect core inflation will decelerate to under 2% by the middle of 2022, as rising capacity alleviates supply constraints and base effects become more challenging. Over the next several years we expect that the Fed will struggle to reach the 2% target, let alone exceed it on a sustained basis, as the secular disinflationary headwinds of debt and demographics have not gone away. The pandemic accelerated technology adoption and digitization, which should boost productivity growth and in turn help restrain price pressures over the medium term.
We expect a continuation of accommodative monetary policy as the Fed seeks to demonstrate the credibility of its new average inflation targeting framework. The Fed is also eager to pursue its new definition of maximum employment, which is focused on reducing labor market disparities between different demographic groups. We don’t expect tapering of asset purchases will begin until Q2 2022 and expect rate hikes will not occur until 2025. We expect more fiscal spending focused on infrastructure, education, and childcare that will likely be paired with tax increases. We expect tax changes will include raising the top marginal individual income tax rate, raising the corporate tax rate a few percentage points and raising taxes on international income, and possibly raising the capital gains tax. Tax hikes will likely be phased in to minimize the near-term economic drag, and higher government spending will outweigh the size of tax increases.
Though credit spreads have tightened below historical averages, history shows they can persist at low levels for years during periods of economic expansion. With continued economic improvement, we expect credit spreads to tighten, with some lower-rated asset classes tightening even further against their higher-rated peers. Expanded Fed support for credit markets has significantly reduced tail risks, but high and rising debt loads means security selection remains paramount. We are finding attractive relative value in structured credit, which has higher yields compared to corporate credit, lower duration risk, and less volatility and correlation. The market has priced in an overly aggressive Fed rate hike path, limiting how far Treasury yields can rise from here. Risk assets will continue to benefit from supportive monetary and fiscal policy and a strengthening recovery. We view any weakness as a buying opportunity.
Neuberger Berman
Market Commentary
Another good quarter for US equity markets had the S&P 500 Index off to its best first half since 1998. In concert, international markets experienced similar gains for the quarter with the MSCI EAFE and EM indexes up 9.17% and 7.58%, respectively. The most straightforward ‘reason’ for such robust equity market returns seems to be simply that it’s where the money went. Per Goldman Sachs, global equity fund flows for the first half of 2021 were the highest on record dating back to 1996. At $517 billion, flows were over 2.5x greater than the previous high in 2017. That’s a staggering number and it’s difficult to discount its impact on equity prices. With 125 trading days in the first half of 2021, that’s ~$4 billion in average daily demand. In June, the S&P 500 Index (S&P 500) jumped 2.33%, the CBOE S&P 500 2% OTM PutWrite (PUTY) added 1.37%, and the CBOE Russell 2000 PutWrite (PUTR) rose 2.93%. Over the quarter, the S&P 500 rallied 8.55%, the PUTY climbed 3.55%, and the PUTR gained 10.19%.
Index Option Implied Volatility
While implied volatility levels continue to subside globally, realized volatility levels continue to further recede. As markets continue to heal from 2020, we expect premiums to continue to normalize while overall volatility levels remain elevated relative to historically low levels observed in the years prior to the pandemic. For the month, CBOE S&P 500 Volatility Index (VIX) was down -0.9 pts with an average 30-day implied volatility premium of 9.3. At the same time, CBOE R2000 Volatility Index (RVX) was down -1.0 pt with an average implied volatility premium of 8.8. (High implied volatility premiums are good for the strategy.) For the quarter, VIX fell -3.6 pts, yielding an average 30-day implied volatility premium of 7.7. Of equal importance, RVX declined -8.3 pts resulting in an average implied volatility premium of 6.8. On the year, VIX is down -6.9 pts with an average 30-day implied volatility premium of 7.7. Likewise, RVX is lower by -8.3 pts with an average 30-day implied volatility premium of 6.2.
Performance Overview
In June, the sleeve of the portfolio managed by NBIA (the sleeve) returned 1.10% underperforming the PUTY return of 1.37% and modestly lagging the Bloomberg Barclays US High Yield Index (US HY)’s 1.34% return. Over the quarter, the sleeve posted a gain of 3.57%, which surpassed the PUTY return of 3.55% and finished ahead of the US HY’s return of 2.74%.
In June, the S&P 500 PutWrite Strategy rose 1.04% and underperformed the PUTY return of 1.37%. Over the quarter, the S&P 500 PutWrite Strategy posted a gain of 3.49% and fell just shy of the PUTY return of 3.55%.
During the month, the Russell 2000 PutWrite Strategy rose 1.04% and fell well behind the PUTR return of 2.93%. Over the quarter, the Russell 2000 PutWrite Strategy posted a gain of 3.49% and notably lagged the PUTR return of 10.19%.
We believe fixed income markets are moving closer to ‘daybreak’ in short-term US interest rates. Over the past decade, 2-year US Treasury yields have averaged ~90bps while the median rate has been 33% lower at ~60bps. That’s obviously not an ideal scenario for strategy collateral portfolios. Any incremental increases in short-term rates will be additive. Over June, short-term US Treasury rates (3M US T-Bill) rose 3bps while long-term rates (10Y US Treasury) were down -13bps. On the quarter, short-term US rates were up 3bps and 10Y US rates declined -27bps. Over the quarter, the collateral portfolio’s 0.02% return is in line with the T-Bill Index return of 0.00%.
Strategy Allocations
The fund’s target allocations across the three managers are as follows: 40% each to Brown Brothers Harriman and Guggenheim Investments, and 20% to Neuberger Berman. We use the fund’s daily cash flows to bring each manager’s allocation toward their targets should differences in shorter-term relative performance cause divergences.
Sub-Advisor Portfolio Composition as of June 30, 2021
| Brown Brothers Harriman Credit Value Strategy | |
|---|---|
| ABS | 19% |
| Bank Loans | 28% |
| Corporate Bonds | 50% |
| CMBS | 2% |
| Cash | 1% |
| Guggenheim Multi-Credit Strategy | |
|---|---|
| ABS | 25% |
| Bank Loans | 28% |
| Corporate Bonds | 40% |
| CMBS | 3% |
| Non-Agency RMBS | 4% |
| Preferred Stock | 6% |
| Other | 2% |
| Reverse Repo | -8% |
| Cash | 2% |
| Neuberger Berman Option Income Strategy | |
|---|---|
| Equity Index Put Writing | 100.0% |