The iMGP High Income Fund rose 2.26% in the first quarter, beating the Bloomberg Aggregate Bond Index (the Agg) benchmark, which was down 0.78%, and high-yield bonds (ICE BofAML U.S. High Yield TR USD Index), which rose 1.51%. The Fund also outperformed its Morningstar Nontraditional Bond category peer group’s 1.74% gain.
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Quarterly Review
Performance of Managers
During the quarter, all three subadvisors produced positive returns. Neuberger Berman was up 5.88%, BBH gained 2.60% and Guggenheim returned 1.93%. (All sub-advisor returns are net of the management fees that each sub-advisor charges the Fund.)
Manager Commentaries
Brown Brothers Harriman
Treasury rates continued to respond to investors’ predictions for forward-looking Fed interest rate decisions. Strong economic data and stubbornly high inflation data caused investors to shift back to a “higher for longer” disposition for 2024, although the yield curve still had three 25 basis point Fed interest rate cuts priced in by the end of the calendar year. The Fed last met on March 20th and kept the target range of the federal funds rate unchanged at 5.25% – 5.50%. The Fed’s next announcement is scheduled for May 1st, 2024. In addition, the Fed’s campaign of shrinking its portfolio of assets acquired through open market operations by a maximum of $95 billion per month continues.
Shorter duration fixed-income indexes generated positive returns during the first quarter, while longer duration indexes experienced losses. Excess returns to credit were positive across sectors as risk spreads continued to narrow across sectors. One notable exception was agency mortgage-backed securities (MBS), which underperformed comparable duration Treasuries during the quarter.
Economic data remained strong, with inflationary pressures persisting and few signs of recession on the horizon. Headline consumer inflation prints have been stronger than anticipated, and wage growth remains higher than historic averages. The Chicago Fed National Activity Index remains above its recession indicator threshold. Default rates for below-investment-grade companies remain subdued despite higher interest rates. The U.S. consumer appears to be strong, with loan delinquency rates generally rising off very low bases and not indicating widespread issues. Auto loan delinquency rates rose to their highest levels since 2009, and defaults for subprime auto loans increased above their pre-COVID levels, within expected ranges for asset-backed securities (ABS) to withstand losses without risk of impairment to bondholders. Delinquency rates on business loans held at U.S. commercial banks remain near cyclical lows. Commercial real estate loan delinquency rates at U.S. banks continue to creep higher, while commercial mortgage-backed securities (CMBS) delinquency rates are continuing to rise due to the ongoing challenges faced by office properties.
Credit issuance was robust during the first quarter as narrow credit spreads, a clearer economic condition, and differentiation among subsectors and commercial property types overwhelmed any concerns issuers might have had over higher nominal interest rates. Investors met the supply with strong demand as evidenced by credit spreads narrowing throughout the quarter. Investment-grade corporate credit issuance increased 30%, bank loan issuance rose 171%, high yield bond issuance increased 117%, ABS volumes surged 54%, and CMBS issuance increased 165% versus their respective 2023 paces. ABS issuance was record-breaking and eclipsed its previous quarterly record by 25%, and high-grade corporate bonds saw its highest volumes since the second quarter of 2020.
We are finding fewer opportunities in traditional segments of the credit markets as risk spreads continue to narrow. According to our Valuation Framework, the percentage of investment-grade corporate bonds that screened as a “buy” decreased to 13% versus 23% at the start of the quarter and 47% at the end of the first quarter last year, with the prospects for longer-duration bonds looking particularly unattractive. The percentage of high yield corporate bonds that screened as a “buy” in our Valuation Framework declined to 16% from 24% at the start of the quarter and 47% at the end of the first quarter last year, with “buy” candidates having become sparse in the double-B benchmark. No cohort of 30- or 15-year agency MBS met our Valuation Framework for new purchases at quarter-end.
There remain opportunities in select subsectors of the market. Senior bank loans continue to screen attractively, with 87% of the universe screening as a “buy” candidate. We continue to find opportunities in investment-grade bonds issued by life insurers and banks. Several “BB” and “B” rated bonds issued by specialty financial companies, wireline communication companies, banks, and real estate investment trusts (REITs) screen attractively in the high yield bond universe. In the structured credit markets, we continue to find opportunities despite the recent narrowing of risk spreads, with spreads in certain sectors remaining disconnected from their underlying credit risk. Opportunities are arising in the CMBS market as investors are differentiating between office properties and other property types with still strong credit dynamics. We continue to avoid non-agency RMBS 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 outperformed credit market indexes during the first quarter on the heels of strong selection results. Selection in the portfolio’s investment-grade corporate bond positions contributed notably to performance, with strong results in holdings of bonds issued by property and casualty insurers, business development companies, life insurers, and banks. The portfolio’s ABS holdings also experienced favorable selection results, with positions in collateralized fund obligations, aircraft equipment ABS, and collateralized loan obligations impacting results positively. Selection results were also positive in the portfolio’s holdings of high yield corporate bonds and senior bank loans, where holdings of high yield corporate bonds issued by retailers and senior bank loans to electric utilities were additive to results. The portfolio’s sector and quality composition contributed further to returns, as the portfolio emphasized stronger-performing segments of the credit markets during the quarter. The portfolio’s duration profile had a smaller but positive impact on results as its defensive duration profile helped preserve capital despite rising interest rates. Holdings of high yield corporate bonds issued by technology companies hindered results during the quarter.
We found opportunities for the portfolio during the quarter despite weakening valuations. We purchased corporate bonds issued by finance companies, an industrial goods and machinery company, and a business development company during the quarter. We also added positions in a syndicated senior bank loan to an airline and a bond of a venture debt ABS deal.
At the end of the month, the portfolio’s duration was 2.0 years and remained near levels consistent with long-term capital preservation. The portfolio’s weight to reserves increased to 23% from 3% reflecting fewer opportunities in the credit markets. The portfolio’s allocation to high yield and non-rated instruments decreased to 35% from 44% at the start of the quarter. The portfolio’s yield to maturity was 8.2% and remained elevated versus bond market alternatives. The portfolio’s option-adjusted spread was 326 basis points; for reference, the Bloomberg U.S. Corporate Index’s option-adjusted spread was 90 basis points and the Bloomberg U.S. Corporate High Yield Index’s option-adjusted spread was 299 basis points at quarter-end.
We believe that credit discipline remains essential as investors pursue the return potential associated with still-elevated interest rates. With robust issuance, eager investor demand, and narrow credit spreads, it is imperative that each opportunity’s valuation and durability is properly calibrated and vetted prior to investment. The most worrisome risks are often those that are unanticipated, hence the reason we continue to evaluate each credit’s durability, structure, management, and transparency while stress-testing the credit to the worst environment its industry faced before investing. We believe preparation and discipline will be necessary for navigating the months and quarters ahead.
Guggenheim Investments
The U.S. economy has been resilient to tight monetary policy, helped by falling inflation boosting real incomes and consumer sentiment, expansive fiscal policy, and a supply-side boost as labor force participation and immigration rose. These tailwinds are likely to fade going forward which will pressure growth. Job growth has been cooling and increasingly concentrated in less cyclical sectors. Consumer spending also faces headwinds from dwindling excess savings buffers.
However, there are some offsetting positives for the outlook. While hiring is slowing, layoffs remain extraordinarily low as memories of the labor shortage from a few years ago lead to “labor hoarding”. Additionally, the economy has been through a series of rolling recessions, with different industries seeing downturns at different times. Beaten down industries like housing and manufacturing could see some upside in 2024. The Fed pivot caused an easing of financial conditions that takes some pressure off the economy and helps bring down recession risk. While recession risk has come down, it is still materially higher than very optimistic market expectations.
We see an increasingly bifurcated economy, with stress concentrated in small businesses, small banks, commercial real estate, and low income consumers. Inflation has rebounded in recent months, but we remain optimistic for further declines. Shelter inflation and auto insurance costs are proving sticky, but should eventually cool, and broader services inflation will respond to slowing wage growth. Base effects will keep year-over-year core PCE above 2.5% this year, but it should fall closer to 2% in 2025.
Three consecutive hot inflation reports to start the year substantially raise the bar for the evidence the Fed needs to see that inflation is returning to target. We now expect two rate cuts this year, starting in September. We expect rate cuts will accelerate in 2025 as inflation falls further and the economy slows, especially with elevated recession risk. The fed funds rate should ultimately fall to around 3%, which is where we estimate the neutral rate is. Recent communication suggests we should soon see a tapering in the pace of balance sheet runoff, as early as this summer.
The 2024 election will add to volatility and uncertainty this year, particularly with polls showing a close race for the presidency and Congress. No matter the outcome, there is little appetite to address fiscal sustainability, meaning large fiscal deficits will continue. More protectionist trade policy and efforts to curb immigration are likely under either candidate, though a Republican victory would see larger and quicker moves on both fronts. The most market friendly outcome is likely a divided government, which would limit ambitious tax and spending proposals that could reignite fiscal sustainability concerns. An extension of the 2017 tax cuts at the end of 2025 and/or sharply higher tariff rates are a risk for both inflation and interest rates.
Given a high bar for the Fed to consider additional rate hikes, we continue to believe Treasury yields have peaked for the cycle, though they are unlikely to return to the lows of the last cycle. Indicators of credit conditions, like lending standards and corporate fundamentals, suggest some ongoing stress but a peak in default rates later this year. This stress is becoming increasingly bifurcated between large and small companies. While aggregate corporate fundamentals remain solid, investors should remain selective as downgrades continue in the next 6-12 months in sectors most sensitive to high interest rates.
We are finding value in high-quality corporate and structured credit where 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
Market Commentary
Equity Markets
US equity markets enjoyed yet another period of exceptional growth, with the S&P 500 Index climbing by 10.56%. This first quarter surge was anchored in solid economic data, which bolstered both investor confidence in a smooth economic transition and the chances for a ‘soft landing’. The Technology sector, significantly boosted by major contributions from industry leaders, became a central force propelling the market indices’ upward trajectory, driving the Nasdaq-100’s return of 8.72%.
US Treasury Markets
Fixed income markets experienced mixed fortunes, reflecting a changing landscape of expectations around the Federal Reserve’s rate policy. The Bloomberg US Aggregate Bond Index saw a modest downturn, with a -0.78% return, indicating the market’s adjustment to evolving interest rate expectations and inflationary pressures. Conversely, the Bloomberg US High Yield Index showed resilience, with a 1.47% return, benefiting from a risk-on sentiment and the search for yield among investors.
Option Implied Volatility Indexes
During the quarter, the Cboe S&P 500 Volatility Index (“VIX”) demonstrated an average level of 13.3, underscoring a sustained trend of market stability and investor confidence reminiscent of the previous year. The quarter also witnessed sustained positive implied volatility across global exposures, as market participants adeptly navigated the balance between capitalizing on potential market gains and implementing protective hedges in response to the shifting economic and monetary policy landscape. Notably, US markets registered average implied volatility premiums of 1.9 over the quarter. (As a reminder, positive (and high) implied volatility premia are better for the strategy.)
After a relatively strong first quarter for financial markets in the face of growing geopolitical turmoil, all eyes will soon begin to focus on the US presidential election. VIX Index futures markets have priced the November contracts at a sizable premium to adjacent expirations to account for the potential uncertainty and demand for ‘hedging’ around the election. This dynamic will likely become ‘headline-worthy’ as we work our way through the summary and the election prognosticators build their cases for who will win Biden vs. Trump II. In practice, option markets will continue to adjust implied volatility levels to reflect the ongoing risk to equity markets with the election being just one potential risk factor. Whereas VIX futures markets may carry a bit of additional speculating/hedging premium as demand for the alluring convex nature of VIX remains elevated.
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, 2024
| Brown Brothers Harriman Credit Value Strategy | |
| ABS | 16.1% |
| Bank Loans | 19.2% |
| Corporate Bonds | 46.2% |
| CMBS | 0.9% |
| Cash & Equivalents | 21.1% |
| Guggenheim Multi-Credit Strategy | |
| ABS | 30.1% |
| Bank Loans | 14.9% |
| Corporate Bonds | 26.3% |
| CMBS (Non-Agency) | 1.7% |
| Preferred Stock | 2.7% |
| RMBS (Non-Agency) | 7.0% |
| RMBS (Agency) | 6.6% |
| Other | 4.5% |
| Cash | 6.2% |
| Neuberger Berman Option Income Strategy | ||
| Equity Index Put Writing | 100% |