The iMGP High Income Alternatives Fund gained 4.46% in the quarter, compared to the 0.62% gain for the Bloomberg Barclays U.S. Aggregate Bond Index (Agg) and 4.71% gain for high-yield bonds (BofA Merrill Lynch U.S. High Yield Cash Pay Index). Year to date through September 30, the fund is down 0.81% while the Agg is up 6.79% and high-yield is down 0.30%.
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 again produced healthy gains in the quarter, continuing to rebound from losses suffered in March. All four of the fund’s sub-advisors were positive for the quarter, with gains ranging from almost 4% to a bit over 5%. On the year, three of the four (BBH, Guggenheim, and Neuberger Berman) are now positive, with returns between 1% and 4%, while Ares remains underwater with a 16.1% decline, still digging out of a large performance hole despite the dramatic gains of the last two quarters. The fund is lagging its benchmarks year to date largely due to the Ares sleeve, which invests primarily in the hard-hit areas of business development companies (BDCs,) mortgage real estate investment trusts (REITs), and master limited partnerships (MLPs)/midstream energy. (Although it is little consolation to Ares or us as fellow investors in the fund, for context regarding the investment environment, the Ares strategy has outperformed its blended benchmark by over 1,300 basis points (bps) year to date through the third quarter.) We discussed Ares in some detail in our last quarterly review, so we won’t rehash it here other than to say we have unfortunately experienced a remarkable left-tail environment for the strategy early in the fund’s life, and we are optimistic that the fund will benefit for an extended period going forward from exposure to the high-yielding and less-efficient sectors in which Ares invests.
As we write this in mid-October, the fund is slightly positive on the year and essentially even with high-yield bonds, one of the fund’s benchmarks. Our managers have performed very close to how we would have expected through this unprecedented environment; however, we didn’t anticipate a great-financial-crisis-style meltdown compressed into a three-week period. The abrupt flight to safety earlier this year has been the dominant factor in the fund trailing the Agg significantly on the year. Without reviewing the fund’s “life story” again, the Agg’s high-teens cumulative return (since the fund’s 9/28/18 inception) has been the great surprise relative to starting expectations (especially when considering 2019 was a “risk-on” year in which the Agg also performed extremely well (up over 8.7%). On a forward-looking basis, the fund’s yield (3.90% trailing 12-month distribution yield) with relatively low duration compares quite favorably to the Agg’s yield of less than 1.3% and duration of nearly 6 years. To put things in perspective, it will currently take the fund two to three months to generate a level of income that the Agg will generate in a 12-month period.
There are no guarantees, but we certainly like the fund’s relative-return prospects going forward, particularly in an environment where the Federal Reserve has committed to keeping interest rates lower for longer. The fund should also benefit (on a relative basis at least) in the event rates increase due to higher-than-expected economic growth since it has significantly lower duration
than the Agg (and more credit sensitivity). From this point, we would only expect to materially underperform the Agg over the medium term in a deflationary environment, which of course could happen, but that seems like a low probability given the Fed’s stated intentions and the expectation of further fiscal stimulus at some point over the next few quarters.
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 bonds with a low correlation to them 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.
We wish everyone good health and prosperity as we head into the final months of what has been a challenging and dramatic year.
Performance of Managers
During the quarter, all four managers delivered solid gains, though not to the same degree as in the second quarter amid the immediate aftermath of the March crisis. Ares gained 5.35%, Guggenheim rose by 5.07%, Neuberger Berman returned 4.75%, and Brown Brothers Harriman was up 3.90%. (These returns are net of the management fees that each sub-advisor charges the fund.)
Markets continued to claw back losses from March lows with a rally that continued well into September, due in large part to the Fed’s supportive stance and improving consumer spending data. Going into quarter-end, volatility picked up amid the looming U.S. election and lockdowns being re-imposed as coronavirus cases ticked up globally. BDCs in particular benefitted from a stronger-than-expected 2Q earnings season and we estimate book values have increase by 1.5% since June 30, largely due to continued spread tightening in the liquid credit markets. We believe this is a positive sign that we should see the overall trend of net asset value (NAV) recovery continue, albeit at a slow pace. In the midstream sector, we are seeing attractive relative value opportunities as the space continues to be on pace to generate significant potential free cash flow as the industry shifts from meaningful capex spending to asset optimization in a post-COVID world. Mortgage REITs continue to be the most under pressure among our asset classes, as the long-term effects of the pandemic begin to play out and debt relief provisions expire. We anticipate substantial credit issues going into year-end.
Brown Brothers Harriman
We are pleased to see the continued recovery in portfolio performance these past two quarters after the large market shock experienced in March. The intervention of the Federal Reserve in debt markets ignited a powerful rally whose momentum carried into the beginning of the third quarter. New issue markets were wide open for corporate borrowers and record amounts of new bonds were sold to investors. The structured products market also gained strength as new and seasoned asset-backed securities (ABS) issuers experienced a very strong quarter of issuance that helped catch up with delays from the tumultuous events in the first half of the year. However, in the face of so much new issuance and concerns about potential fourth quarter volatility, credit spreads began to level off as the quarter progressed. The third quarter closed with corporate credit spread levels in similar ranges to where they started the period and structured credit spreads moderately tighter.
We have been confident that underlying business fundamentals would eventually re-emerge as valuation factors for credit when the markets moved towards an acceptance of the COVID-19 reality. In the third quarter that process began. Company earnings were released that reflected the full effects of the pandemic on individual businesses—and the numbers tended to be better than the dire expectations. It was only one quarter, and the near-term future still has significant uncertainty, but analysis of real data is resetting credit risk assumptions for many durable businesses with solid business models and sufficient financial flexibility to weather the current environment. We are fundamental bottom-up investors and so we remain optimistic that the positive performance trend of the strategy will continue when the strength of individual credits becomes the focus of the market. The yield on the portfolio is currently 5.04% and we believe there is room for credit spreads on our investments to tighten, improving our total return. We were active in the new issue and secondary markets during the quarter with many attractive opportunities becoming available. Our valuation approach and disciplined credit criteria drives evaluation of these new opportunities and anchors our process as we head into year-end. Although financial markets are expecting higher volatility from U.S. elections and a potential second wave of COVID-19 infections, we are, as always, focused on credit opportunities that provide attractive long-term potential returns for our investors.
We were active in the quarter as many sectors and credits continue to offer attractive compensation for taking credit risk, inclusive of COVID-19 effects. Credit sales in the quarter were mainly executed to swap into higher yielding positions.
In the aviation sector we swapped into higher yielding aircraft lessors Aviation Capital and Avolon Holdings. Both companies are world-class aircraft lessors with significant multi-cycle experience that have taken swift actions to bolster liquidity and manage fleet sizing. We purchased Aviation Capital’s new 4-year bonds, rated BBB-, at an average spread of 536 bps or a 5.6% yield. Similarly, Avolon Holdings came to the market in the quarter with new bonds rated BBB- at the attractive average spread of 618 bps or 6.3% yield. We also added and extended our position in aircraft lessor AerCap. We initiated a new position in the debt of Delta Air Lines SkyMiles. SkyMiles is the largest co-branded airline loyalty program in the world and is managed by business partner American Express. The new 8-year senior secured debt issued by this bankruptcy remote subsidiary of Delta is rated BBB+ and offered a spread of 436 bps for a 4.8% yield.
In the insurance sector we purchased new junior subordinated bonds of PartnerRe. The company is a well-capitalized reinsurer with a 20-year track record of prudent risk management and capital allocation. The coupon on the new notes is fixed for the first ten years and will then reset every five years based upon a spread over the then 5-year Treasury note. The notes are rated BBB and offer a spread of 388 bps for a yield of 4.3%. Another insurance credit already in the portfolio, Enstar Group, also issued a similar note structure in the quarter at the BB+ rating level with the attractive spread level of 546 bps for a 5.8% yield, which increased our exposure to this well-managed acquirer of run-off insurance portfolios.
Oxford Finance is the largest independent venture-debt lender focused exclusively on the health care industry, and is a repeat holding in the portfolio. The senior management team has worked together for more than 15 years, and the firm has never had an unprofitable year. There is limited competition in venture debt lending, which allows for more stable loan yields close to 10%. The company has very low annualized charge-offs of less than 1% and moderate leverage of 2.2x net debt-to-equity. Oxford’s existing bonds with two years remaining to maturity became available in the secondary market and we purchased the B+ rated notes at a spread of 950 bps for a yield of 9.6%.
We added positions in two BDCs in the quarter. Blackstone GSO Secured Lending is a private and externally managed BDC that focuses on offering loans to private equity sponsored middle-market companies. The company operates with low leverage of 53% debt-to-assets, strong liquidity, and a deep committed capital reservoir that can be called upon to support the business. This was the company’s first bond offering and the 3-year unsecured notes were priced at a spread of 363 bps for a yield of 3.8%. Mainstreet Capital is a publicly listed and internally managed BDC that targets its secured lending activity towards middle and lower-middle market companies. One-quarter of the Mainstreet portfolio is focused on direct equity investments in these targeted companies. Leverage on the business is low at 46% debt-to-assets with solid liquidity. We purchased unsecured notes in the secondary market with four years remaining to maturity at a spread of 420 bps or a yield of 4.4%.
Scentre Group is an A-rated retail REIT with market-leading shopping centers across Australia and New Zealand under the Westfield brand name. Due to their locations, the company’s centers have not been as impacted by COVID-19 as U.S. or European peers. The company has modest leverage for a REIT at 6.9x or 33% debt-to-assets. Although some pressure on future earnings is
reasonable, the company has strong liquidity to meet upcoming maturities and good financial flexibility. The company came to market with a unique hybrid junior note rated BBB+ and having a 2080 final maturity. The debt is not callable for 10 years and then has penalty interest step-ups thereafter. The debt was issued at a spread of 450 bps to the expected 10-year call for a yield of 5.2%.
We initiated a position Occidental Petroleum, which is a global-scale energy company with integrated business lines in exploration and production, chemicals, and midstream pipelines. The credit rating of Occidental was downgraded to high-yield (i.e., a “fallen angel”) early in 2020 due to increased leverage from a large acquisition. However, the company has significant financial flexibility to manage through near term maturities. The senior notes we acquired in the secondary market have BB ratings, four years to maturity, and were acquired at a spread of 624 bps for a yield of 6.5%.
The new-issue market for structured products was more robust this quarter and we were able to take advantage of opportunities from new issuers and many well-known repeat issuers. PGIM, INC (DRSLF 2020-86A) is a new-issue collateralized loan obligation (CLO) portfolio comprised of broadly syndicated loans selected for low exposure to COVID-19 stresses. The CLO is managed by a top tier manager, Prudential Financial, and has a 3-year reinvestment period. The manager is retaining partial equity beneath our debt and the BBB- rated tranche has 13% credit enhancement. The floating-rate bonds were purchased at a 425-bps spread to 3-month LIBOR for a current yield of 4.5%. As we move further away from the initial COVID-19 shock, credit fundamentals are generally better than feared and portfolio performance is reflecting that shift in market view. We remain optimistic on achieving further gains in the portfolio. The fourth quarter is upon us and we remain focused on the possible risks to our credits from rising COVID-19 infection rates globally, a tumultuous U.S. election, and questions on further fiscal stimulus. These events may create further volatility, but we feel well positioned to take advantage of the opportunities that may ensue.
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. The recovery since May has been faster than expected, with consumer confidence holding up due to the temporary nature of layoffs and positive personal income growth thanks to massive fiscal support. However, the outlook for the next several months is more challenging. Fiscal support is fading, so incomes will likely fall in the fourth quarter. Also, colder weather and the reopening of schools make the likelihood of another large COVID wave very high, risking renewed lockdowns and a setback in the recovery. 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 possibly longer. 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. We expect core inflation will trend downward over the next year due to the fact that inflation is a lagging indicator and prices take time to adjust.
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 will soon shift its quantitative easing (QE) focus to easing financial conditions and shift purchases further out the Treasury curve. The Fed’s recent changes to its longer-term strategy, which commits to seeking 2% inflation on average and to not reacting to the labor market overshooting, ensures rates will remain at zero long into the recovery. Congress also acted much faster than in previous downturns, with the budget deficit headed to the highest level since World War II. Despite the unprecedented size of this fiscal response, it’s clear that more support will be needed. Crucial issues for the outlook will be whether and how much additional stimulus is forthcoming, and whether aid is provided to struggling state and local governments, which face job and spending cuts without more support. It’s unlikely these issues will be addressed before the end of the year, risking a reversal in the recovery. Polls and betting markets suggest the most likely election outcome will be Democratic control of the presidency, the House, and the Senate. While this would usher in a more challenging tax and regulatory environment, higher government spending will provide an offsetting boost. We expect more fiscal support will be passed in early 2021 regardless of election outcome, but a Democratic sweep would see a significantly larger package.
With credit spreads back to historical averages, 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 level, Treasury yields have further room to fall, with the possibility of much of the curve falling into negative territory. Risk assets are vulnerable to a near-term pullback, given policy and election uncertainty, worsening COVID metrics, and a weakening recovery. We view any weakness as a buying opportunity.
With the exception of a modest pullback around the end of the quarter, equity markets continued to push higher for the year. Yet, as the highly anticipated U.S. election draws closer, markets continue to send mix signals with the rare coincidence of elevated levels of implied volatility and the S&P 500 Index near all-time highs. Equity markets sold off in September, following strong gains in July and August, with emerging markets, as measured by the MSCI Emerging Markets Index, proving more resilient than the U.S. (S&P 500 Index) and non-U.S. developed (MSCI World Index) equity markets for the month. The S&P 500 Index (S&P 500) slid 3.80% the Russell 2000 Index (R2000) fell 3.34%. On the other hand, the CBOE S&P 500 2% OTM PutWrite Index (PUTY) gained 1.22% and the CBOE Russell 2000 PutWrite (PUTR) returned 1.52%.
For the quarter, the Option Income strategy returned almost 5%, while the PUTY (the most similar index to Neuberger Berman’s strategy for the fund) gained 6.0%. Year to date, the challenges of the 1st and 2nd quarters seem to be a distant memory for the S&P 500. To date, the S&P 500 is positive on the year while non-U.S. markets remain in the red. The sleeve’s approximate 1.3% year to date return significantly outpaces PUTY’s 7.7% decline.
Only on a few historical occasions has the S&P 500 been near all-time highs and the CBOE S&P 500 Volatility Index (VIX) been at elevated levels above 25. The combination is a clear signal the option markets expect potential wide outcomes over the next couple of months around the U.S. election. In addition, looking at the VIX futures market, option implied volatility levels are expected to remain elevated well into 2021.
Quarter to date, despite the brief uptick at the start of September, implied volatility levels drifted lower for the S&P 500. VIX was down 4.1 points (pts) with an average 30-day implied volatility premium of 9.4. In a like manner, the CBOE R2000 Volatility Index (RVX) was down 3.7 pts with an average implied volatility premium of 12.8. (The positive implied volatility premium indicates realized volatility was lower than implied volatility, which is typically a good environment for the strategy.) On the year, VIX is up 12.6 pts with an average 30-day implied volatility premium of negative 1.6. Of equal importance, RVX is up 18.5 pts with an average 30-day implied volatility premium of negative 3.5. Over the past twelve months, VIX is up 10.1 pts with an average 30-day implied volatility premium of 0.0. Moving in lock step, RVX is up 14.4 pts with a 30-day implied volatility premium averaging negative 1.4.
Rate uncertainty remains high on the long end of the U.S. Treasury yield curve, but short-term U.S. Treasury rates (<3 years) are clearly pricing in the U.S. Fed’s intention to keep rates lower for longer. Over the quarter, the collateral portfolio’s 0.03% return matched the ICE BofA 0-3M U.S. T-Bill Index (T-Bill Index) return of 0.03%. Year to date, the collateral portfolio gained 2.24% and ended the period ahead of the T-Bill Index return of 0.52% by 172 bps.
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.
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|
|Brown Brothers Harriman Credit Value Strategy|
|Guggenheim Multi-Credit Strategy|
|Net Credit Derivatives||-9%|
|Neuberger Berman Option Income Strategy|
|Equity Index Put Writing||100.0%|