The iMGP High Income Fund rose 2.10% in the second quarter, outperforming the Bloomberg Aggregate Bond Index, which fell 0.84%, and high-yield bonds (ICE BofAML US High-Yield Index), which posted a 1.63% gain. The Fund also outperformed its Morningstar Nontraditional Bond category peer group, which rose 0.94% in the three-month period.
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Quarterly Review
Performance of Managers
During the quarter, the two credit managers outperformed the Aggregate Bond index. BBH gained 2.33% and Guggenheim gained 1.60%. High-yield bonds were up 1.63% in the three-month period. Neuberger Berman gained 4.11% compared to a 3.62% gain for the CBOE S&P500 2% OTM PutWrite Index.
Manager Commentaries
Brown Brothers Harriman
U.S. Treasury rates rose across tenors during the second quarter as investor expectations for future Fed interest rate decisions shifted to “higher for longer.” Shorter-term interest rates ended the quarter at recent highs, while longer-term interest rates were near their beginning-of-year levels. The Fed met on June 14th and kept the federal funds rate unchanged at a range of 5.00% – 5.25%. The Fed’s next announcement is scheduled for July 26, 2023. Investor expectations reveal a belief that the Fed will hike rates in July by 0.25% and keep rates near that level for the next twelve months. In addition, the Fed’s campaign of shrinking its portfolio of assets acquired through open market operations by a maximum of $95 billion continues.
The performance of mainstream, investment-grade fixed-income benchmarks were negative during the second quarter amid rising rates. Spreads narrowed across all credit sectors, qualities, and instruments. Agency mortgage-backed securities (MBS) outperformed Treasuries despite the Fed’s waning support and its extended duration. Investment-grade corporate bonds outperformed similar duration Treasuries by a notable margin as spreads compressed. Indexes of nontraditional asset-backed securities (ABS), high-yield corporate bonds, bank loans, and collateralized loan obligation (CLO) debt had positive returns during the quarter and outperformed Treasury alternatives.
Valuations weakened amid the strong performance in the credit markets. According to our valuation framework, 39% of investment-grade corporate bonds screened as a “buy” with the majority residing in intermediate maturity bonds of rated “single-A” and “BBB.” 36% of high-yield corporate bonds screened as a “buy” with most opportunities among smaller issuers of “BB” and “B” rated bonds. Over 95% of senior bank loans screened as a “buy.” Away from the corporate credit markets, we are finding an abundance of attractively valued opportunities in the structured credit markets, particularly among non-traditional ABS issuances and collateralized loan obligation (CLO) debt. We believe that opportunities in the Commercial Mortgage Backed Securities (CMBS)_ market will arise as stronger properties come to market with single asset single borrower (SASB) securitizations that facilitate strong transparency. We remain unconstructive on the outlook for agency Mortgage Backed Securities (MBS) due to concerns over valuations and prospects of further duration extensions, while we continue to avoid non-agency Residential MBS due to poor technical factors and weak fundamentals underpinned by weak housing affordability, low inventory of homes for sale, and stable-to-declining home prices.
The portfolio gained during the second quarter despite the headwind of rising interest rates. Sector allocation drove the portfolio’s outperformance, as the portfolio emphasized the stronger-performing segments of the credit markets, including senior bank loans, investment-grade corporate bonds, high-yield corporate bonds, and Asset Backed S. Security (ABS) selection results were mixed but detracted modestly in aggregate. The portfolio’s positions in senior bank loans and ABS lagged during the quarter, while the portfolio’s holdings of investment-grade corporate bonds, CMBS, and high yield corporate bonds outperformed. The portfolio’s duration profile detracted modestly from results as rising interest rates rose.
At the end of the quarter, the portfolio’s duration was 2.1 years and remained near levels consistent with long-term capital preservation. The portfolio’s weight to cash reserves increased slightly while its weight to corporate credit declined in similar magnitude. The portfolio’s allocation to high yield instruments declined to 49% from 54% last quarter. The portfolio’s yield to maturity was 10.4% and remained elevated versus bond market alternatives. The portfolio’s option-adjusted spread was 545 basis points; for reference, the Bloomberg U.S. Corporate Index’s option-adjusted spread was 123 basis points, and the Bloomberg U.S. Corporate High Yield Index’s option-adjusted spread was 390 basis points at month-end.
“Proceed with caution” might be an apt summary of our generic advice for credit investors. Caution is necessitated with weakening valuations of index-eligible securities and when researching how the credits are impacted by higher interest rates. Opportunities remain, but dispersion is likely to increase in several of the sectors that attract investors’ interest. The importance of bottom-up selection is as evident as ever as we look ahead.
Guggenheim Investments
The U.S. economy remains resilient, with second-quarter real GDP growth likely to be around 2% and the unemployment rate remaining low. The economy has been helped by falling inflation boosting real incomes and consumer sentiment, easing financial conditions, and a supply side boost as labor force participation improves and immigration recovers. Despite this resilience, we continue to see a high probability of recession, with our base case seeing a recession start around the end of the year. Job growth should continue to slow as backlogs are worked through and it becomes more difficult to reduce the length of the workweek. Falling profit margins as inflation cools will also add to pressures for layoffs. Consumption also faces headwinds from dwindling excess savings buffers and the continued impact of higher interest rates, which bite more as time goes on.
While near-term pressure on the banking sector has abated, the impact of a sharp tightening in credit standards and the resulting slowdown in credit growth has yet to be fully felt. Business investment is likely to slow further as a result. Because private sector balance sheets are generally healthy in aggregate and the economy lacks major imbalances, we do not expect a particularly deep recession. But the likelihood of a limited monetary and fiscal policy response means the economic recovery will likely be weak. Inflation should trend lower over the next year, helped by shelter inflation cooling. Services inflation outside of shelter is the main concern for the Fed, but a softening labor market and slowing wage growth should gradually bring this category down as well. We expect core inflation will fall close to 2% in 2024.
We are nearing the end of the Fed’s hiking cycle. Concerns over the lags of monetary tightening and banking sector stability led to a Fed pause at the June meeting. Our base case sees one more hike at the July meeting and another in September, though the September hike is a close call. The Fed is wary of letting financial conditions ease too far and too fast, which would undo the economic impact of their aggressive rate hikes. Even as they pause rate hikes, they will maintain a hawkish rhetoric and try to push back against market expectations for rate cuts. As evidence inflation is heading back toward target mounts and the rise in unemployment gets more substantial, we expect to see large rate cuts in 2024 and early 2025, taking rates down to around 2%. As the Fed starts cutting rates we expect they will also pause balance sheet runoff, so that quantitative tightening is not offsetting the easing of policy from rate cuts. Despite recession risk, major fiscal stimulus is unlikely given inflation concerns. Divided government virtually ensures policy gridlock through 2024.
At the portfolio level, we are turning more defensive, but remaining opportunistic, as the credit cycle reaches an inflection point. As the economic cycle rolls over later this year, Treasury yields should decline, but are unlikely to return to the lows of the last cycle. Defaults have been rising as U.S. companies cope with rising borrowing costs and limited credit availability. We believe we are tracking a broader pullback in the economy that will present downside risk to equity and high beta credit this year. Corporate fundamentals remain solid, but investors should remain selective as downgrades and defaults increase in the next 6-12 months. We are finding attractive value in high-quality corporate and structured credit and are reducing exposure to bank loans. Attractive yields provide an income cushion that could reduce the impact if spreads should widen from here. We are using market strength as an opportunity to rotate, seeking diversification, and adding structured credit exposure that we find attractive. Higher yields at the short end of the curve have lowered the opportunity cost of short-term investments; building our allocation to such holdings not only maintains our return profile, but it also provides the necessary dry powder for us to become a source of opportunistic capital at the appropriate time.
Neuberger Berman
In the second quarter, the strategy posted a gain of 4.1%. ahead of the Cboe S&P 500 2% OTM PutWrite Index (“PUTY”) return of 3.6%. Year to date, the strategy has gained 7.6% compared to the PUTY return of 10.0%.
Market Commentary
Equity Markets
Fueled by a US Federal Reserve ‘pause’ in raising rates, an avoidance of US debt default, and the bullish expectations for breakthrough Artificial Intelligence (“AI”) technology, the S&P 500 Index returned 8.74% for the quarter, approximately doubling its year-to-date return to 16.89%. Not to be outdone by its ‘slower growth’ cousin, the NASDAQ 100 Index soared 15.39%, pushing its year-to-date rebound to 39.35%.
US Treasury Markets
Short-term US Treasury returns were mixed on the quarter with 0-3M US T-Bills posting a positive 1.22%, while 1-3 Year US Treasuries fell a modest -0.57%. We expect collateral yield levels to remain attractive despite the pause by the US Fed as the threat of inflation persists due to relatively resilient US economic forecasts. Investors remain divided on if/when the US Fed will raise interest rates after their recent pause. We continue to believe the ‘genie is out of the bottle’ and rates will need to be higher for longer given the apparent strength of the US economy thus far. Higher rates offer investors more income from their investment portfolios than they have seen in years. This income may increase spending which reinforces upward price pressures, in turn, increasing the likelihood of persistent inflation. One additional driver of inflation may come from a lack of skilled labor as the average age of skilled US laborers continues to climb due to years of workers choosing other career paths. This begs the question of how AI might push workers back towards more labor-oriented jobs. Regardless, these trends will not resolve themselves in a matter of quarters. On the quarter, short-term US Treasury rates (3M US T-Bill) were up 55bps and long-term rates (10Y US Treasury) gained 37bps. In like fashion, year to date, short-term US rates increased 92bps and 10Y US rates sold off -4bps.
Option Implied Volatility Indexes
Implied volatility levels continued to wane as investors found fewer near-term risks to contemplate. The Cboe S&P 500 Volatility Index (“VIX”) fell -5.11 points, ending the quarter at 13.59. Despite the decline, VIX’s 2023 average level of 18.56 remains in line with its long-term average. Much will be made of VIX’s retreat towards the low teens, but much like Goldilocks’ search for porridge, VIX is always too high or too low for investors and they fail to appreciate that the average VIX is usually ‘just right’. More specifically, focusing on the current level of VIX neglects the fact that most option strategies generally seek to earn money not on a single VIX move higher or lower, but on average implied volatility levels as option premiums decay with time. The S&P 500 implied volatility premium averaged 6.29 for the quarter pushing the year-to-date average premium to an attractive 4.95. (As a reminder, higher implied volatility premiums are better for the strategy.)
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 targeted allocation should differences in shorter-term relative performance cause divergences.
Sub-Advisor Portfolio Composition as of June 30, 2023
| Brown Brothers Harriman Credit Value Strategy | |
| ABS | 22.4% |
| Bank Loans | 31.4% |
| Corporate Bonds | 34.7% |
| CMBS | 4.4% |
| Cash | 7.1% |
| Guggenheim Multi-Credit Strategy | |
| ABS | 29% |
| Bank Loans | 11.7% |
| Corporate Bonds | 23.9% |
| CMBS (Non-Agency) | 3.3% |
| Preferred Stock | 2.7% |
| RMBS (Non-Agency) | 8.1% |
| RMBS (Agency) | 6.5% |
| Other | 7.9% |
| Cash | 6.9% |
| Neuberger Berman Option Income Strategy | ||
| Equity Index Put Writing | 100% |