The fund gained 1.07% in the third quarter, bringing year-to-date performance to 6.83%. In comparison, during the third quarter the Bloomberg Barclays U.S. Aggregate Bond Index rose 2.27% and high-yield bonds (BofA Merrill Lynch US High-Yield Cash Pay Index) gained 1.22%. Year-to-date, the returns for those indexes are 8.52% and 11.50%, respectively.
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.mastersfunds.com. Investment performance reflects fee waivers in effect. In the absence of such waivers, total return would be reduced. The gross and net expense ratios can be found in the most recent Summary Prospectus (4/30/2019). There are contractual fee waivers in effect through 4/30/2020.
Quarterly Review
The end of the third quarter marks the fund’s one-year anniversary. The return since inception is 3.49%, compared to 10.30% for the Bloomberg Barclays U.S. Aggregate Bond Index, and 6.34% for the BofA Merrill Lynch US High-Yield Cash Pay Index. The first year of performance looks poor in comparison to both indexes, unfortunately. Not surprisingly, we think there’s more to the story than a quick look indicates. We commented previously on the unusual dynamic of the simultaneous sharp rallies this year of “risk-on” high-yield bonds and “risk-off” government/investment-grade bonds, and while the rally has slowed, the magnitude still makes the trailing performance numbers look strong. Given that the fund has had less credit risk than the high-yield index, and significantly less duration than the investment-grade index, we would have expected to trail both indexes if we knew the extent of the rally in credit and rates.
It would be quite surprising to us for the fund to trail both indexes over an extended, multi-year period, since rates and lower-quality credit shouldn’t rally together for multiple years, especially given the starting points in short-term interest rates and credit spreads. Over time we expect the fund to benefit from superior credit selection from BBH and Guggenheim, as well as from those managers’ ability to find value in less-efficient sectors within credit (e.g., “crossover” corporate issues and non-traditional/esoteric securitized credit). Over the long-term, we also expect to benefit from their capital preservation mindset, losing less than the broader market when credit sells off and being in position to invest “dry powder” more aggressively when credit spreads are wider and bargains abundant. This year, however, prudence has been costly (on a relative basis).
We also expect our more equity-sensitive sleeves to generate strong performance over time, with reasonable levels of risk. That has largely played out, although the timing of the fund’s launch into a steep decline in risk assets in Q4 2018 led to a significant drawdown for these sleeves right out of the gate. (Note that the Guggenheim and BBH credit sleeves held up much better than high-yield in that period.) The Ares alternative equity-income sleeve has been opportunistic, adding beaten-down sectors (e.g. closed-end funds) during last year’s fourth-quarter decline and trimming sectors they perceived as fairly valued and/or facing headwinds this year, ending Q3 as defensively positioned as they’ve been since the fund’s inception. The Neuberger Berman out-of-the-money put-write strategy has similarly performed well after a tough start, taking advantage of high implied volatility after the Q4 2018 sell-off to generate strong income earlier this year and keeping up steady risk-adjusted performance even after implied volatility declined to around its current level. We think including these less commonly used strategies (at smaller weightings), which take advantage of inefficient sectors (Ares) and attractive structural market dynamics (Neuberger Berman) will benefit the fund over the long term. Over the last year, however, they have failed to keep pace with simply owning high-yield beta and duration. With a longer time horizon, we still believe the fund’s diverse non-traditional sources of income will be an attractive complement to traditional fixed-income allocations, offering returns comparable to high-yield bonds with lower volatility and downside risk because of the diversified sources of return and manager flexibility to manage risk.
Quarterly Portfolio Commentary
Performance of Managers
During the second quarter, each of the four managers performed in line with our current expectations amid the risk-on market environment. The fund’s two flexible credit managers, Brown Brothers Harriman and Guggenheim, generated gains, while remaining cautious on overall credit conditions. Brown Brothers gained 2.23%, while Guggenheim rose 0.91%. Ares Management’s Alternative Equity Income sleeve generated a 1.40% gain amid a sharp equity market rebound, while Neuberger Berman’s Option Income strategy returned 2.29%. (These returns are net of the management fees that each sub-advisor charges the fund.)
Manager Commentaries
Ares Management: The third quarter of 2019 provided modestly positive returns across our asset classes as economic concerns in August were reversed by coordinated monetary easing from the European Central Bank (“ECB”) and Federal Reserve (“Fed”) in September. Despite the positive market movements in September, we believe there is a rising probability for market headwinds over the coming months, driven by a global slowdown in economic growth. As a result, we have positioned the portfolio defensively to protect returns and have ample dry power to take advantage of any potential volatility in the coming months.
The Business Development Company (“BDC”) segment of the portfolio had a strong third quarter with total returns of 3.77%, driven predominately by dividends and a modest increase in stock prices. Earnings were generally in-line for the group with 72% of the industry meeting or beating consensus estimates. On average, book values declined by 0.6%, which was slightly below expectations but still indicative of strong credit quality throughout the portfolios. Overall, economic returns totaled 6.6% annualized for the group, which was down from 10.9% annualized in the first quarter when book values rose for the group. While credit quality remains positive for the BDC industry, we are concerned about slowing economic trends and how this will impact market perception on the BDC industry. If the market becomes concerned with slowing US growth, the BDC industry has historically underperformed as investors anticipate weakening credit quality in the BDC loan portfolios. Combining the strong stock returns in the BDCs this year with the potential headwinds should the US economy begin to slow, we have been actively taking profits in stocks that have reached our price targets. At the end of June, BDCs accounted for 48% of our portfolio investments. By the end of September, we have reduced our BDC exposure to 34% of the portfolio. The remaining BDCs in our portfolio have both an attractive yield and a defensive bent (either a high-quality portfolio or already discounted valuations), which should provide strong risk-adjusted returns.
The Midstream Energy (“midstream”) industry experienced notable headwinds in the third quarter with our midstream portfolio declining -9.94% in the quarter. As a reminder, we cut our midstream exposure in half in early May as we took the view that the following headwinds were forming for the group: 1) the potential risk to export markets from ongoing trade disputes; 2) pressure on exploration & production (E&P) operators to show positive free cash flow, especially as they begin to roll out fiscal year 2020 drilling plans this fall; and 3) the narrowing of geographic commodity price spreads as several large scale pipeline takeaway projects have come online. That being said, we believe the midstream sector is relatively well positioned within energy. In particular, the fiscal second quarter of 2019 saw aggregate dividend coverage in excess of 1.5x. We note that the private markets continue to price midstream assets at attractive valuations relative to the public equity markets. Specifically, midstream space saw the second proposed take-private transaction this year with Tallgrass (TGE) and Blackstone Infrastructure Partners. Given the strong cash flow backdrop and the decline in the stock prices late in the second quarter and third quarter, we began adding back to our midstream exposure in early September to the larger, more diversified midstream operators. Our midstream exposure increased to 13% in September, up from 9% at the end of the second quarter.
The Mortgage Real Estate Investment Trust (“MREIT”) industry had much more consistent returns in the third quarter following the turbulence we experienced in the second quarter. The MREIT segment of our portfolio generated a total return of 2.50% in the quarter, driven primarily by the dividend yield. The agency MREIT second quarter earnings were weak, with most of the cohort missing earnings estimates. Given the liquidity and price transparency in the agency MREIT market, these moves were reflected in real time during the second quarter, driving elevated volatility in the stock prices. We expect book values have risen modestly in the third quarter and the market reflected that stability in the stock prices throughout the period. Commercial MREITs continued their steady performance with solid second quarter earnings as credit quality remains attractive for the group. Approximately 75% of the industry beat consensus expectations and book values rose by 0.1% on average. Commercial real estate values remain high and lending standards remain sound in terms of loan-to-value and covenants. However, it should be noted that pricing on new loans continues to compress. Our portfolio consists of 14% commercial/hybrid MREITs and 7% agency MREITs.
We continue to have a cautious view on the markets and shifted the portfolio even more defensively in the third quarter. We currently have 21% cash in the portfolio and when combined with an 11% position in preferred securities and 7% in agency MREITs (which is a counter-cyclical business model), we have ~40% of the portfolio defensively positioned, up from ~30% at the end of the second quarter. Despite the defensive positioning, the portfolio is still yielding 7.6% (inclusive of the cash drag).
Neuberger Berman: Over the quarter, the portfolio appreciated almost 1.37%, outperforming its benchmark (40% CBOE S&P 500 PutWrite Index / 60% ICE BofAML 0-3M US Treasury Bill Index) return of 0.56%. Year-to-date through September 30, 2019 the portfolio has returned over 8.54%, notably outperforming its benchmark return of 4.54%. The portfolio’s third quarter return was comprised of option gains of 81 basis point (bps) split between S&P 500 option exposures (+75bps) and Russell 2000 option exposures (+6bps), and gains from the collateral portfolio totaling 61bps (gross of fees).
In the third quarter, the S&P 500 Index returned 1.70%, and the Russell 2000 Index returned -2.40%. The CBOE S&P 500 PutWrite Index (PUT) returned 0.57%, outperforming the CBOE Russell 2000 PutWrite Index (PUTR)’s return of -1.57%. For the year, the S&P 500 Index has produced an attractive 20.55%, substantially exceeding the 14.18% return of the Russell 2000 Index. Meanwhile, the PUT and the PUTR indexes returned 8.67% and 9.26%, respectively.
On the year, the VIX level has retreated -9.2 points from 25.4 at the start of the year, averaging 15.9 for the period. Meanwhile, volatility on the S&P 500 Index has realized at 13.4, leading to a positive average implied volatility premium of 2.5 year to date, creating a modestly favorable environment for put-selling (though not as good as owning the index outright). The CBOE Russell 2000 Volatility Index (RVX) level has retreated -8.5 points from 28.5 at the start of the year, averaging 19.2 for the period, while volatility on the Russell 2000 Index has realized at 17.4, leading to a positive average implied volatility premium of 1.8 year to date. Again, a modestly positive implied volatility premium among small cap stocks is a decent environment for the strategy, but the significant decline in implied volatility since the beginning of the year reduces the absolute return potential. This can change quickly, of course, if volatility spikes.
The sleeve’s option strategy notional allocation remains near its strategic weights of 85% to S&P 500 Index and 15% to the Russell 2000 Index. During the third quarter, 2-year US Treasury yields declined -13bps. The collateral portfolio has returned approximately 0.61%, performing in-line with the 0.58% return of the ICE BofAML 1-3 year US Treasury Index over the quarter. Year to date, the collateral portfolio has climbed approximately 2.62% as 2-year US Treasury yields fell -87bps.
Brown Brothers Harriman: The third quarter continues this year’s trend of mildly positive (and certainly non-recessionary) fundamental U.S. economic news and heavy flows into U.S. credit from abroad, both supportive of credit markets here. Offsetting the positive flows, however, are massive corporate and Treasury issuance, weaker growth in Europe, and an expanding list of geo-political uncertainties. The quarter ended with investment-grade credit (the non-Treasury components of the Bloomberg Barclays US Aggregate Index) outperforming Treasuries by a modest 4 basis points of excess return, most of it from BBB-rated corporates. A-rated corporate bonds underperformed Treasuries in the quarter. The portfolio returned 1.51% in the third quarter. We are pleased with this level of performance considering the lower excess returns posted by most credit sectors during the quarter, and the lower rate duration maintained by the portfolio with Treasury yields rallying.
A core tenet of the strategy is the flexibility to invest across all different classes of U.S. credit where we find the most attractive valuations. This quarter saw more opportunities emerge in structured credit and we were able to purchase several new credits across asset types. Corporate credit purchase activity in the quarter included a new loan credit, UGI Energy Services, along with additions to two prior corporate bonds holdings, Mednax and Tegna.
During the quarter we purchased the secured term loan of UGI Energy Services Inc. at an attractive yield of 6.1%. The company is a midstream subsidiary of the publicly listed UGI Corporation and operates natural gas pipeline and gathering systems in the Pennsylvania region. The term loan was used to acquire additional pipeline assets in UGI’s core markets. The loan is well supported from a cash flow perspective due to low starting leverage and significant revenue stability derived from long-term contracts. The loan structure also includes financial maintenance covenants.
We purchased a new issue from TEGNA Inc., which is one of the largest owners of television stations in the U.S. Within the top 25 broadcast markets, the company has the highest number of Big 4 affiliates (CBS, FOX, NBC, and ABC) and owns 62 stations across the U.S. covering 35 million households. Tegna benefits from an increasing percentage of its revenues coming from subscription fees which enhances its margins and provides long-term stability to its business model. We were pleased to purchase the new bonds at a 5% yield.
We added to our position in Mednax Inc., a leading physician staffing company that we began buying earlier this year. The company is comprised of 4,500 physicians and several thousand supporting personnel. These professionals provide clinical services in neonatology, anesthesiology, radiology, and maternal-fetal care at about 570 client hospitals and related facilities across 41 U.S. states. Current bond yields of 7% are still attractive for this BBB/BB split-rated credit.
CFG Holdings, Ltd. is a 30-year old consumer finance company focused on branch-network lending to under-served consumers across seven markets in the Caribbean and Panama. CFG, founded in 1979 and until recently a unit of Wells Fargo, is the largest independent lender in its markets. The company issued its second installment loan ABS securitization in the quarter with ample loan yields, a sizable equity cushion beneath the notes, and strong structural protections. We purchased the BB-rated 4.3-year notes at an attractive yield of 7.75%.
We purchased a collateralized loan obligation (CLO) debt tranche from well-established credit manager Bain Capital. The Bain Capital BCC 2016-2A was a refinancing of an earlier CLO portfolio with a high level of credit diversification that can withstand substantial stress case scenarios and has a short expected-life to the anticipated future call period. The floating-rate bonds were purchased at a spread of 255 bps over 3-month London Interbank Offered Rate (LIBOR) for an A-rated credit with a 2.3-year expected life.
We also purchased STWD 2019-FL1, a commercial real estate CLO (“CRE CLO”) comprised of $1.1 billion of loans originated by Starwood Property Trust, Inc. The loan pool is diversified both across geography, with properties in nine U.S. states, and by property type, with a solid balance of multifamily, office, hospitality, and other properties. Starwood, operating for more than a decade, is one of the oldest and largest CRE credit real estate investment trusts (REITs). The company will continue to oversee the collateral management of the pool and has significant “skin in the game” as it retains the junior-most tranches of the transaction. Based on our thorough re-underwriting of the individual loans in the pool we expect in our base case that the AA- rated bonds have multiple layers of coverage against losses the pool might experience. The bonds were purchased at a spread of 160 bps over 3-month LIBOR.
Guggenheim: We believe real gross domestic product (GDP) growth will continue to lose momentum, with most major expenditure categories slowing down. Household consumption will continue to be the engine of growth, due to a still high level of consumer confidence and healthy household balance sheets. However, cooling labor market momentum and sentiment beginning to roll over will weigh on the consumer. Housing activity could see some near-term upside from the decline in mortgage rates, but price constraints and limited supply will limit the rebound.
The Fed has shifted into easing mode given soft inflation data, a slowdown in foreign economies, and trade policy uncertainty. We are watching for signs that Fed cuts may lead to an economic reacceleration. But given the fading labor market momentum, decelerating improvement in consumer confidence, flat yield curve, and weakening leading economic indicators, our forecasting tools continue to point to a recession beginning as early as the first half of 2020. We are watching closely for a stock market rally and/or a steepening yield curve as signals that Fed cuts are successful in temporarily delaying a recession.
While corporate bond credit spreads could benefit further from easier Fed policy, excesses will continue to build in corporate debt. These excesses will make spread widening and defaults more severe once the recession hits. With a compressed credit curve and tight credit spreads, our focus is to protect from downside volatility. We increasingly favor high quality assets, with a preference for government-backed securities. Within credit, we continue to stay up in quality via securitized credit and very limited corporate bond exposure. Maintaining higher-than-typical liquidity will allow us to pick up undervalued credits during more opportune times.
Strategy Allocations
The fund’s allocation 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 September 30, 2019
(Exposures may not add up to total due to rounding)
| Ares Alternative Equity Income Strategy | |
|---|---|
| BDCs | 33.3% |
| Midstream | 21.1% |
| Mortgage REITs | 12.5% |
| CEFs | 0.0% |
| Other | 11.8% |
| Cash | 21.3% |
| Brown Brothers Harriman Credit Value Strategy | |
|---|---|
| ABS | 28.0% |
| Bank Loans | 37.0% |
| Corporate Bonds | 27.0% |
| CMBS | 6.0% |
| Cash | 2.0% |
| Guggenheim Multi-Credit Strategy | |
|---|---|
| ABS | 37.7% |
| Sovereign | 12.5% |
| Bank Loans | 10.0% |
| Corporate Bonds | 10.5% |
| CMBS | 4.1% |
| RMBS | 17.8% |
| Other | 3.9% |
| Interest Rate Swap | -0.4% |
| Treasury Bonds | 1.0% |
| Cash | 2.9% |
| Neuberger Berman Option Income Strategy | |
|---|---|
| Equity Index Put Writing | 100.0% |