The iMGP High Income Fund rose 3.20% in the first quarter, outperforming the Bloomberg Aggregate Bond Index (Agg), which gained 2.96%, but slightly trailed high-yield bonds (BofA Merrill Lynch US High-Yield Cash Pay Index), which posted a 3.72% gain. The fund outperformed its Morningstar Nontraditional Bond category peer group, which rose 1.57%.
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Quarterly Review
Performance of Managers
During the quarter, the two credit managers performed in line with or better than the Aggregate Bond index. BBH gained 2.92% and Guggenheim gained 3.54%. High-yield bonds were up 3.68% in the period. Neuberger Berman gained 3.39% compared to a 6.17% gain for the CBOE S&P500 2% OTM PutWrite benchmark. Specific to Neuberger’s recent underperformance, it is due to a combination of factors. First, the path dependency of the index worked largely in its favor relative to Neuberger’s active, diversified approach, as the dates of the index rolls coincided with fairly high levels of implied volatility (generating good levels of option income) but not significant drawdowns from the last roll date. Over time, we believe Neuberger’s approach of active diversification and risk management tend to work better and Neuberger has meaningfully outperformed since inception. This has been the case as Neuberger has beaten this benchmark since inception with 5.68% annualized return compared to 3.99% for the index. But in any given month, quarter, or even year, a more concentrated, less-diversified, passive strategy can perform better. (All sub-advisor returns are net of the management fees that each sub-advisor charges the fund.)
Manager Commentaries
Brown Brothers Harriman
The BBH sleeve returned 2.92% during the first quarter of 2023. Fixed-income indexes gained during the quarter as longer-term rates declined. Spreads of bonds issued by banks widened, but excess returns in the broader corporate debt markets (investment-grade bonds, senior bank loans, and high-yield bonds) were positive. Indexes of non-traditional asset-backed securities and CLO debt outperformed during the quarter. Agency MBS and commercial mortgage-backed securities (CMBS) underperformed during the quarter. U.S. dollar-denominated emerging-market bonds also lagged during the quarter.
Credit valuations remain broadly appealing. According to our valuation framework, 47% of investment-grade corporate bonds screened as a “buy,” 47% of high-yield corporate bonds screened as a “buy,” and 95% of bank loans screened as a “buy.” These figures increased from their respective levels at the start of the year, when 36% of investment-grade corporate bonds, 46% of high-yield corporate bonds, and 80% of 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, floating-rate single-asset single-borrower (SASB) CMBS, and collateralized loan obligation (CLO) debt.
The portfolio’s 2-year duration contributed to the strategy’s total return as U.S. Treasuries with maturities of one year and greater declined during the quarter. Sector allocation was additive to performance, as holdings of strong-performing sectors, including bank loans, high-yield corporate bonds, and asset-backed securities (ABS), more than offset exposures to weaker-performing sectors. Selection results contributed modestly. Results in high-yield corporate bonds, CMBS, and ABS were positive, while results in loans and investment-grade corporate bonds were negative.
With the intra-quarter volatility in credit spreads, we were able to buy some attractively priced new credits. We purchased a venture debt ABS, a BB-rated corporate bond issued by a REIT, and a loan to a midstream energy company.
At the end of the month, the portfolio’s duration was 2.1 years and remained near levels consistent with long-term capital preservation. High-yield investments represented 54%, were comprised primarily of credits rated BB. The portfolio’s yield to maturity was 10.2% and remained elevated versus bond market alternatives. The portfolio’s option-adjusted spread (OAS) was 588 basis points; for reference, the Bloomberg U.S. Corporate Index’s OAS was 138 basis points, and the Bloomberg U.S. Corporate High Yield Index’s OAS was 455 basis points at month-end.
Guggenheim Investments
We continue to believe the economy is on track for a recession this year. Helped by lower energy prices, warm weather, and easier financial conditions, real economic growth reaccelerated over the past few months. However, we continue to see a high probability of a recession starting later this year.
The Fed is explicitly targeting a weaker labor market, and several leading indicators point to rising unemployment later this year. Our analysis shows that employment levels have caught up to GDP, which should ease the need for “labor hoarding”. Consumption also faces headwinds from dwindling excess savings buffers and a negative wealth shock as financial asset and home prices fall.
The fallout from recent regional bank failures is ongoing. Recent data shows some signs of stabilization indicating reduced risk of an acute crisis, but we expect a further tightening in bank lending standards resulting in a slowdown in credit growth. 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.
While goods prices could see a near-term rebound, inflation should trend lower over the 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 end the year around 3% and fall close to 2% in 2024.
We think the Fed will proceed more cautiously, but additional tightening is needed. Resilient labor market data and services inflation mean the Fed is not convinced their job is done. At the same time, concerns over the lags of monetary tightening and banking sector stability argue for a more cautious approach to policy. We see two more 25 basis point hikes after which the Fed will be on hold.
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 keep rate hikes on the table. Fed communication has made it clear they are aware of elevated recession risk, but they see the risks of letting inflation expectations become unanchored as far more dangerous. Fed policy is unlikely to pivot to rate cuts as quickly as in the past, even amid rising unemployment.
Despite recession risk, major fiscal stimulus is unlikely given inflation concerns. A divided government virtually ensures policy gridlock for the next two years. We expect the debate over raising the debt ceiling will get pushed to the last minute and lead to market volatility. The end result is likely to be government spending cuts, further pressuring economic growth.
From a portfolio-position perspective, we have been turning more defensive, but remaining opportunistic, as the credit cycle reaches an inflection point. As the economic cycle rolls over this year, Treasury yields should see a significant decline, but are unlikely to return to the lows of the last cycle. Recent bank failures are evidence that pockets of distress are likely to emerge given the lagged effect of monetary policy.
The emergence of a recession presents 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. At quarter end, the portfolio’s yield to maturity was 9.7%, with an effective duration of 2.4 years.
Neuberger Berman
As if trying to remind investors of their unpredictability, broad-based equity and fixed-income markets posted healthy gains over the quarter in the face of the unexpected collapse of Silicon Valley Bank (SVB), which sparked U.S. regional banking contagion fears (e.g., $30 billion injection into First Republic Bank) and UBS’s government orchestrated absorption of Credit Suisse. In simple terms, markets seem to have entered the ‘bad news is good news and strong economic results is bad news’ phase of the U.S. Federal Reserve rate cycle. The on-going tug-of-war between expectations for continued interest-rate increases to fight inflation and the risk of pushing the U.S. economy into a recession seems to be tilting towards the latter. We believe financial markets are returning to historically ‘normal’ dynamics with ‘zero-rate’ policies a thing of the past barring some exogeneous events (e.g., pandemic, war, natural disasters) that require extraordinary measures. The more likely return drivers over the next few years seem to be non-zero rates, company margin durability, leveraged balance sheets, rising commodity and labor prices, geo-political uncertainty, social unrest, and global trade disruptions. One might argue this list is somewhat evergreen. Yet, we feel the accommodative flexibility and coordination of global monetary authorities that has helped inoculate many economies and global trade from disruptions has ‘left the building’. In short, durable capital formation will likely be harder going forward than it has been since the 2008/09 Global Financial Crisis. Conveniently, we believe this could support the case for diversifying strategies, like option-writing, that have the potential to offer structured return payoffs.
The U.S. Federal Reserve Board of Governors raised its target rate 50bps during the quarter to 5.0%. However, increased concerns over financial conditions resulted in a lowering of expectations for the magnitude of future rate increases, which was a positive for risk assets. Over the quarter, the S&P 500 Index rallied 7.50%, the Cboe S&P 500 2% OTM PutWrite (“PUTY”) jumped 6.17%, and the Cboe Russell 2000 PutWrite (“PUTR”) rose 0.32%.
US Treasury Markets
The bad news in the quarter was ‘great’ news for fixed income markets with the Bloomberg US Aggregate Bond Index and the Bloomberg US Corporate High Yield Index rallying 2.96% and 3.57%, respectively. Short-term US Treasury index returns anticipated a potentially more accommodative Fed in late 2023 as the ICE 20+ Year US Treasury Index gained 6.45% as 10-Year interest rates fell -40bps. The shorter duration ICE BofA 0-3 Year US Treasury Index rose 1.42% in the quarter. In general, gains in US Treasuries helped our strategies regain a portion of collateral losses suffered in 2022. On the quarter, short-term US Treasury Rates (3M US T-Bill) were up 38bps and the long-term rates (10Y US Treasury) declined -41bps.
Option Implied Volatility Indexes
Despite the SVB crisis, implied volatility levels declined across markets during the quarter. The relatively ‘behaved’ response of option markets, the VIX Index, to the SVB crisis suggests that higher levels of volatility have priced in ‘unexpected’ events. Given the events of the first quarter, we believe they are likely to continue to do so. For the month, the Cboe S&P 500 Volatility Index (“VIX”) was down -2.0 pts with an average 30-day implied volatility premium of 2.9. Further, the Cboe Russell 2000 Volatility Index (“RVX”) was down -0.7 pts with an average implied volatility premium of 0.6. For the quarter, VIX fell -3.0 pts yielding an average 30-day implied volatility premium of 3.3. Accordingly, RVX declined -1.0 pts resulting in an average implied volatility premium of 2.5.
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 March 31, 2023
| Brown Brothers Harriman Credit Value Strategy | |
| ABS | 23% |
| Bank Loans | 36% |
| Corporate Bonds | 32% |
| CMBS | 4% |
| Cash | 5% |
| Guggenheim Multi-Credit Strategy | |
| ABS | 30.8% |
| Bank Loans | 13.7% |
| Corporate Bonds | 26.6% |
| CMBS (Non-Agency) | 3.4% |
| Preferred Stock | 3.2% |
| RMBS (Non-Agency) | 7.3% |
| Other | 8.8% |
| Cash | 6.2% |
| Neuberger Berman Option Income Strategy | ||
| Equity Index Put Writing | 100% |