The iMGP High Income Alternatives Fund gained 2.12% in the quarter, compared to the 3.37% loss for the Bloomberg Barclays U.S. Aggregate Bond Index (the Agg) and 0.81% gain for high-yield bonds (BofA Merrill Lynch U.S. High-Yield Cash Pay Index).
Past performance does not guarantee future results. Index performance is not illustrative of fund performance. An investment cannot be made directly in an index. Short-term performance in particular is not a good indication of the fund’s future performance, and an investment should not be made based solely on returns.The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance of the fund may be lower or higher than the performance quoted. To obtain the performance of the funds as of the most recently completed calendar month, please visit www.partnerselectfunds.com. Investment performance reflects fee waivers in effect. In the absence of such waivers, total return would be reduced.
The High Income Alternatives Fund produced solid gains during the first quarter of the year, continuing a strong stretch of absolute and relative performance following the acute dysfunction and dislocation of markets in March 2020. Over the trailing year ending March 31, 2021, the fund is up 25.12%, unsurprisingly beating the Agg’s 0.71% return, but also outperforming the 23.15% gain of the high-yield index.
Neuberger Berman’s strategy has paid off handsomely as the portfolio has continued to collect attractive option premiums, as equity market implied volatility has remained relatively high since March 2020 (although obviously down dramatically from its all-time peak level reached during that month). BBH and Guggenheim continued to benefit from their shifts to more aggressive postures following the pandemic-induced selloff in credit, while maintaining their disciplined risk-sensitive investment processes.
We are actively working with BBH and Guggenheim on modestly broadening their opportunity sets (staying within their range of expertise, of course) in order to potentially increase the portfolio’s yield without materially increasing risk, as well as potentially expanding Neuberger Berman’s notional exposure band modestly. (See the Strategy Allocations section below for details on the new manager allocations.)
As a reminder, the fund is intended to be a complement to traditional fixed-income allocations, seeking long-term returns that are significantly higher than core fixed-income with a low correlation to core bonds and less interest-rate sensitivity, but almost certainly higher volatility. Over the long term, we believe returns will be comparable to high-yield bonds, but with lower volatility and downside risk because of the diversified sources of return and manager flexibility.
Performance of Managers
During the quarter, all three managers produced positive performance. Neuberger Berman returned 4.58%, Brown Brothers Harriman was up 2.38%, and Guggenheim gained 1.34%. (These returns are net of the management fees that each sub-advisor charges the fund.)
Brown Brothers Harriman
The BBH sleeve had a strong first quarter performance of 2.38%. Our solid results stand in stark contrast to the negative returns generated across most sectors of the U.S. bond market so far in 2021. Our focus on achieving investment returns from credit selection, with a low exposure to interest rate risk given the 2-year duration of the portfolio, has always been the foundation of the strategy. The first quarter was an excellent example of our differentiated approach to active management yielding returns that do not follow traditional credit benchmarks. In addition, we achieved these results with credit spreads remaining mostly range-bound for the quarter. For example, corporate credit spreads for BBB- and BB-rated bonds tightened just 4 basis points (bps) and 29 bps, respectively, as markets debated whether the Federal Reserve’s actions and additional government stimulus may create inflationary pressures with the possibility of an overheated economy. Today’s credit valuations remain generally expensive across most sectors, but our team is still finding ample investment ideas in off-the-run and niche subsectors of the securitized asset-backed securities (ABS) market and subsectors of the corporate bond and loan markets. The sleeve has a yield of 4.5% and we are optimistic that our investments will continue to perform well in 2021. Although we do not predict what may drive future market volatility in the coming quarters, we are confident that we have an effective investment approach to seize the available opportunities.
Looking backward to the events of March 2020 has been a constant and justifiable theme for these past 12 months. The one-year anniversary of that terrible first quarter is a good occasion for reflection and transition. Upon reflection, the economic damage priced into markets at that time was excessive as companies were able to quickly respond to the demand shock via operational and financial actions with a boost from the enormous liquidity injection provided by the U.S government. Looking forward, we normally would be expecting a more gradual transition towards a post-pandemic economy. However, credit markets have already moved quickly beyond a transition period. Credit spreads reflect a complete economic recovery in just one year, even as COVID-19 remains a threat and many companies are struggling to repair the economic damage suffered in 2020. We have heard justifications for such tight credit spreads based upon speculation of a coming wave of pent-up consumer spending, leading to a “golden age” for credit. We are generally wary when language like that is rolled out to explain expensive valuations that keep investors buying credit at unattractive prices. We do acknowledge, however, that tight credit spreads can continue for longer than seems appropriate. It is during these episodes that we remain committed to our disciplined process of buying durable credits only when they are available at attractive yields. As a result, the opportunities we are finding today tend to be in higher-yielding, but shorter-duration credits, where compensation for credit risk and inherent volatility are still adequate. We may have to find more attractive credits more often due to the shorter durations, but it is better than accepting inadequate compensation for long-term credits and underperforming when volatility returns to the market.
Highlights of Investing Activity
We continued to be active in the first quarter, finding attractive values in niche sectors, smaller off-the-run issuers, and businesses still in recovery mode from the pandemic or undergoing regulatory changes. Credit sales in the quarter were executed to swap into these more attractive opportunities. Included below are descriptions of some notable additions to the portfolio.
Business development companies (BDCs) are an area where we remain very active due to the significant value available versus more seasoned corporate credit. This quarter we continued to rotate our BDC exposure by adding positions from many first-time issuers at very attractive valuations, while selling the more seasoned credits in the portfolio. Stellus Capital Investment is a public and internally managed BDC that focuses on offering loans to lower middle-market companies primarily in the services and health care industries. The management team has decades of experience in direct lending and the business has experienced low credit losses since formation, inclusive of 2020. We purchased the new 5-year notes with a BBB rating at a spread of 438 bps for a 4.9% yield. Horizon Technology Finance is a public and externally managed BDC focused on venture lending to technology, life sciences, and health care companies in various developmental stages. The management company was founded back in 2004 and has deployed over $2 billion of capital in these types of venture debt loans with very low realized losses due to low loan-to-values (~10%) and the valuable intellectual property offered as collateral for the loans. The company brought a small initial debt offering to market after numerous discussions with BBH, and we ultimately acquired the 5-year notes rated BBB- with a spread of 406 bps for a 4.9% yield. CION Investment Corporation is a private and externally managed BDC that is focused on lending to middle-market borrowers in health care, services, and the broader basic-industrial sector. The company has also experienced very low credit losses in its 10-year history. The company brought a small deal to market and reached out to a small group of experienced investors in this niche sector. We purchased new 5-year senior notes with a BBB- rating and a spread of 407 bps or 4.5% yield. Some additional BDC exposure was purchased from OFS Capital and FS KKR Capital at a spread of 453 bps and a 4.8% yield.
Like last quarter, we continued to add investments in the recovering sectors of aviation and energy. For example, we initiated a position in the American Airlines/AAdvantage Loyalty term loan, which is secured by the airline’s customer loyalty program. The recent trend of airlines building balance sheet liquidity by borrowing against loyalty programs has been a great source of value for credit investors. The 7-year secured term loan rated BB was acquired at a spread of 498 bps over 3-month London Interbank Offering Rate (LIBOR) for a yield of 5.1%. We also added to our Delta Skymiles floating-rate loan position at a spread over 3-month LIBOR of 312 bps for a 3.3% yield. Additional purchases in the energy sector were also in the existing credits of Occidental Petroleum, Enlink Midstream, and NorthRiver Midstream at an average yield of 4.8%.
System One is a provider of critical technical services and staff outsourcing to telecom, utility, and pharmaceutical companies. The business proved resilient through 2020 as technical maintenance and infrastructure build-out work is difficult to defer for the underlying customers. The floating-rate secured term loan is B rated and was purchased at a spread of 516 bps over 3-month LIBOR for a yield of 5.3%. ILPEA is one the largest private suppliers of magnetic gaskets, rubber, and extruded plastic parts for appliance, automotive, and building products manufacturers. We were able to source this floating-rate secured term loan, rated B with 2-years left to maturity, in the secondary market at a very attractive spread of 550 bps over 3-month LIBOR for a yield of 5.7%.
Fairfax India is an investment company focused on financial and infrastructure investments in India that are designed to take advantage of the rising middle class and pro-business government initiatives. Leverage is moderate with a significant amount of the underlying investments already publicly traded. The company is controlled by its parent company Fairfax Financial for whom we have great respect as operators and astute value investors. The 7-year notes are rated BBB and were purchased at a spread of 420 bps for a 5% yield.
Edison International is the holding company for one of the nation’s largest electric utilities, SoCal Edison. The company is primarily a transmission and distribution operation that is inherently low risk since California changed its regulatory framework for wildfire risks. The company came to market with perpetual preferred stock that is resettable every five years based on the then 5-year Treasury rate plus a spread of 4.7%. SoCal Edison is investment-grade and the holding company preferred stock was issued with a BB rating for a yield of 5.4% to the next reset date. Over in Texas, terrible winter weather was curtailing the power supply to customers and disrupting power pricing dynamics. We leaned into that market stress as credit spreads widened for power producers by initiating a position in Vistra Energy. The company is the largest provider of merchant power in the U.S., with diversified operations across the country and stabilized sources of cash flow. This durable credit will suffer some temporary revenue declines from the power outages but may emerge as a primary beneficiary of needed regulatory changes in that region. We purchased the short 2.3-year duration bonds rated BB at a spread of 265 bps for a yield of 2.8%.
The collateralized loan obligation (CLO) issuance market has been building momentum in 2021 with attractive valuations in less typical opportunities such as refinancing CLOs and static-pool CLOs. We purchased CLO tranches from well-established credit managers such as Angelo Gordon LP and Palmer Square. WOODS 2019-20A (Angelo Gordon) is a refinanced CLO comprising broadly syndicated loans. This loan portfolio was resilient through the economic shock of 2020 and is structured with short reinvestment periods. The floating-rate bonds of this securitization are rated BBB-, with a discount margin of 435 bps over 3-month LIBOR. PSTAT 2021-2A (Palmer Square) is the subordinated or “equity” tranche of a static CLO comprising broadly syndicated loans. The loan portfolio was fully invested with no reinvestment period and began amortizing immediately. This CLO investment is extremely attractive based upon the short 2.5-year expected life, and an estimated model return to the subordinated debt in the range of 16%.
Prices remain expensive for on-the-run credit investments and we are passing on most of the enormous wave of new-issue corporate credit being brought to market. It makes complete sense for companies to sell additional debt or extend maturities now due to the possibility of even higher interest rates in the near future. It makes little sense for investors to buy most of them. The overhanging economic questions of where interest rates are headed, and the strength of this economic recovery, will be a much-discussed topic throughout all of 2021. As valuation-sensitive investors in search of credits that can survive a wide range of economic outcomes, we do not feel compelled to chase investments at poor valuations. Going forward, our focus remains on locating those new, niche, or durable recovering credit investments that differentiate our process and performance from competitors.
The U.S. vaccination campaign has ramped up faster than most expected, with a current pace well over 3 million doses per day. Combined with falling new cases, the improved COVID situation has let the reopening of the service sector begin. Stimulus checks, unemployment benefits, and other fiscal support have driven strong gains in personal income, and net worth has been boosted further by stock market gains and surging home prices. With consumer savings the past year over $2 trillion in excess of normal levels, consumption growth will be strong as spending opportunities normalize. Real GDP growth will get a further boost from a continuation of housing market strength supported by low inventories and low borrowing costs, and with rising business investment as uncertainty is reduced post-election and post-COVID. We expect over 7% real GDP growth in the U.S. this year, and over 3% next year. Accelerating economic growth, a high share of layoffs classified as temporary, and job openings at high levels mean we should see unemployment fall significantly this year. We expect volatile inflation readings in the near term due to base effects from price declines in the first half of 2020, supply chain problems causing backlogs in the manufacturing sector, and price adjustments as consumption shifts from goods to services. On balance, we expect core inflation will trend lower over the next year due to the lagging nature of inflation and health care policy measures that turn to a drag in 2022. Over the next several years we expect that the Fed will struggle to reach the 2% target, let alone exceed it on a sustained basis, as the secular disinflationary headwinds of recent years have not gone away.
We expect a continuation of ultra-accommodative monetary policy as the Fed seeks to demonstrate the credibility of its new framework. Easy Fed policy will be supported by a continuation of below target inflation and the need to subsequently make up that shortfall. The Fed is also eager to demonstrate the credibility of its new definition of maximum employment, which looks at a broader range of indicators than just the unemployment rate and is focused on reducing labor market disparities between different demographic groups. We don’t expect tapering of asset purchases until the second half of 2022 and expect rate hikes are still several years away. Later in the year we expect more fiscal spending focused on infrastructure and climate. This new spending is likely to be paired with tax increases, but the need to get the support of moderate Democrats will limit the size. We expect tax changes will include raising the top marginal individual income tax rate, raising the corporate tax rate a few percentage points and raising taxes on international income, and possibly raising the capital gains tax. Tax hikes will likely be phased in to minimize the near-term economic drag.
Though credit spreads have tightened below historical averages, history shows they can persist at low levels for years during periods of economic expansion. With continued economic improvement, we expect credit spreads to tighten, with some lower-rated asset classes tightening even further against their higher-rated peers. Expanded Fed support for credit markets has significantly reduced tail risks, but high and rising debt loads mean security selection remains paramount. We are finding attractive relative value in structured credit, which has higher yields compared to corporate credit, lower duration risk, and less volatility and correlation. The market has priced in an overly aggressive Fed rate hike path. Oversold conditions and seasonals suggest near-term downside for rates. Risk assets will continue to benefit from supportive monetary and fiscal policy and a strengthening recovery. We view any weakness as a buying opportunity.
“Volatility Selling is Back…” read a recent Bloomberg headline. It only took a few months following high-profile exits and unanticipated ‘blow-ups’ for new option/volatility focused firms and strategies to begin to sprout like spring flowers. In March, the S&P 500 Index (S&P 500) earned an attractive 4.38% while the Russell 2000 Index (R2000) earned 1.00%. Concurrently, the CBOE S&P 500 2% OTM PutWrite Index (PUTY) gained 3.23% and the Bloomberg Barclays U.S. High Yield Index (BB HY) managed a positive return of 0.15%. Over the quarter, markets continued to digest unanticipated events including short squeezes, rising rates, and hedge fund liquidations. Yet, the S&P 500 jumped 6.17% and the R2000 gained 12.70%. In like fashion, the PUTY climbed 4.37% and the BB HY produced a reasonable return of 0.85%.
Index Option Implied Volatility
Listed option markets are resilient and profit-seeking organisms. They adapt and have historically repriced risk to be able to recoup losses realized in prior periods. The past three quarters of above average implied volatility premiums are not a mispricing or aberration, they are simply a rational pricing response where buyers of protection pay higher premiums to sellers of protection following such periods. Rational equity index option markets can’t underwrite equity risk effectively over the long term if they are not able to raise prices after unanticipated losses. Continued above-average levels of implied volatility premiums in the first quarter are just the latest example. The CBOE S&P 500 Volatility Index (VIX) retreated -30.59% to end the month at 19.4. Moving in lock step, the CBOE R2000 Volatility Index (RVX) fell -16.39% to 30.6. Over the period, 30-day implied volatility premiums averaged 5.8 and 1.4, respectively. On the quarter, the VIX is down -3.4 pts with an average 30-day implied volatility premium of 7.8. Moreover, RVX was up 0.1 pts with an average implied volatility premium of 5.6.
In March, the portfolio generated a return of 2.77%, underperforming the PUTY return of 3.23% but significantly outpacing the BB HY return of 0.15%. Over the quarter, the portfolio posted an attractive 4.58% return, which surpassed the PUTY return of 4.37% and substantially exceeded the BB HY return of 0.85%.
With 30-year U.S. Treasury rates jumping another 76 bps, or 46%, to 2.41%, the quarter provided a further reminder of why we avoid duration risk in the collateral portfolio. Comparatively, shorter-dated U.S. T-Bill rates fell a few basis points. For the month, the collateral portfolio finished roughly flat with a decline of 0.03%, which finished slightly behind the ICE BofA 0-3M U.S. T-Bill Index (T-Bill Index) return of 0.01%. Over the quarter, the collateral portfolio’s 0.01% loss performed in line with the T-Bill Index return of 0.02%.
The fund’s new target allocations across the three managers are as follows: 40% each to Brown Brothers Harriman and Guggenheim Investments, and 20% to Neuberger Berman. We use the fund’s daily cash flows to bring each manager’s allocation toward their targets should differences in shorter-term relative performance cause divergences.
Sub-Advisor Portfolio Composition as of March 31, 2021
|Brown Brothers Harriman Credit Value Strategy|
|Guggenheim Multi-Credit Strategy|
|Neuberger Berman Option Income Strategy|
|Equity Index Put Writing||100.0%|