The iMGP High Income Alternatives Fund gained 2.46% in the fourth quarter, finishing ahead of the Bloomberg U.S. Aggregate Bond Index’s (Agg) gained 1.875% but behind high-yield bonds (BofA Merrill Lynch US High-Yield Index), which gained 3.98%. The fund performed better than its Morningstar Nontraditional Bond category peer group, which was up 1.60%. Year to date, the fund was down 6.85%, outperforming both the Agg and high-yield bonds, which lost 13.01% and 11.22%, respectively, while trailing narrowly trailed its category peer group (down 6.44%).
Past performance does not guarantee future results. Index performance is not illustrative of fund performance. An investment cannot be made directly in an index. 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.
After several years of low yields, followed by some of the worst annual return since 1975, it looks as though bonds are finally set up to generate attractive returns again. While returns are likely to be more attractive, volatility is likely to persist as there are several factors in play including inflation, central bank interest-rate policies, and questions around global economic growth in the U.S. and abroad. While there are question marks, we think 2023 could be a good year for bonds as they provide attractive return potential with lower risk then we’ve seen in years.
Looking ahead we expect the Federal Reserve to end its rate hikes sometime in the first half of 2023, against the possibility of a recession and lower inflation. With short-term rates likely to be pegged at current or modestly higher levels, the yield curve will remain inverted.
Our positive near-term view on bonds rests on three main factors: Higher starting yields, inflation trending lower, and the Fed being close to ceasing its rate hikes. As for the Fed rate hikes, they have been signaling that they will continuing hiking in early 2023, moving to smaller increments from the recording setting pace of rate hikes we saw last year. As we write this the market is pricing in a 95% probability that the Fed will hike 25bps at their next meeting in early February. Many expect small hikes through most of the year, with potential rate cuts happening later in the year.
The fund’s active credit managers are excited about the current yields for their respective sleeves but are heading into the year somewhat cautious in the face of a potential recession. It is likely that volatility will remain elevated as the markets continue to adjust to today’s higher rates and economic risk. But overall, our message is that there are many reasons to be optimistic about bonds, particularly with flexible managers with wide opportunity sets that can better navigate the credit and macroeconomic environments.
The High Income Alternatives fund will reach its five-year anniversary at the end of the third quarter 2023. Over the life of the fund, it has been able to demonstrate its ability to generate an attractive risk-adjusted returns and income, while diversifying core bond exposure. Over the trailing one-, two-, three, and since-inception periods, the fund remains comfortably ahead of both the high-yield and Aggregate bond benchmarks, as well as the Morningstar Nontraditional Bond category.
We appreciate your continued confidence in the fund.
Quarterly Portfolio Commentary
Performance of Managers
During the quarter, all three managers posted gains. Neuberger Berman was up 6.23%, Guggenheim gained 2.24%, and Brown Brothers Harriman was up 1.48%. (All sub-advisor returns are net of the management fees that each sub-advisor charges the fund.)
Brown Brothers Harriman
The BBH sleeve returned 1.48% during the fourth quarter and -4.84% during calendar year 2022. The positive return in the fourth quarter was a welcome relief after three consecutive quarters of negative market returns due to the rapid pace of interest-rate increases that caused the worst performance episode in the history of the bond markets. While the sleeve posted a negative return for the year, it outperformed nearly all fixed-income market alternatives. The Bloomberg U.S. Aggregate Bond Index declined 13.0% during the year, investment-grade corporate bonds lost 15.8%, and high-yield corporate bonds fell 11.2%. Indexes of structured credit investments declined, too; the ICE BofA AA-BBB Miscellaneous Asset Backed Securities (ABS) Index declined 10.2%, while the Bloomberg Non-Agency Commercial Mortgage-Backed Securities (CMBS) Index declined 10.8%. Floating-rate loans were a top performing asset type during the year, declining only 0.6%.
The benefit of this environment is that the general level of interest rates is high and there is an array of attractive credit opportunities available. We continue to search for durable credits that can survive this period of economic stress and be purchased at appropriate valuations for the risk. Our disciplined bottom-up approach towards credit offers the potential for outsized returns in the years ahead.
Helped by lower energy prices, real economic growth looks to have reaccelerated in the fourth quarter. However, our outlook for the U.S. economy remains negative. We expect 2023 will see negative real GDP growth (Q4/Q4), with a high probability of a recession starting by Q3 2023. The Fed is explicitly targeting a weaker labor market, and several leading indicators point to rising unemployment by the middle of the year. Consumption also faces headwinds from dwindling excess savings buffers and a sharply negative wealth shock as financial asset and home prices fall. Business investment is also weakening due to the sharp tightening in financial conditions and more challenging outlook for economic growth. The housing sector is likely to subtract further from GDP as the spike in mortgage rates has cratered demand. 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. Moderation in goods prices as supply chains normalize should bring inflation lower over the next several months, and shelter inflation should roll over by mid-2023. Services inflation outside of shelter is the main concern for the Fed, but a softening labor market and cooling wage growth should keep this category contained. Core inflation could fall below 3% by the end of the year.
The end of the Fed hiking cycle is in sight, but there is no rush to cuts rates. Given concerns about the lags of monetary policy, The Fed is eager to downshift the pace of rate hikes. We see the hiking cycle winding down by Q2 2023. 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 slow the pace of rate hikes and then pause, they will maintain a hawkish rhetoric and try to keep rate hikes on the table. The 1970s experience of premature easing of monetary policy causing inflation to reaccelerate is at the top of the Fed’s mind. They will need overwhelming evidence that inflation has come down and will stay down, which means not only will they need to see several months of cooler inflation readings, they will also need to a see a weaker labor market to ensure wage growth moderates and takes pressure off underlying inflation. 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. Divided government virtually ensures policy gridlock for the next two years.
What this means for the portfolio, we are turning more defensive, but remaining opportunistic, as the credit cycle reaches an inflection point. The Fed’s continued rate hike campaign should cause the yield curve to invert further in the near term. As the economic cycle rolls over this year, Treasury yields should see a significant decline. Cooling inflation could drive a near-term relief rally in risk assets. Weakening corporate earnings growth and an emerging recession present downside risk to equity returns later 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.
In the fourth quarter of 2022, the the portfolio was up 6.2%. The strategy’s S&P 500 PutWrite component compounded at 6.1%, lagging the Cboe S&P 500 2% OTM PutWrite Index (“PUTY”) return of 7.9%, while the Russell 2000 PutWrite segment also gained 6.1%, matching the Cboe Russell 2000 PutWrite Index (“PUTR”) return of 6.1%. The collateral portfolio’s 0.7% return captured the majority of the ICE 0-3M US Treasury Bill Index (“T-Bill Index”) return of 0.9%.
In the equity markets, despite another 125bps of tightening from the US Federal Reserve Board of Governors over the fourth quarter, financial markets tried to salvage 2022 with broad gains. The MSCI EAFE Index was a clear winner posting an exceptional return of 17.40% over the quarter, well ahead of the S&P 500 Index and MSCI Emerging Markets (EM) Index returns of 7.56% and 9.79%, respectively. However, despite the holiday rebounds, all three indexes ended 2022 squarely in negative double-digits: the S&P 500 finished at -18.11%, the MSCI EAFE posted -14.01%, and the MSCI EM came in behind both with a -19.74% return. To paint the year with a single statistic, we offer the following: 2022 had more +/-8% monthly returns than any year since 1939 (source: Neuberger Berman, Bloomberg). Over the quarter, the Cboe S&P 500 2% OTM PutWrite (“PUTY”) gained 7.89% and the Cboe Russell 2000 PutWrite (“PUTR”) jumped 6.08%.
Turning to the bond markets, fixed-income markets suffered a similar fate as equity markets in the fourth quarter with the Bloomberg US Aggregate Bond Index and the Bloomberg US High Yield Index rallying 1.87% and 4.17%, respectively. However, 425bps of US Fed rate increases doomed the indexes to 2022 losses of -13.01% and -11.19%, respectively. Short-term US Treasury index returns weathered the inflation storm with the ICE 3-Month US T-Bill index posting an attractive 1.49% for the year with 91bps accruing in the fourth quarter. The slightly longer duration ICE 1-3Y US Treasury Index rose 74bps in the quarter but remained in negative territory for the year at -3.65%. This 2022 performance differential was the most notable headwind for our strategy’s relative performance as passive option strategy indexes generally hold 1- to 3-month US T-Bills as collateral. On the quarter, short-term US Treasury Rates (3M US T-Bill) were up 110bps and long-term rates (10Y US Treasury) rates gained 4bps.
With the annual cycle of financial and economic prognostication upon us, we believe the next decade looks far more challenging than the last as investors face a combination of risks not seen in our careers, if ever. Specifically, in our view, investors face a ‘dirty dozen’: higher interest rates, aging demographics, polarized politics, uncertain inflation, pandemic policies, ESG regulation (social taxation), energy/commodity insecurity, decentralized finance (DeFi), climate disasters, social media (conspiracies), decreasing financial liquidity, and armed conflicts (war has many modern names). Each of these factors will potentially impact global economic outcomes in the coming decade but it’s impossible to handicap what combinations will emerge as the key economic drivers/influences. Regardless, we believe their confluence will lead to an unprecedented equity market volatility landscape characterized by less cyclical implied volatility levels that remain ‘higher for longer’.
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 December 31, 2022
|Brown Brothers Harriman Credit Value Strategy
|Guggenheim Multi-Credit Strategy
|Neuberger Berman Option Income Strategy
|Equity Index Put Writing