The iMGP High Income Fund rose 1.94% in the second quarter, beating the Bloomberg Aggregate Bond Index (the Agg), which was up 0.07%, and high-yield bonds (BofA Merrill Lynch US High-Yield Cash Pay Index), which rose 1.02%. The fund also outperformed its Morningstar Nontraditional Bond category peer group’s 0.90% gain. Through the first half of the year, the fund was up 4.24%, significantly outperforming the Agg (-0.71%), high-yield bonds (+2.50%), and the category (+2.52%).
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Quarterly Review
Performance of Managers
During the quarter, all three subadvisors produced positive returns. Neuberger Berman was up 5.01%, Guggenheim returned 2.23%, and BBH gained 1.83%. (All sub-advisor returns are net of the management fees that each sub-advisor charges the fund.) For the first half of the year, Neuberger Berman returned 11.19%, BBH was up 4.48%, and Guggenheim gained 4.20%.
Manager Commentaries
Brown Brothers Harriman
Treasury rates continued to respond to investors’ predictions for forward-looking Fed interest-rate decisions. Strong economic data and still-high inflation data caused investors to continue to shift towards a “higher for longer” disposition for the remainder of 2024. Investors still believe the Fed will cut rates by 50 basis points during 2024, but the anticipated amount of rate cuts was 150 basis points at the start of the year. Longer-term interest rates increased across the yield curve to reflect those changes in expectations. The Fed last met on June 12th and kept the target range of the federal funds rate unchanged at 5.25% – 5.50%. The Fed’s next announcement is scheduled for July 31st, 2024. The Fed continues its 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 second quarter while longer duration indexes experienced negative total returns. Excess returns to credit were generally positive with two notable exceptions: agency mortgage-backed securities (MBS) and long duration corporate bonds.
Economic data remained strong, with inflationary pressures persisting and few signs of recession on the horizon. Headline consumer inflation prints have been declining, but wage growth and job openings remain higher than historic averages and could still exert upward pressure on inflation. The Chicago Fed National Activity Index remains above its recession indicator threshold. Default rates of 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 but are within expected ranges for ABS to withstand losses without risk of impairment to bondholders. Business loan performance appears healthy, as delinquency rates are low and default rates are declining. Office delinquency rates remain elevated, while non-office commercial mortgage delinquency rates rose moderately. Return-to-office dynamics remain weak and continue to pressure office real estate values. The weakening office market has not had an outsized impact on banks’ commercial real estate loan portfolios to date, as delinquency rates and charge-offs have been muted.
Credit issuance was robust during the second quarter as issuers took advantage of narrow credit spreads, a clearer economic condition, and heavy demand for credit to refinance looming maturities and issue ahead of any uncertainties that may prevail later this year. Gross investment-grade corporate bond issuance increased 19% from 2023’s pace, although 56% of issuance was for refinancing existing debt. Corporate loan issuance increased 182% while high yield bond issuance increased 77% year-over-year, with 83% of issuance used to refinance existing debt. ABS volumes have been record-setting and eclipsed last year’s pace by 37%, while CMBS issuance jumped 148% off of a low base in 2023 driven by single asset single borrower (SASB) deals.
We are finding fewer opportunities in traditional segments of the credit markets as risk spreads remain narrow and net issuance is low. According to our Valuation Framework, the percentage of investment-grade corporate bonds that screened as a “buy” remained near to 13%, and the percentage of high-yield corporate bonds that screened as a “buy” in our Valuation Framework increased to 20% from 16% at the start of the quarter. No cohort of 30- or 15-year agency MBS met our Valuation Framework for purchases at quarter-end.
There remain opportunities in select subsectors of the market. The percentage of corporate loans that screened as a “buy” according to our Valuation Framework stood at 77% at quarter-end, down from 87% last quarter. Investment-grade corporate bonds in several interest-rate-sensitive subsectors, such as life insurance, banking, and finance companies, continue to offer attractive opportunities. 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 among property types with differing credit dynamics.
The portfolio generated a positive during the second quarter due to its defensive interest rate posture, its sector and quality positioning, and security selection results. The portfolio’s duration posture was managed near shorter-term interest rates that maintained positive returns in spite of changes to longer-term interest rates. This contributed to performance results as shorter-duration bonds managed positive returns despite the overall rise in interest rates. The portfolio’s sector and quality positioning contributed to performance as the portfolio emphasized stronger-performing segments of the credit markets while our valuation discipline helped us avoid two underperforming segments of the market: agency MBS and long-dated corporate bonds. Finally, selection results contributed. Subsectors with the highest impact on results included high yield pharmaceuticals, high-grade property and casualty insurers, electric utilities corporate loans, aircraft equipment ABS, high yield technology, and high-grade banking. Subsectors that detracted from selection during the quarter included healthcare and media entertainment corporate loans and high-grade specialty real estate investment trusts (REITs).
We found numerous opportunities for the portfolio that met our valuation and credit criteria during the quarter despite weakening valuations in mainstream segments of the market. We purchased corporate bonds issued by property and casualty insurers, finance companies, banks, electric utilities, a life insurer, an airline, a midstream energy company, and a packaging company, to name a few. We added positions in corporate loans in several subsectors, including technology, consumer services, aerospace, electric utilities, and healthcare. We also purchased positions in a collateralized loan obligation, aircraft equipment ABS, and recurring revenue ABS.
At the end of the month, the portfolio’s duration was 2.1 years and remained near levels consistent with long-term capital preservation. The portfolio’s weight to reserves decreased to 10% from 23% reflecting opportunities identified by our process in the credit markets. The portfolio’s allocation to high yield and non-rated instruments increased to 38% from 30% at the start of the quarter. The portfolio’s yield to maturity was 8.6% and remained elevated versus bond market alternatives. The portfolio’s option-adjusted spread was 348 basis points; for reference, the Bloomberg U.S. Corporate Index’s option-adjusted spread was 94 basis points, and the Bloomberg U.S. Corporate High Yield Index’s option-adjusted spread was 309 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 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 bring growth closer to potential. Consumption should also slow with weaker labor demand driving slower wage growth and excess savings buffers being used up, particularly for low-income households. Household and corporate balance sheets are generally in good shape, helping contain downside economic risks. Financial conditions are also no longer a headwind to growth.
Balancing these factors, we see real GDP growth slowing to a bit below 2% by the end of 2024 and close to 1.5% in 2025. Recession risk remains elevated. We see an increasingly bifurcated economy, with stress growing for small businesses, commercial real estate, and low-income consumers. We are also mindful of risks of a more abrupt labor market weakening, or a renewed tightening in financial conditions, which are currently supported by lofty equity valuations. Inflation has cooled back down after some hot readings to start the year. We remain optimistic on the outlook now that shelter inflation is cooling, and broader services inflation will be kept in check by slowing wage growth. Base effects will keep year-over-year core PCE above 2.5% this year, but 3- and 6-month annualized rates should be below 2.5% by the end of the year, within the Fed’s comfort zone.
Inflation is likely to come in lower than the Fed’s latest projections, while unemployment should end the year higher. We expect two rate cuts this year, in September and December. We expect further rate cuts in 2025 and 2026, as inflation falls further and the economy slows, especially with elevated recession risk. The fed funds rate should ultimately fall to 3-3.5%, which is where we estimate the neutral rate is. The Fed has tapered the pace of balance sheet runoff, and we expect its quantitative tightening will end in early 2025.
The election will add to policy uncertainty. 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 tariffs are an upside risk for both inflation and interest rates.
Given inflation progress and Fed rate cuts drawing closer, we continue to believe Treasury yields have peaked for the cycle, though 10-year Treasury yields are unlikely to fall below 3%, even with the Fed cutting rates. 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
Equity Markets
The second quarter sustained the momentum from the first, delivering positive returns across equity markets despite sector-specific challenges and varied regional performances. Economic resilience in the US and Europe, coupled with persistent inflation, influenced market dynamics, while central banks’ policies and rate expectations played a significant role. Political events, such as the European parliamentary elections and the announcement of snap elections in France, introduced volatility but did not derail the positive trend. The Nasdaq-100 Index led the major indices with an 8.05% return for the second quarter as the S&P 500 Index followed closely with a 4.28% gain for the quarter.
US Treasury Markets
Despite expectations of a potential US Federal Reserve rate cut buoying equity markets, fixed income markets faced challenges over the quarter. The Bloomberg US Aggregate Bond Index remained relatively flat for the quarter, posting a return of 0.07%. The Bloomberg US Corporate High Yield Index performed slightly better, achieving a gain of 1.09% in the second quarter, bolstered by resilient corporate earnings and robust coupon payments. Throughout the quarter, short-term rates, as represented by 3-Month US T-Bills, remained virtually unchanged. In contrast, longer-term rates, indicated by 10-Year US Treasuries, rose by 20bps.
Option Implied Volatility Indexes
In the second quarter, the Cboe S&P 500 Volatility Index (VIX) averaged 14.0, basically unchanged from the previous quarter, reflecting a notable period of sustained market calm and steady investor confidence, mirroring the conditions observed earlier in the year. During the second quarter, positive implied volatility premiums persisted as US markets recorded an average implied volatility premium of 3.7.
Future market volatility is poised to be shaped by a confluence of central bank maneuvers, economic signals, and geopolitical undercurrents. The Federal Reserve’s anticipated rate cuts have been deferred until at least September, hinging on inflation and employment data. Meanwhile, central banks like the ECB, Bank of Canada, and Swiss National Bank have already embarked on easing cycles, setting the stage for potential market volatility. Persistent core inflation in developed markets and stable US unemployment around 4% as of June may further delay rate cuts and contribute to market turbulence.
Geopolitical risks, particularly the looming US elections, are expected to inject additional volatility into the markets, a sentiment already reflected in VIX index futures markets. The November elections will be pivotal, determining the fate of significant fiscal policies, including the $3.5 trillion personal income tax cuts set to expire in 2025. Beyond the US, political uncertainty in Europe, evidenced by the snap election in France, is sure to send ripples through the developed markets.
Walking the Economic Tightrope
The financial landscape is poised for an intriguing second half of 2024, building on the momentum of a robust first half. US equities have thrived so far, with major indices like the Nasdaq-100 and S&P 500 reaching impressive levels, buoyed by the stellar performance of large-cap growth stocks, particularly in the technology space. Historically, it’s hard to beat the results of the first half of 2024 with the S&P 500’s return of 15.29% amid an average VIX level of 13.9. Looking back to 1990, only one other first half of the year (1995) delivered a higher S&P 500 return with comparable volatility. However, a stellar first half doesn’t guarantee a repeat performance in the latter half of the year.
While the Federal Reserve’s much-anticipated rate cuts remain on hold due to persistent inflation and robust economic data, the S&P 500’s remarkable rise seems largely driven by the mere expectation of these cuts. In contrast, fixed income markets have not shared the same optimistic outlook; instead, the asset class faces a challenging landscape marked by rising Treasury yields mixed returns across different bond sectors and significant asset growth in private credit strategies. Looking ahead, the market’s trajectory may hinge on a delicate balance of economic data, inflation trends, and central bank actions – all of which we believe could usher in a period of renewed uncertainty and volatility.
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 June 30, 2024
| Brown Brothers Harriman Credit Value Strategy | |
| ABS | 16.3% |
| Bank Loans | 20.3% |
| Corporate Bonds | 52.6% |
| CMBS | 0.8% |
| Cash & Equivalents | 10.0% |
| Guggenheim Multi-Credit Strategy | |
| ABS | 39.7% |
| Bank Loans | 15.5% |
| Corporate Bonds | 30.3% |
| CMBS (Non-Agency) | 1.8% |
| Preferred Stock | 2.5% |
| RMBS (Non-Agency) | 9.3% |
| RMBS (Agency) | 5.8% |
| Other | 4.5% |
| Cash | 0.6% |
| Neuberger Berman Option Income Strategy | ||
| Equity Index Put Writing | 100% |