Alternative Strategies Fund 10-Year Anniversary Q&A
To commemorate the anniversary, co-Portfolio Managers Jeremy DeGroot and Jason Steuerwalt have penned a Q&A retrospective on the fund and the category at large. MORE
Interviewee: Matt Eagan, Loomis Sayles and Ken Shinoda, DoubleLine
Interviewer: Jason Steuerwalt and Jeremy DeGroot
Date: April 19, 2023
Mike: Hi, everyone. Thanks for joining us today for our Fixed-Income-Focused Client Update Webinar, on the IMGP Alternative Strategies Fund – Ticker MASFX.
I’m Mike Pacitto with iM Global Partner. This is going to be a great webinar, chock-full of interesting, actionable information from two of the premier fixed-income managers in this space. DoubleLine and Loomis Sayles.
As you know, both of these managers run unique strategies that are exclusive to the IMGP Alternative Strategies Fund. DoubleLine’s Opportunistic Income Strategy, and Loomis Sayles’ Absolute-Return Strategy.
We have a lot of ground to cover, today. There are lots of compelling slides and information, here. Let me just start off with some quick introductions.
Jason Steurwalt, Head of Alternative Strategies here at IMGP – he’s the co-portfolio manager of MASFX. Jeremy DeGroot. Jeremy is the US CIO for IMGP. He’s also a co-portfolio manager on the fund.
From DoubleLine – Ken Shinoda is chairman of the Structured-Products Committee. He also oversees the non-agency RMBS team, there. Ken is co-PM on the Total Return Opportunistic Income and MBS strategies. He’s also a permanent member of the fixed-income asset-allocation committee.
And Matt Eagan, Executive Vice-President, and portfolio manager and co-head of the full discretion team at Loomis Sayles. Matt’s also a member of the firm’s board of directors – and the lead PM on its strategy within MASFX.
In terms of agenda for the webinar – here it is. I’ll touch on some performance points on my end, and then I’m going to hand it over to Jason. Jason will talk about positioning within the various strategy sleeves of the fund. Jeremy’s going to lead the panel discussion with Ken and Matt.
We’re also going to take your questions. So please enter those into the chat on the Zoom, and we’ll take them as they come.
On to performance.
Short-term – meaning Q1 of this year – performance was subdued, but positive, with the fund up 63-bps. Call it perhaps spring-coiling for what we think is most exciting about the fund, going forward. How the underlying strategies are currently priced and positioned, which Jason will touch on.
Particularly in the fixed-income area of the fund, we believe that that area of the fund is as attractive in those areas as ever – going back to when the fund was first incepted, in 2011. That’s also why we overweighted DoubleLine’s strategy earlier this year, as we did in 2011. You’ll hear more about all of that in a bit.
As I mentioned, there’s going to be a lot of data and content in these slides, today. So, we’ll be sure that all attendees and people who didn’t attend, but RSVPed and couldn’t attend, will also get a copy of the dec, as a follow to today’s webinar.
Let’s zoom out to a longer-term view of the fund. You’ll see here on this slide that it’s done well. Very well, in fact, compared to not only the Morningstar category, and the HFRX Global Hedge Fund Index, but also – when stacked against the Agg Bond Index. There, you’ll see it’s outperformed by nearly 2% a year, annualized – with similar volatility and a comparable yield, along the way. While many clients use the fund as a core multi-alternative allocation — which we do on our private-client side, as well – many also use it as a tool that [inaudible] their fixed-income portfolios.
Along those lines, you’ll see on this slide that the upside/downside capture statistics are very compelling, in that regard – with the fund realizing only a quarter of the average downside of bonds in draw-downs, while capturing ¾ of the upside in rallies.
This risk-reward profile is why we see quite a few consultants and advisors utilizing the strategy in the defined-benefit area, and in various models in client contribution.
Class performance slide here – where you’ll see some more strong statistics. In fact, extrapolating the annualized return of the fund and turning it into cumulative, this punctuates the fund’s long-term outperformance against the Agg, the Morningstar category and the HFRX. Also notable is the sizeable, positive difference between the fund and those comparators, in terms of Sharpe Ratio.
Lastly, the fund’s low beta-to-equities of under 0.3. And the low correlation of the fund to the Agg of 0.33.
With those quick performance flyover metrics, Jason, I’m going to hand it over to you – where you can see the overweights, where DoubleLine in highlighted at the bottom of this slide.
Jason: Yes. Great! Thanks, Mike.
Really, not too much to say on this slide. Just highlighting that overweight. It was funded across the board from the other managers, except Loomis Sayles. The other managers, in increments from 1 to 3 percentage points.
If we go to the next slide, you can see from the stats on this page, how attractive the DoubleLine portfolio is.
If we go to the next one – it’s a really attractive portfolio. We wrote about the move. You can read about it on the fund’s website. This was really about taking advantage of the opportunities created by the turmoil in fixed-income markets, last year.
DoubleLine’s yield, when we decided to make this move, was over 11%. As you can see, at the end of Q1, it was still over 10%, with a duration of about 5.3.
When we thought about the potential impact of making this move, we ran some numbers to look at the potential upside and downside in different scenarios. Our 12-month base-case return-estimate for the fund increased by over 70-bps. Our downside-return-estimate decreased by only 20-bps. Importantly, it was also still positive. Then our upside-return-estimate increased by almost 1.5%.
Also, importantly to us, even when we adjusted the assumptions significantly, to account for the fact we know that we won’t get everything exactly right, the positive asymmetry was consistent. Which is what we want to see when making tactical adjustments like this.
If we go to the next page, you can see the Loomis Sayles portfolio, which is also very attractive – with a yield of about 8%, and a duration of only 2.2. Loomis isn’t as focused on securitized credit as DoubleLine. Some areas that were hardest-hit last year. It also has less duration. A little bit – not quite as far out on risk-return spectrum and has a little bit of a lower yield. But it’s still quite attractive, especially on a risk-adjusted return basis. Because of that attractive opportunity set, we didn’t fund any of the DoubleLine overweight in this sleeve, either.
Just as a quick point of reference, last time we saw yields in this ballpark from these two portfolios, which was very early in the fund’s life, the returns over the next year were in the neighborhood of 20% for DoubleLine, and in the mid-teens for Loomis Sayles. We obviously aren’t saying that’s what’s going to happen again. The specifics of the environment, and risks, are always different. But it is, I think, illustrative of the type of performance that you can see when you have fixed-income portfolios priced like this.
Obviously, these portfolios have more credit risk than the Agg, but we do think that we’re getting more-than-fairly compensated for it.
If I could just run through performance, quickly. In Q1, five of the six sub-advisors were up. Net of sub-advisory fees FPA was up 4.4%. DoubleLine, up 3.7%. Blackstone Credit – formerly known as DCI – was up 2%. Loomis Sayles was up 1.6%. Water Island was up about 0.5%. Only DBI was a detractor – down about 6%.
I’d note here that, based on our modeling of the DBI strategy and the fund’s returns, if we had added the strategy at the beginning of 2022, it would’ve improved the fund’s returns very substantially. On the order of several hundred bps. Unfortunately, DBI wasn’t on the fund since last January, and it’s been a detractor, since going live on the fund. It’s been a really challenging few quarters for managed-futures, which make up the majority of this strategy. Regardless of the short-term challenge, we think DBI’s a really attractive, strategic addition to the fund, long-term.
If we go to the next slide and turn to a quick overview of the other subadvisors’ positioning –
Blackstone Credit – again – formerly, DCI –
The elements that make an attractive environment for this strategy are all in place. I’m not going to run through them all. But you can see the opportunity set’s attractive – being reflected in the gross exposures in the long-short CDS portfolio. That’s about double what they were five quarters ago.
This strategy did quite well last year. Up about 4%. We expected it to do well in challenging periods. It’s up 2% so far, this year.
Looking at FPA, I’d say they have one of the highest-quality portfolios they’ve had, at attractive valuations. I’ve characterized this before, as somewhat of a blend – a barbell – of really franchise-type, high-quality, growth, internet-tech names on one end, and then more classic-value names that are reasonably-good quality, but much better valuation, on the other.
Then, some special situations in both equity and credit. They also now have the optionality of about 30% cash. Finally, that earns significantly more than zero.
If we go to the next page, DBI is still short bonds; significantly less than in March. They’re close-to-neutral in commodities, with very little gross exposure. Slightly long the dollar and long equities – primarily, international.
March was a horrible period for managed-futures. But the equity-hedge component of that sleeve that we worked with them to design was beneficial – in terms of moderating the losses. The performance has improved significantly in the last few weeks.
We expect the strategy, over time, to really improve the fund’s risk-adjusted-return profile, especially in down markets — without reducing its total-return, over time. That said, it will go through periods of negative returns. Especially when you have dramatic reversals in markets, like you did in the rates market in March, after the bank failures.
Water Island held up well last year, with a positive return. Assuming good deal selection, they should be positioned to generate really nice performance, going forward, as well. The annualized gross deal spread in the portfolio is more than 20%.
Of course, deal-extensions and deal-breaks happen, but historically, that’s a really strong starting point.
I’d say overall, if we look at Water Island, combined with the two long-biased credit managers, it makes up about 68% of the portfolio. We consider these harder catalysts types of strategies that should have a tendency to realize value more quickly than just long-only equity-type positions that rely more on the market to agree with your valuation assumption.
Of course, we still really like the other portfolios. Obviously, there are risks to any strategy. But we’re really excited about the prospects for the fund, going forward – given how much is in these types of strategies, and their high-return potential, which we’ve highlighted – and which we’ll hear more about.
With that quick summary, let me pass it back to Jeremy for the conversations with Matt and Ken.
Jeremy: Great! Thank you, Jason. Thanks, Mike, for the intro. And thanks, everyone on the call for your time, today.
Yes, we’re really excited to have a dual-portfolio manager panel. Just the big-picture gameplan for our 45-minutes or so, is first to ask each – Matt and Ken – to walk through their bigger-picture macroeconomic outlook. And the current setup in the fixed-income markets.
I’ll get each of them separately to walk through some of the slides they presented, here. Then we’ll circle back and get more granular – really digging into the specific portfolio-positionings for both of their strategies on our fund. Where they’re seeing best opportunities and where there are some riskier areas. Ultimately, where they have the biggest differences. Where they have the most variance on their views, relative to what the market’s currently discounting. That’s where opportunities are, and potentially where risks are that can be avoided.
We’ll kick it off with Matt, joining us from Boston, as usual. Matt, good to see you again!
M: Thanks, Jason! Thanks for having me!
Jeremy: Yes! Thanks. Appreciate your time.
I know you sent us some slides that are extremely interesting. Kind of a blend of secular, starting off with a longer-term outlook. Then we’d also like to hear more of the 6-to-12-month outlook. I’ll just turn it over to you and let you run with that, for a bit.
From a thematic, longer-term perspective, the one overarching statement we make is we think there are more structural tailwinds to inflation. This is encompassed by our 4-D theme.
The 4-Ds – starting with “Deglobalization,” which really stems – on the left, here, you can see – world, global trade. We had such a boom in global trade with the entry of China, and so on. But the rivalry between China and the US has come to the fore, again. It’s tense. We think that security is becoming very important to companies, in terms of their value chains, as well as energy and security and things like that.
We see more of a decoupling going on. We’ve seen this being discussed for a long time. A lot of these themes somewhat predate the pandemic. But all of them will lead to inflation, which is a much different story, I think, than we encountered in the years leading up to the great financial crisis, and then for some years, after.
Around 2018 and 2019, some of these structural headwinds or tailwinds to inflation started to pop up. We talked about [deglobalization]. Decarbonization, we all know what that is. And the costs that will be required to wean us off of carbon. It’s going to take a long time and a lot of money.
Thirdly, on the next page, demographics. We talked a lot about this – even predating the pandemic. We noticed a tightening in the labor force. We think that resides with the demographic shift. It’s really about a shrinkage of the working-age population, or stagnation there – and also a further-aging of the baby-boomers out of the workforce.
Lastly, and very importantly, structural deficits in the developed world. We show a chart here on the right, with deficits broken out by spending. We wonder where are the cuts going to come that politicians talk about? It’s really things like social security and entitlements – defense, which we think is going up – not down. Even in that category up at the top, which is something that doesn’t get a lot of commentary, but is really important, is the net-interest burden. We can see coupons resetting at higher levels. We think that’s going to persist and add pressure to the deficit.
All of these.
I think the consequence is that we’re moving out of the QE world. That’s out of the picture, now. We’re going to see and already have seen, a normalization of real yields. And we think higher inflation-break-evens in the longer run. Lastly, we’d say, more compacted economic cycles – one of which we just went through. A very short and unusual cycle.
We also recognize that inflation is cyclical. If you turn the page here, just to kind of set up where we are in the cycle – we do believe we’re clinging on to late-cycle expansion. It wasn’t very long. It was short-circuited by inflation, by the Ukraine war and things of that nature. The response by the Fed and other central banks.
Let’s start out with interest rate risk. We have a little bit of our views highlighted here. We’re going to talk a little bit more about credit risk. We’re actually pretty sanguine about credit spreads, and I’ll describe that in a moment. Currency-risk may be emerging. We do have some liquidity within the portfolio to take advantage of some of the volatility that we’ll see as the Fed finishes its rate cycle.
Let’s drill in on interest rate risk. We’d been very short, for a long time, and we’ll just flip the page and take a look at our view, here. The cycle is, we think, over for the Fed. Or close to being over. Inflation has peaked, for this cycle. It’s coming down. We recognize that it’s much easier to go from 8% to 4%; 4% to 2% is much harder work. Because of the 4-Ds that we’re talking about, we think going back to 2% is going to be next to – on a sustained path – very, very difficult and probably not achievable.
Having said that, we think 5% or 5.25% — and we’ve been saying this for a long time, now – is a reasonable stopping point for the Fed, in terms of the terminal rate. You can argue that it’s a good stopping point, simply by observing that inflation is coming down. Now the gap between all aspects of the rate-curve now – relative to inflation on a rolling-forward basis – is well into the positive, real-rate side. That’s what really drives the economy and the restrictiveness.
I think the Fed could arguably say we’ve built some restrictiveness into the market. We can see that it’s biting. The banking crisis, I think, was inevitable as a manifestation of that. It typically will work through the bank channel. We’re seeing that it is.
The short-end of the curve – where we see the terminal rate priced in – is not a big thing. We don’t have any contention on that view, any longer. We did, and we’ve been increasing our duration moderately here, as this has transpired.
For the 10-year, extending out, we think 3% to 4% is the kind of trading range that we’ll see. We’re kind of right in the middle to the upper end of that category. We break that down between –
We think the going real-rate should be somewhere over 1%. Maybe 1.5%, as a fair real-rate in that part of the curve. With about a 2.5% break-even on the inflation front. That gets you somewhere between 3% to 4%, depending on where those reside.
I think the key debate now is, is the Fed restrictive enough to really slay inflation, meaningfully. We have some doubts about that. Which is why we think it’ll resurge on the other side of the cycle.
But now the market is pricing in when the Fed pivots. When do they start cutting rates? Our 4-D themes and our view is, we think that path will be less downward-trending in the rate path, and perhaps more extended at a higher level. That’s where we fall out.
We like the intermediate part of the curve, for those reasons. Where we can pick up yield and ride in on the 5-year and that type of duration stance.
Jeremy: Matt –
Matt: Yes, go ahead, please.
Jeremy: Before we just jump to credit – I mean I think it’s related to your next point –
That Fed chart to the right, where you were just talking about the Fed Fund futures market, at least, is baking in Fed cuts. Right?
The consensus is around what you’re saying. We’re going to peak with one more 25-bps hike, give or take. Then, you’re saying you disagree at least with what is shown in the futures, of the Fed starting to cut by the end of the year. Maybe significantly.
It sounds like you’re saying because inflation’s going to remain sticky – I guess this’ll lead into the credit risk – but something has to give. Right?
If the Fed isn’t cutting –
The market thinks the Fed’s going to be forced to cut, because there’s going to be bad economic news, presumably. Rather than inflation coming down.
Jason: Does that imply that – well – it would seem to suggest that not just inflation remains high, but the economy remains strong-enough for the Fed not to be politically pressured into cutting. I guess this is a kind of lead-in to your view on credit.
M: Yes. I think they want a slowdown in economic activity. I think the signs – reading the economic tealeaves – it’s definitely worsening. We saw that in some of the more frequent data. Like manufacturing is definitely in a recession. No doubt about it. Some of that is inventory. We’ve gone through a very long destocking and inventory cycle. Partly just due to the pandemic. It was even less-related to the Fed. But part of it was.
Then I think you’re going to start to see weakness in job growth coming down the line. I think cyclically or more structurally, where the Fed has a hard time is at this point. Because you’ve got to get unemployment up to enough of a level to really slay wage-inflation. That goes back to the demographic issue we were talking about.
I don’t think that there’s really the will or ability to drive unemployment up high enough to permanently affect that. It’s just going to come through an aggregate demand type of channel. I think a lot of these are supply types of issues. Those are going to be difficult for the Fed to wrestle with.
I think there’s a lot of resiliency still, in the wage market. I think with a lag, wages are going to remain perky, here. That could lead to the next round of inflation on the other side. A little bit of that wage price could spiral. But these things take time.
You go back to the ’60s. Late ’60s. There was a big liftoff in inflation. But it was very cyclical. A lot of false moves or head-fakes, as you went through. The way we’re looking at it is, you have to recognize that it is cyclical. We’re guided by our principles on 4-Ds, in terms of how much we’re willing to accept on the downside.
When I run the job calculator, it’s going to be you’ve got to drive job-losses to at least 75,000 per-month for the next year, just to get up to 5% unemployment. I don’t think that’s a big deal for the economy.
We think this economy is going to be more of a moderate downturn by historical standards. You have to go back to the old cycles. Inventory-related. Run of the mill. This one is probably more focused on earnings-recession. Which speaks to the credit question that we’ll get to.
Jeremy: Let’s move to the next slide.
M: Sure. Let’s take a look, here. One of the things I think Loomis does really well is taking a look at what the climate is for losses. Credit losses in the market. What’s the weather outside? It kind of varies through the cycle. It’s important for pricing risk in the market. Both the bottom-up that we do and the top-down lenses that we look through.
Spreads – the risk-premium that we’re earning for credit spreads is driven by losses. Losses related to downgrades and defaults. This is a very cyclical process, as we all know.
This chart on the left shows high-yield, risk-premium as we describe it. These two area charts at the top level are simply the observed spread and the high-yield index. The dark greenish color on the lower part are losses that are going to be realized by the market.
This is just the model we have here at Loomis, to help guide us as a tool. The difference – that other shady area – is simply the risk-premium. The risk-premium is simply the spread-minus-expected-losses from downgrades. In the case of high-yield, defaults. You can also run this for investment-grade.
The thicker that risk-premium is, the more success you’ll have as an investor. You’ll earn a greater percent of the premium or greater percentage of the total-return will be driven by that premium. We’re always on the lookout for that. It varies through the cycle.
The chart on the right just shows that for a given risk-premium on the X-axis, low – observing that risk-premium today and then looking forward, how successful were you [inaudible] the risk-premium to generate excess-return in the high-yield market.
It turns out that the median spread is roughly just under 200 bps. Something like 187 or 180 or something like that. You win about 68% of the time, which is good odds. If you’re the house at Las Vegas. It’s an argument for structural. Everybody knows that’s a good strategic and structural investment to make, over the long-run, for that reason.
You can see here – it’s hard to see on this chart – but each individual dot is color-coded, based on when that risk-premium was observed. What part of the credit cycle. There’re a lot of dark-blue dots here, because mostly the expansion of the late-cycle is the biggest phase of the credit cycle.
You can see the wings, here. There’s a big dispersion through the cycle. Oftentimes at late-cycle when the market is greedy and [inaudible] have gone down, you typically get negative risk-premiums priced into the market. In other words, losses are greater than the spreads that were affording at the time of the investment.
That was –
You remember we talked about this in January of 2020. That existed then – which is why we were very light on high-yield. Today, that’s right where that other hockey-stick shape is. About an 85% success rate. We’re running at about or over 300-bps of risk-premium. That’s still within the scope of a late-cycle environment, but it’s on the outer-edge of that. That’s very unusual.
It’s saying that the market is already pricing in losses, because the consensus is a downturn.
When I talk to a lot of people, they say, “I’m worried about spreads widening out.” I said, “So isn’t everybody else?” The spreads today are affording you or compensating you, at least the way we’re looking at it, of what we think the losses are going to be in the kind of downturn we just described.
We think the success rate from here is going to be pretty darned good. Could it go wider, based on liquidity? Yes. It could move up the slope. But that just means you’re earning more risk-premium.
If you flip a slide here – I’ll just kind of go through one of the things that drives our risk assessment, here. This credit-health index. We call it the CHIN, affectionately, here at Loomis. This is almost like a diffusion index, if you think of the bias in the [NAPPOM] index that we all know. The ISM manufacturing index.
When you’re above zero, that suggests the healthier corporate credit market. When you’re below zero, that suggests some stress is in the market.
One of the things that this sort of confirmed with me – which I felt after being an over-20-year veteran in these markets – during the pandemic and after, we had some of the best credit fundamentals that I’ve ever seen in my career. You could see that based on the bottom-up fundamentals. The macroeconomic. The policy. A lot of what was driving this way higher were the policy rates that were in existence, then.
It was driving down the losses to next-to-nothing.
We know losses that you saw from the prior period are rising, here. We expect them to. We expect this CHIN to drop closer to zero, to a little bit below zero. But when we look at the inputs to this model and think where it’s going, we have a very difficult time getting down to these other very low levels.
That’s why we think losses are going to rise, from here. But a 3% level – even in high-yield – seems like a realistic level, to us.
The last thing we do, to try to verify this or confirm this data – we go to our analysts. Our industry analysts have covered their sectors for many, many years. We ask, within each of these sectors, how many downgrades and how many defaults. Then we roll it up. Generally, within a reasonable degree, it fits very well with this model.
That’s why we’re saying that we think this time – for a downturn – the losses are going to be pretty moderate, as far as these cycles go.
If you flip ahead, I’ve got a couple more things that we can quickly go through. This is what we’re talking about – the earnings recession. We expect that earnings recession; but a pretty resilient economy, underneath it. Not significantly bad. We’re kind of in the teeth of it, now.
The next page, you can see this is one area where, if we advise –
A lot of what we do with our modeling is based on high-yield and investment-grade bottom-up metrics. We’re not pulling in all of the bank-loan issuers. I’ve followed markets a long time, and what I worry about most, usually, is during excess periods – like we have with QS – where did the money go? We know a lot went to Bitcoin and places like that. Tech. Unprofitable tech. Those markets have come down.
I think about where are some of the other areas where this shows up. I look at bank loans with a wary eye. Some of the things that I look at, just very broadly – and this, I think, paints it very well –
Compared to the high-yield market, which has gone up – and this is showing the high-yield index – the [inaudible] index rated single-B and lower — single-B and triple-C – as pretty much at an all-time low, for high-yield. Or close to it. It’s got more of a double-B feel to it. By definition, that would mean lower losses.
On the opposite side, you see bank loans. That’s where a lot of the LBO activity – especially in the private-lending, and so on – has been funneled through here. 70% of that index, now, is in the single-B area.
I think you’re going to see a lot more credit-degradation in the bank-loan space. That plays into the CLOs, and the quality, as it drops from single-B to single-C. Much like we were talking earlier – about subprime. It reminds me – not in the same way, but a little bit – of subprime. When those bank loans start to go down, they lose sponsorship. They hit an air-pocket, because there’s not a natural buyer of triple-C bank loans.
I think I’ll stop there on the credit-spread, just for sake of time.
The last thing I’ll mention, in terms of credit-spread, and I don’t have a chart on this, but one of the other things that’s more technical that people don’t really think about – when it comes to spreads –
In a non-distressed market, these are the lowest dollar prices I’ve ever seen in my career. It’s just a function that rates lifted up very high, and a lot of companies locked in low levels of rates.
By the way – bank loans aren’t able to do that. They have the floating-rate note. If they didn’t hedge it; and a lot didn’t. They’re just starting to feel the crunch of that floating-rate note adjustment.
For high-yield issuers and investment-grade issuers, they have low coupons. What that means from an investor perspective is, you can buy some interesting opportunities at 60, 70 and 80 cents on the dollar. For us, that’s like a bond-picker’s dream.
We’d been really starved of these opportunities during QE, because everything traded around par. You don’t get paid much more than par in the market for bonds.
But if you buy a bond at 60 or 70 and it gets a rating-adjustment higher or is taken out for some reason, you have a lot of upside. More headroom up to par. More convexity, they say, in the bond.
Ample yields and discounts. The discount, itself, means a bond that’s from the same issuer, with the same maturity. If one has a discount and the other one is at-par, that bond with a discount will actually trade at a lower spread. Mathematically, you have less money at-risk. You have less relative-to-par. Then you’re able to have a recovery.
The bond will trade, in some cases, right close to its recovery. The margin-of-safety is very good, for a discount-related bond. That’s something that’s overlooked.
When you think about the entire market trading at a discount, it’s going to be hard to have that really gapping-out in spreads, other than just some sort of liquidity event. But not fundamentally.
What we’re seeing, and what I think we’re most-excited about –
As much as we talked about the top-down, it’s the idiosyncratic bond opportunities that we can find by looking at what the intrinsic value is of the corporate security – relative to where it trades in the marketplace. And the ultimate margin-of-safety, based around that recovery value.
Jeremy: Great! That just brings to mind, probably, one of the first calls I ever had with Dan Fuss, whom I probably don’t need to introduce. I remember the words, “Long, Discount,” and, “Call-Protected.” That used to be his mantra. That went away; right? For a long period of time.
M: It did.
Jeremy: Great, Matt. Thank you.
Let me bring Ken Shinoda on. That was a great overview. We’ll be back to you in a moment.
K: Hey! How’s it going?
I know you’re in Miami. Not your usual Southern California haunts. But it’s sunny there, too, I presume.
K: Not too shabby, here. Better tax situation!
Jeremy: I’ve heard. As a fellow Californian.
Let’s shift over. Appreciate the slides you sent us, again setting the stage on the macro backdrop. I think there’s a fair amount of overlap. But there are some areas where it would seem you and DoubleLine have different views than Loomis on that. It’d be worth highlighting some of those.
K: Yes. Let me start by saying I very much enjoyed listening to Matt. I’m with him on the 4-Ds. I think that’s a long-term segment thing. I’m going to throw one more “D” at you, Matt. Defense-spending. It’s going up. I think that’s another thing that’ll be a catalyst for more spending in the US and be positive for growth and inflation, in the long-run.
When I think in the near-term, there are definitely signs of economic slowdown. This is LEI – year-over-year and six-month, annualized. Usually, when this drops to the levels we’re at today, you’re imminently in a recession. This is one of the datapoints we’ve been following.
I think the Fed is getting some of what they want. Obviously, the jobs-market is hot. But I think we have to respect this, and the fact that economic data continues to slow. That’s good for bond returns, obviously. That’s why we’ve become more constructive on longer-duration bonds, in many of our portfolios.
Want to go to the next slide, please?
One thing that turned out to be pretty negative was the Silicon Valley Bank incident. My immediate reaction was that the cost-of-capital is going higher. The regional banking system is critical for the US economy, because there are big lenders to small business and small business is about 46% of employment in the US.
This shows you that credit conditions have come down.
I will say that I’m a little surprised more money hasn’t left the regional banks. The deposit outflows seem to be slowing. I’m surprised more money didn’t go from the regional banks to the money-center banks. I’m also surprised that more money hasn’t gone into money-market funds and T-bills – the greatest investment opportunity on the planet, right now.
Nobody’s buying bond funds, because they’re buying T-bills.
I think that the slowdown in that activity has made me a little bit less negative, now, in the near-term. I think that’s why risk-assets have kind of gone up. VIX has dropped; rates are back up. The bond market’s pricing in maybe another hike by the Fed. Maybe even two.
It seems that the money-flow out of those banks has stopped. Maybe credit-creation improves. We’ll have to kind of wait and watch that.
I’ve just come to the conclusion that I think people are lazy and don’t want to move their money – even though you’re better off moving it out of some of these banks. I guess that’s good for Jamie Dimon and all his buddies at the banks.
Next slide, please.
Another thing that’s a sign of calming in the marketplace –
This is basically the utilization of the different funding facilities of the Fed that spiked dramatically as banks needed funding, as they saw redemptions or outflows from deposits.
You can see that this number is coming down. This is looking at the discount window, and this is looking at that new BTFP facility that they set up over the weekend. [inaudible] went down.
This is a positive thing for the market. If this keeps coming down, this means there’s less stress on the banking systems. These are all near-term positive signs, which have basically repriced the expectations of the [inaudible] through the end of the year. One time we were having Fed Funds going down along the way to 3.75%. Now we’re back up to 4.25% or so, I think.
Next slide, please.
Historically, when lending standards tighten, default rates go up. I agree with Matt – default worked toward the end of the cycle, and default rates are probably going higher. That doesn’t mean it’s going to spike to GFC levels.
Basically, the best times are behind us. We got to extremely-low default levels. There’s not much more than downside left, in that. But if you’re compensated by spread and dollar-price, those are very important things. Dollar-price really helps, from a credit-standpoint. And the securitized markets – as Matt mentioned – broadly, fixed-income –
You have a lot of bonds issued with low-coupons. Rates ride; spreads widen. Now you’re buying stuff at $0.60 or $0.70 on the dollar. A lot of convexity and a lot of price-upside. We’re pretty excited about the opportunities that we see up there.
Next slide, please.
Jeremy: Just quickly on that one –
Could you just go back one, Mike? To the previous slide.
Not to pin you down too much, but Matt’s saying default rates may be peaking around 3%, which I think is below 4%, in my mind. Maybe that’s the old average default, on average.
Do you think it’s still in that 3%-range? If you follow this chart, it looks like it could be going up to 6% to 8%. Or doesn’t it really matter for what you’re –
K: I’d say our corporate credit team – well – a good corporate credit bond-buyer will tell you that they’re going to pick the ones that don’t get to the 6% to 8%. That’s what Matt’s going to do. Right? Matt and his team.
I think our team is probably on the same page. I think they’d tell you maybe 3% to 4% is their estimation for defaults. They definitely think the credit-quality of high-yield is better than bank loans. Everything Matt was saying totally jives. The next slide will show you that the market agrees with that.
This is my one-pager, if I have to walk into a client’s office to just show them the lay of the land. This is a percentile-rank of spread across spread-assets in the fixed-income universe. We have corporate credit here, IG, high-yield, bank loans. We’ve got EM and then we’ve got the different pockets of the securitized market – including agency mortgages.
The higher-up you are on the slide, the cheaper you are, relative to your own history. Some of these assets are cheaper for a reason. Bank loans, as an example – are way cheaper, relative to its own history, than high-yield. But for a reason; the cost-of-capital for a lot of these companies has effectively doubled. The bank loan average spread for the index is about 500, going back 10 years. For almost 10 years, LIBOR was zero. Here we are up at 5 or so.
Definitely, we think there are concerns, there. It doesn’t mean there aren’t great buying opportunities. You can find some great bank loans that are high-quality, for which you now get paid that SOFR rate that’s so high. I think while looking at this broad index-based data is helpful, that doesn’t mean through security selection, you can’t find opportunities in risky markets.
CMBS sounds scary – okay – go buy a bond that’s not backed by Office, in the CMBS space. Or decrease your Office exposure. Or buy a bond backed by Office that’s doing okay. There are all sorts of ways you can manage that and create opportunities, I think, in the long-run.
One of our highest-conviction ideas is agency mortgages. I guess CMBS, now, after the recent spread-widening – and this is through March 31st –
Both of those two assets are 98th percentile. That means spreads have only been wider 2% of the trading days over the last 10 years.
IG and high-yield have done pretty well, this year. They’d gone all the way down to about the 50th percentile. They’ve sold off, recently. IG has sold off a little bit more than high-yield. As a basket, I think IG definitely looks better than it did 30 or 45 days ago.
High-yield has done well. I’m not hating on high-yield. I’m just saying because it’s done well, it doesn’t look as cheap as some of these markets that have languished a little bit.
Why has securitized lagged? I think a lot of it has to do with capital flows. I’ll get to that in a second.
If you could flip to the next page, please, Jeremy.
Here’s a comparison of pockets of the securitized market, relative to the corporate credit counterparts. On the left-hand side we compare triple-A CMBS, on the top-left, and triple-B CMBS on the bottom-left. On the right-hand side, we’re comparing triple-A CLOs and triple-B CLOs, with IG and high-yield.
I don’t have a good non-agency index. But I’d say non-agencies are probably a little bit cheaper than CLOs – not as cheap as CMBS, relative – using spread as a metric. CMBS has gotten hit exceptionally hard, recently, after SVNB – with concerns around regional bank-lending of commercial real estate. And then obviously, Brookfield and PIMCO and a bunch of people defaulting on loans.
That doesn’t mean the building’s going to get liquidated. They just want to get a better deal. They want to go to the table with the lender and strike a new deal.
Look at this gap. You can see it really, especially, in triple-A CLOs. This big gap-up in 2022. What basically happened was, if you think about the investment-grade corporate bond market – and even high-yield – there’re just way more players in this space. It’s a much deeper market.
Probably there are 2,000-plus buyers of IG, and the top 40 accounts probably make up 50% of the trading volume. Pension funds are buying them, themselves.
When you go to the securitized market, there are probably only 200 buyers. The top 5 accounts probably make up 50% of the trading volume. If those top 5 accounts stop buying bonds, the bid evaporates. And guess who the top 5 accounts are? Money Managers — PIMCO, WAMCO, TCW, ourselves, Guggenheim, Loomis Sayles. We all saw bond-outflows last year, which sped up toward the end of the year, due to tax-loss selling.
Meanwhile, in the 4th quarter, I think you saw some pension-fund rebalancing. Coming back into fixed-income. Buying IG-corporates. They got all the way up to 6% yields. It was a good time to buy.
That big widening that you see in securitized, relative to IG, really had to do with this concept of capital-flows. The main buyers were out of the market. Supply was up. Spreads kind of stayed wide, as the IG and corporate markets started to rally in the 4th quarter.
Then you can see that there was a sharp U-turn. You could see it especially on the CLO side. That has to do with the end of the calendar year. The calendar year ends, and thankfully, the tax-loss selling stops. Money managers that had cash on the sidelines – it all flowed back into the market, until a limited supply and spreads ripped tighter.
More recently, on SVB, c-spreads widened again a little bit. This was through March. Spreads have come back in April. We’re now through mid-April. CMBS got really hit because of what we talked about earlier.
I think the securitized space – until the money managers come back into the market in full-force, I think spreads will stay wide. Eventually, bond funds will get flows in, and that’s going to be a big catalyst to tighten spreads. What will make people come back into bond funds? Short-term rates need to fall.
At some point in time, short-term rates will fall. The magical T-bill will no longer be the greatest investment on the planet. Money will flow back into – I think – many different asset classes. That could be the catalyst for spread-tightening in some of these pockets.
Next slide, please.
Jeremy: You’re not going to give us the date that that happens?
K: I wish I could tell you. I wouldn’t be here. I’d be on the beach.
Some people ask me, when I show them that last side – “Oh, what about the GFC?” So, here’s the one about the GFC – a version of the previous slide. Not all of those indices exist. Some of those markets were smaller. There wasn’t a good index.
But, going back to the GFC – agency mortgage is still 82nd percentile. Agency mortgages look really cheap, here. We have some exposure in opportunistic income accounts. About 12% to 15% of the portfolio. If spreads tighten broadly on agencies, I think that portion of the portfolio will do well. If rates fall, that portion of the portfolio will do well, too.
CMBS, also, is very cheap. 84th percentile, here, you can see – going back to the GFC.
The GFC skews things, because you have that big blowout where IG got all the way up to 600, and high-yield got to almost a 2,000-spread. I don’t think that’s going to happen, again. But just for those that doubt the 10-year lookback – like I’m trying to hide something – here’s the GFC version of that.
Next slide, please.
The next few slides – and I’ll try to run through these quickly, because I know we’re coming up on time.
People are worried about commercial real estate. If you look at the regional banks, they weren’t as big as some people thought. They were rolling in national banks with regional banks.
Regional banks are about 20% of the market. The agencies do multi-family loans. The CMBS market is anywhere from about 10% to 20% of the origination volume.
I think while regional banks are important, there are all sorts of other lending facilities out there. And there’s a massive private-credit market that’s grown. I think private-credit will step in to do some of this lending activity.
I think it’s not as dire, broadly-speaking, for all of commercial real estate. Office is unique. It has its own challenges. But as we look at the risk of the market based on LTVs or loans-to-values of commercial real estate loans, we’ve been getting much more conservative, through time.
Look at the LTVs of apartment and commercial today, versus where they were back pre-crisis. We’re 10-plus or 15-plus points lower in LTV. We look at opp-income in our Office exposure, and the SASB space. Single-asset single-borrower. Our LTVs are like in the 50s, on our exposure. That’s a lot of protection.
Our Office is only sub-3% of the portfolio. I think about ¾ of it is fixed-rate. I think all of those things are a positive toward the opp-income portfolio.
Next slide, please.
We also have a lot of residential-credit exposure. I do think housing continues to correct. It’s not going to crash. We’re down about 5% from the top. I think we go down maybe 10%, nationwide. Some certain regions that went up too much are going to come down maybe 15% or 20%. Some regions are already down 15%. Seattle – San Diego – Phoenix – San Francisco – San Jose – already down double-digits. But some places are actually starting to flatline and go up in price, on the East Coast.
The things that drive home price are affordability and supply/demand. Affordability has obviously collapsed, with prices and rates up. But rates are starting to come down. Mortgage spreads will eventually tighten. Supply is just non-existent, still. The supply is about a million units, nationwide. Relative to the population; relative to the millennial demographics that are hitting peak ownership age. There are just not enough homes for people to buy, because we haven’t been building enough. That’s the next slide.
This shows you the deficit of housing starts relative to household formation. Since the GFC, we’ve been building multi-family. We really didn’t focus on single-family homes. There’s just lack of availability. The demographics are pretty strong.
Housing’s going to correct; it’s not going to crash. For many of the bonds that we own, we didn’t buy them today. We bought them 2 or 3 or 5 years ago. Home prices, over that time period, have gone up a lot. People have been amortizing their mortgages and making principle payments. There’s a lot of equity in housing – which is the next slide that we have on here.
When people have equity in a house, they will not throw the keys back and walk away, like they did during the GFC. You can see the blue line, which is equity, dipped between the debt – which is the grey line – and we have tons of equity in there.
We’re overweight mortgages and opp income. We’re overweight mortgage credit in opp income. We think that credit will continue to perform, because not only do borrowers have a lot of equity, but if we do see defaults or delinquencies, what we did during the pandemic, which is mortgage-forbearance – borrowers miss payments – move them to payments at the back of the loan. The economy heals and they get a job again and they start paying. That means lower losses for mortgage-credit assets.
I’ll turn it back to you, Jeremy, in the interest of time.
Jeremy: Great. Appreciate that, Ken. Thanks for the great backdrop.
I’m going to jump back to Matt and then come back to you. We’ve got about 10 minutes, or maybe a little bit less. Just hit the highlights. Mike, if you could go to the next slide, which is our summary slide – the one Jason showed at the front.
Just big-picture. The sector. Fixed-income sector gross-and-net exposures, there. With focus on the net line.
I guess just to set it up, I just kind of compare to year-end. Not dramatic changes, but, what would you highlight besides the very attractive yield-to-maturity, relative-duration? Which I think are the big-big picture-points.
Matt: Yes, that’s the most compelling, when you look at the duration we’re getting in the yield, here. But we’ve been pushing our duration out, even since this time period. We’re moving it out, for the reasons that we’ve discussed.
We like securitized for all of the reasons Ken said. We have a lot of similarities, I think, in some of the holdings that we have, and positions. That’s still been the workhorse of the portfolio, for a while. Particularly when we’ve been shorter-duration. Even shorter-duration.
I’d say in the credit markets, it’s really idiosyncratic, where we’re going. It’s sort of bond-by-bond – looking for opportunities. You’re not going to be surprised to see us leaning into our strengths here, as bond-pickers. As I said, with the discounts now, we’re just slowly adding in.
We think there’s really a kind of sweet-spot, as we see it. On the investment-grade side, we’re okay going down in quality, to triple-B. That’s really where we tend to operate, anyway. But in the high-yield space, we’re kind of gravitating toward the double-B segment – and maybe a smidgen to the single-B.
That’s it, in a nutshell.
We’ve got some dry powder, here. As you know, this portfolio – like we did in 2020 – can become much riskier. We have a lot of dry powder here that we intend to use. We’re kind of just waiting for some more opportunities that we think will shake out over the course of this year.
Jeremy: The dividend-equity piece.
I guess a couple of other highlights. Bank loans, you noted. Looking at high-yield, relative to bank loans. Reflecting the more-attractive opportunity set. Dividend-equity has been around that 4%.
Just a quick summary of what’s in that basket. That’s not pure fixed-income, obviously.
Matt: Yes. We have a diversified basket of dividend payors that we can write calls on top of, to earn extra income. That sort of runs systematically, in portfolios. It’s a small part of the portfolio, right now. That can grow, significantly, when we get more bullish on equities, with our expectations.
When we look at the valuation to the equity market, relative to some of the earnings that we should see coming forward, we just don’t think the upside/downside worth is compelling for our strategy, right now. But that can grow, when we’re on the other side of that. We’ll move that exposure out, considerably.
The other area where we can move the needle very significantly is on the high-yield corporate side. When we pull the trigger on that, we can go as much as 75% to over 100% invested. You know that.
I should’ve mentioned – the other part. We see some interesting opportunities on a name-by-name basis out of the equity space that we’re attracted to, based on the research we do on the debt side.
All of our research is done with an equity lens. We’re focused on understanding enterprise value, when we’re looking at corporations over assets. What are the assets worth that are securing our position?
When we look around, there are some interesting opportunities. For example, on the energy side, we’re buying some of those variable-rate dividend-paying stories, now, in the oil-patch. Names like FANG and others that pay out pretty much what they earn from oil. It’s variable with oil.
We think oil is constrained, globally. We think there’s pretty good protection down to 60. There’s a more than compelling case for it to run a lot more; particularly with China coming out.
I noticed recently they produced stronger-than-expected GDP for the first quarter. But one of the things I took note of was, they had record-refinery runs. That was pretty interesting.
We think there’s going to be a lot of fuel-demand and a lift to oil. The buoyancy to oil on that, as well as scarcity of supply. We like that.
There are a few other idiosyncratic ideas that we’ve been running in the portfolio. T-Mobile was another example of a name we covered on the debt side. We saw a sensational move from high-yield to investment-grade in the coming years. When we bought that, we said, “Hey. This is going in the right direction; it’s going to free up a lot of cash-flow that they can return to shareholders.”
That, indeed, came to fruition with them finally getting full investment-grade across the rating category. The stock has really bucked the trend, I think. Particularly last year.
We have the ability to do that on one-off names. But when we start to go more bullish on stocks, in general, we’ll kind of push more diversified into the equity space.
Jeremy: Thanks, Matt. I’m going to turn to Ken. We appreciate the detail.
One comment, Ken. I noticed you’ve got a Volkswagen Beetle behind you. I have a Porsche 911. I don’t know what that says. But we’ll move on.
Ken: I listen to the Grateful Dead. I don’t know.
Jeremy: Okay. Moving on!
Ken: It’s not my office. I’m in somebody else’s office. But don’t hate me. Let’s go – move on to the Opp Income.
Jeremy: Moving on to the final slide, Mike, if you would.
Here we go.
Jeremy: Just hit the key points.
Ken: Yes. Look – the yield is up a lot. Rates back up a ton. Spreads have widened at least 200-bps on most products in the securitized space, at the bottom of the capital structure.
Discounted dollar-price, which we’ve all been talking about, creates convexity and safety in the credit market.
We’ve really been increasing the safety of the portfolio by adding to either agencies or treasuries. You can see that almost a third of the portfolio is in some mix of treasuries – well – these are long-duration treasuries. Agency mortgages and cash.
Why is that? It’s defensive.
Last year was unique. The Fed was hiking. Inflation was high. If spreads are widening, and let’s say spreads widen like 100 bps or 200 bps – it’s highly likely that rates are falling across the curve. You want the duration in your portfolio to offset some of the risk of that potential spread-widening.
If your duration is around 5, and the spread-duration of our portfolio is probably roughly around 5 or 6 – based on the average life of many of our cash flows – that means if spreads widen 100 and rates fall 100, they totally offset each other. You end up just earning your carry.
If the yield is 10, the carry’s probably a little bit lower than that. Some of the yield is price-appreciation.
We honestly haven’t seen the setup, as Jason mentioned, since we launched this strategy in 2010 – going into the European credit-crisis. Yields haven’t been this high, since then. All-in yields haven’t been this high. It’s actually better, this time. Because short-term rates are up.
Back then, short-term rates were at zero. A lot of the credit that’s on the front of the curve has a lot more yield to it than it did back then.
We’re very excited about the future potential returns. It’s not going to be a straight-line [tight-earned] spread lower than yield. But I think that if we back up a little bit more in rates – maybe back up to 4% like Matt’s talking about – I don’t know if we get back to 4%. Maybe it’ll be something more like 3.80% or 3.85%. We’ll probably add a little bit more duration into the portfolio.
We had a duration of 2.5 to start, last year. That, for us, is short. Being more intermediate-term bond-focused, in general, at DoubleLine. But now we’re kind of more neutral to longer, relative to the history of this strategy’s duration. It’s probably had an average duration of 4 or 4.5 years, through time.
Again, that heavy weighting toward resi, CMBS – taking advantage of some of these securitized markets that are not wide because necessarily people are worried about defaults; they’re just wide because there are just no buyers out there. Nobody’s adding money to some of the funds that buy these things.
Everyone’s long. Everyone’s long the story. It’s just going to take some time for time to pass. Eventually, technicals I think will improve. That’ll push spreads back in on these products. But in the near-term, we want that safety in the portfolio. We’re just kind of holding on to these attractive positions that we own.
Jeremy: Great. Yes, we’re – for both of these particular portfolios, just to reiterate –
We see a strong return potential ahead. We’ve got the overweight tactical weight to DoubleLine. Extremely attractive. A ton of confidence in expectations for Matt and the Loomis sleeve.
I guess with that, we really appreciate your time. Sorry for the quick rush here, at the end. In honor of the Grateful Dead, we’ll keep on truckin’, and I’ll pass it back to Mike.
I don’t know if you’re a Grateful Dead fan, Mike. But it’s okay, either way.
Mike: Not really. But that’s okay. All good.
Love the setup. But love the positioning of the fund. Great call. Great webinar. Thank you, everyone, for attending. I’ll send a deck to everyone who’s attended. And everyone will get that who hasn’t. Yes, we appreciate it. Until next time, from IMGP, take care!
Jeremy: Thank you. Bye.
To commemorate the anniversary, co-Portfolio Managers Jeremy DeGroot and Jason Steuerwalt have penned a Q&A retrospective on the fund and the category at large. MORE
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