The iMGP High Income Alternatives Fund gained 10.14% in the three-month period, compared to the 2.90% gain for the Bloomberg Barclays U.S. Aggregate Bond Index (Agg) and the 9.58% gain for high-yield bonds (BofA Merrill Lynch U.S. High-Yield Cash
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Quarterly Review
We are happy to report strong gains for the quarter to our fellow shareholders. The High Income Alternatives Fund was up over 10% in the second quarter, bouncing back significantly from the losses suffered in the difficult environment of the global pandemic-induced financial markets panic of March.
However, the fund still lags its benchmarks year to date largely due to the fund’s Ares sleeve, which invests primarily in business development companies (BDCs,) mortgage real estate investment trusts (REITs), and master limited partnerships (MLPs)/midstream energy. That sleeve generated extremely strong performance in 2019 and during the rebound in the second quarter of this year, but suffered a dramatic decline in the first quarter (down close to 40%) as the market worried about credit quality and leverage in mortgage REITs and BDCs, as well as the collapse in energy prices. Despite that result, we think Ares managed through the period relatively well considering the environment. They entered the year very conservatively positioned relative to their mandate and outperformed their benchmark quite significantly. But even with double-digit levels of cash and a higher-quality-tilted portfolio, there was nowhere to hide given the investment universe for their strategy. The market carnage in their target universe was reminiscent of the 2008 financial crisis, despite generally better fundamentals and more responsible use of leverage by the management teams of the companies in which Ares invests.
Our flexible credit managers Brown Brothers Harriman and Guggenheim are both down less than 2% through June 30, beating the ICE BofAML U.S. High Yield TR USD Index, which lost almost 5%. This is consistent with our expectation for them to hold up significantly better on the downside. They are also both ahead for the trailing year, up slightly while high-yield is down close to 1%. Neuberger Berman’s strategy is down a bit more than 3% year to date, a very respectable result given the unprecedented volatility spike in March of this year. Their strategy is now benefiting from higher-than-average option premia in the aftermath of the stock market plunge.
In its still-brief history, the High Income Alternatives fund has lived through a wild ride. It was launched into a mini-meltdown in the fourth quarter of 2018 that saw high-yield down almost 5%. This was followed by a “risk-on” year of mid-teens gains for high-yield, leading into the meltdown in the first quarter of 2020 that saw high-yield lose essentially all of 2019’s gains (and significantly more than that) before a sharp rally in the last week of the quarter.
Throughout it all, the Bloomberg Barclays Aggregate Bond Index (Agg) has rallied dramatically and almost continuously (aside from a stretch of less than two weeks in March 2020 that saw it experience its own shocking drawdown of nearly 10%—truly a sign of how incredibly dysfunctional markets were during that period). The Agg’s high-teens gain during that time is a surprise to us given what seemed like an unattractive combination of high duration (6.0 years) and relatively low yield (3.5%) when the fund launched. Little did we (or anyone) know that owning as much duration as possible would be the winning formula for total return in fixed-income over the next six to eight quarters. All the features we thought would generate attractive returns relative to core investment-grade bonds—namely, partnering with managers who excel at credit selection, targeting less efficient and niche market segments, and diversifying beyond bonds for income—would prove ineffective in that pursuit. We are hard pressed to believe the current characteristics for core bonds of a 1.3% yield and duration of 5.5 years will produce a similarly compelling relative performance story over the next 18–24 months. We could of course be wrong, but the odds seem stacked much more in our favor at this point than they were at the fund’s inception.
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 could 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 second quarter, all four managers delivered strong gains, bouncing back significantly as markets recovered. Ares gained 29.81%, Neuberger Berman returned 9.86%, Brown Brothers gained 8.09%, and Guggenheim rose 7.05%. (These returns are net of the management fees that each sub-advisor charges the fund.)
Manager Commentaries
Ares
The second quarter of 2020 provided sharp positive returns across our asset classes as forced selling and fears of worst-case scenarios subsided. The equity market recovery continued throughout the second quarter, largely driven by Fed support, easing coronavirus fears and a gradual reopening of the U.S. economy.
In our portfolio, we have primarily focused on BDCs with lower leverage and excess liquidity, which provide both downside protection as well as dry powder to make new investments. We have observed that most BDCs with excess capital continue to be very cautious and are hesitant to deploy a meaningful amount of capital; however, in the new loans they are choosing to underwrite, all reported much better covenant protections, stronger structures in the documents and about 1.5%–2.0% higher coupons versus pre-COVID-19 deals.
The midstream sector continues to face uncertainty with near-term volumes as E&P (energy exploration and production) customers continue to weigh production shut-ins in the depressed commodity pricing environment. That said, the sector benefited in April from both revised outlooks that were better than feared and the cessation of forced selling among energy-dedicated closed-end funds. We note earnings season saw a majority in the space report earnings that beat or were in line with consensus.
The mortgage REIT industry suffered significant disruption and loss of capital in late March and early April as higher leverage funded with bank repo led to margin calls and forced selling across a number of companies. Book values declined 10% for commercial mortgage REITs and nearly 50% for many residential mortgage REITs. Within the mortgage REIT space, our focus remains on hotel and retail exposure. Some hotels in driving tourist markets are rebounding very quickly; in contrast, other hotels that serve as urban conference centers could run at low occupancy for a prolonged period. Retail properties that were already struggling have quickly declined and urban office centers could have negative headwinds for years to come. Overall, the credit performance of real estate is very slow moving and typically plays out over quarters to years, and we continue to be underweight and selective in our mortgage REIT portfolio.
Brown Brothers Harriman
After the unprecedented first quarter sell-off in credit markets, the second quarter began a remarkable turnaround that combined strong performance for credit, with record issuance of new credit into the markets. As the tide turned through the quarter, we were pleased to see the recovery reflected in positive changes to the prices of our credits. Performance of the BBH sleeve in the second quarter was a solid +8.1% (net), which also pulled year-to-date performance up to -1.9%. Economic activity is increasing across the country in these first two weeks of July and the rebound in credit is continuing. We expect credit prices to remain firm and credit availability to incrementally improve as the economy begins to regain some momentum.
The second quarter began with attractive valuations across credit markets reflecting the pandemic risks roiling the economy exacerbated by a liquidity problem in short-term credit. Noting these economic headwinds, we continued assessing attractive opportunities during the quarter anchored by our disciplined credit approach. The focus for the team was sifting through the broad opportunity set and adding positions in credits that should be capable of surviving an economic downcycle of this scale through business model flexibility, adequate liquidity buffers, or collateral protection. Although the rebound in credit markets was strong during the quarter, there is still ground to be recovered over time as the market has not returned to normal levels. As the timing of a lasting economic rebound is far from a certainty at this juncture, we continue to invest at a measured pace. Fortunately, we still see ample opportunities to deploy capital in new issuance and the secondary markets, while being mindful that additional pandemic-related volatility could still be on the horizon.
The Federal Reserve put an enormous and credible bid under the corporate bond market in the quarter. These governmental actions were assisted by a recovery in oil prices from the negative levels in early April and a seeming stabilization of pandemic health risks. Such factors helped drive credit valuations significantly tighter in the quarter—but they were not a panacea for markets. ABS (asset-backed securities) and CMBS (commercial mortgage-backed securities) compensation remain at or near the most attractive levels seen since the Great Financial Crisis of 2008–2009. As we look forward from today, we still see a broad opportunity set for disciplined investors to acquire durable credits at attractive valuations.
New Purchases
As the aerospace industry shook from the turbulence of COVID-19 airline disruptions we added exposure away from the center of the stress in an aircraft manufacturer and a lessor at attractive spreads in the second quarter. The Boeing Company has endured multiple business issues recently on different fronts. However, its formidable commercial aviation franchise, significant backlog, and nationally important business position allowed the company to issue $25 billion of notes for liquidity purposes in April. We participated in both the 3-year and 5-year tenors that were rated BBB and offered spreads of 425 bps and 450 bps, respectively, for yields of 4.4% and 4.9%. The bonds rallied quickly into our “Sell” zone and we began to exit the positions prior to the end of the quarter. We built a short-dated position in a leading aircraft lessor, AerCap. Aercap is a world-class lessor with significant multi-cycle experience dealing with both manufacturers and airlines customers. Although the management team of this company will be busy managing both new purchases with suppliers and leasing terms with customers for the next few months, the fact that the company retains broad options pertaining to accessing the capital markets supports our investment thesis in these short-dated bonds. Another travel-related credit we purchased in the quarter was Expedia, a global-scale online travel agent. Although the disruption to travel bookings was severe in the first quarter, an eventual return to travel is expected as countries lift pandemic restrictions. Expedia took swift action to shore up its capital base and liquidity by issuing equity and debt. With a significant equity injection and deep liquidity cushion, we felt very comfortable adding exposure to the new five-year BBB-rated bonds at a spread of 588 bps for a 6.25% yield.
In the insurance sector we purchased a first-time issuance from Fidelis Insurance Holdings. The company is Bermuda-domiciled and focuses on specialty and “bespoke” lines of business, along with standard property insurance. The company’s founder has an excellent underwriting track record at Fidelis and with a prior business he founded. Fidelis met our investment criteria due to the management team’s track record plus a conservative investment portfolio, reserving policy, and diversified book of business. The new 10-year bonds are rated BBB and offered a spread of 433 bps for a 5% yield.
We initiated a new position in the bonds of Austrian sensor manufacturer ams AG (“AMS”). The company is a world leader in sensors and photonics having completed the acquisition of OSRAM Licht AG. The combined business now has a more diversified product line and a flexible manufacturing model. The financial model is also a solid combination of low steady-state leverage bolstered by significant liquidity to support the company through this period of COVID-19 disruptions. The five-year senior notes are rated BB- and were priced at a very attractive spread level of 695 bps for a yield of 7.24%.
Another new credit to the portfolio is Hillenbrand, which is a diversified industrial business that derives sales from its three diverse segments of materials handling, death care, and plastic extrusion equipment. A high percentage of revenues is derived from repeatable aftermarket sales that produce stable and significant free cash flow to repay debt. The company issued five-year bonds with a rating of BB+ and at a solid spread level of 532 bps for a 5.75% yield.
Owl Rock Technology Finance is a private business development company (“BDC”) managed by the same experienced team at Owl Rock Capital that we have invested with before. This BDC is focused on originating first lien private credit loans to technology and software companies with business essential applications. The technology loan portfolio has a low loan-to-value at 35% and zero non-accruals since inception. The BDC has low leverage with a debt-to-asset ratio below 50% and benefits from being part of the larger $17 billion credit platform at Owl Rock. The first-time issuance of five-year bonds from this entity was rated BBB- and came very attractively priced at 682 bps for a 7.1% yield.
The new-issue market for ABS was slower to re-open in April and May but returned to normal levels in June. Nonetheless, we added new structured product offerings from issuers we know well from previous investments. West River Group is a venture debt lender to late-stage biotech and technology firms. Loans are co-originated by Silicon Valley Bank (SVB), which has an impressive underwriting history, with minimal credit losses and high returns on lending. The 2.3-year BBB-rated privately-placed tranche has 32% credit enhancement and was issued at a spread of 642 bps to yield 6.6%.
We were pleased to see the strong rebound in portfolio performance this quarter, with a strong basis for future performance. However, COVID-19 still weighs on the global economy, and we remain alert for second wave effects on our investments. We will be closely evaluating the second quarter financial reports of our investments in the coming weeks and assessing the continuing durability and valuations of each credit.
Guggenheim
COVID-19, the deadliest pandemic in a century, caused a steeper plunge in output and employment in two months than during the first two years of the Great Depression. A recovery began in May as states began to reopen, but the subsequent rise in infections shows the difficulty in managing an economic recovery amid a pandemic. We expect the recovery will continue at an uneven pace as households, businesses, and governments gradually learn how to adapt. However, we do not expect a full recovery will be possible until a vaccine has been developed, tested, approved, produced, and administered across the globe. This process will likely take until mid-2021 or possible longer. Even after a vaccine is deployed, the recovery will be sluggish due to the long-term damage being done to the economy. The surge in joblessness is damaging household balance sheets, and precautionary saving will further hold back the recovery in consumption. Small business failures and corporate bankruptcies are doing permanent damage to the productive capacity of the economy, which will stunt the recovery in output and corporate profits. Higher business debt burdens will be another post-crisis drag.
The Fed has acted quickly to restore market functioning and cushion the economy, cutting rates to zero, engaging in massive asset purchases, and launching an array of lending facilities. As more support will be needed, we expect the Fed provided forward guidance that rates will be at zero for several years and launch a formal quantitative easing (QE) program to keep longer-term rates low. The Fed’s policies are necessary, but not sufficient to deal with the current crisis. They can help prevent conditions from worsening but have limited ability to lift economic demand. They also have the negative side effect of worsening corporate leverage. Congress has also acted much faster than in previous downturns, with the budget deficit headed to the highest level since World War II. Government income support through stimulus checks and unemployment benefits have been crucial in supporting consumption and confidence. Despite the unprecedented size of this fiscal response, it’s clear that more support will be needed. Two crucial issues for the outlook will be whether federal unemployment benefits are extended past July, and whether additional aid is provided to struggling state and local governments, which face job and spending cuts without more support. Ultimately, monetary and fiscal policy will take a backseat to public health policy. Progress in testing, treatment, non-pharmaceutical intervention, and vaccine development will be the biggest determinants in the shape of the recovery.
The resetting of valuations across most asset classes has presented significant opportunities and prompted us to significantly increase credit risk. Even as credit spreads have retraced from March wides, they still present attractive long-term value. Expanded Fed support for credit markets has significantly reduced tail risks, but default risk still remains elevated. High and rising debt loads and a severe demand shock will inevitably lead to defaults and downgrades, so security selection remains paramount. With the Fed set for a protracted period at the zero bound, Treasury yields have further room to fall, with the possibility of much of the curve falling into negative rate territory. We view this environment as one with significant risk, but larger opportunity. Our positioning heading into the crisis now allows us to play offense as others play defense.
Neuberger Berman
For the quarter, the Option Income strategy returned almost 10%, while the CBOE S&P 500 2% OTM PutWrite (“PUTY,” the most similar index to Neuberger Berman’s strategy for the fund) gained 9.47%. Year to date, the sleeve has suffered a modest loss of approximately -3.3%, substantially outperforming the PUTY’s loss of -12.9%.
Despite a rapid collapse of implied volatility levels from their peak late in the first quarter, the second quarter implied volatility levels remained historically elevated partly due to the significant jump in June. Futures markets continue to forecast higher levels of implied volatility out into the beginning 2021. Over the course of the second quarter, the VIX fell -23.1 points, with an average 30-day implied volatility premium of 2.7. Meanwhile, RVX (the VIX equivalent for the Russell 2000 Index) was down -22.3 points, with an average implied volatility premium of -6.0. On the year, VIX is up 16.7 pts with an average 30-day implied volatility premium of -7.3. Similarly, RVX is up 22.1 pts with an average 30-day implied volatility premium of -11.9. (The negative implied volatility premium indicates realized volatility was higher than implied volatility, which is typically not a good environment for having already written puts but does usually provide good return opportunities going forward.)
Central banks around the world remain committed to their efforts to keep rates at or below zero for the foreseeable future. After dropping rates to zero, the U.S. Fed has gone as far as discussing further “yield curve control” measures in the event they need to address a prolonged recovery. Over the quarter, the collateral portfolio has changed little, with a return of 0.12%, surpassing the T-Bill Index return of 0.02%. Year to date, the collateral portfolio has generated a positive 1.95%, surpassing the T-Bill Index return of 0.48%.
The portfolio’s option strategy notional allocation remains near its strategic weights of 85% to S&P 500 Index and 15% to the Russell 2000 Index.
Strategy Allocations
The fund’s target allocations across the four managers are as follows: 32.5% each to Brown Brothers Harriman and Guggenheim Investments, 20% to Neuberger Berman, and 15% to Ares Management. 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 June 30, 2020
| Ares Alternative Equity Income Strategy | |
|---|---|
| BDCs | 76.6% |
| MREITs | 0.0% |
| Midstream Energy | 0.0% |
| CEFs/Pfds/Other | 0.0% |
| Cash | 23.4% |
| Brown Brothers Harriman Credit Value Strategy | |
|---|---|
| ABS | 29% |
| Bank Loans | 17% |
| Corporate Bonds | 50% |
| CMBS | 4% |
| Guggenheim Multi-Credit Strategy | |
|---|---|
| ABS | 28% |
| Bank Loans | 22% |
| Corporate Bonds | 42% |
| CMBS | 4% |
| Non-Agency RMBS | 9% |
| Preferred Stock | 5% |
| Other | 3% |
| Reverse Repo | -2% |
| Net Credit Derivatives | -9% |
| Cash | -1% |
| Neuberger Berman Option Income Strategy | |
|---|---|
| Equity Index Put Writing | 100.0% |