The iMGP High Income Alternatives Fund gained 0.91% in the quarter, compared to the 0.05% gain for the Bloomberg Barclays US Aggregate Bond Index (Agg), and 0.93% gain for high-yield bonds (BofA Merrill Lynch US High-Yield Cash Pay Index). Year-to-date through September 30, the fund gained 5.30%, compared to returns of -1.55% and 4.55% for the Agg and high-yield, 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. 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.
The High Income Alternatives Fund climbed 0.91% during the third quarter of the year, continuing a strong stretch of absolute and relative performance following the pandemic-driven dislocation of credit and equity markets in March 2020. The fund’s trailing one-year performance ending September 30, 2021 is 12.13%, well ahead of the Agg’s 0.90% loss, and the high-yield index’s 11.46% gain.
In the three-month period, the 10-year Treasury yield ended the quarter just a bit above where it began, at 1.53%. But it wasn’t a smooth ride with yields falling to 1.17% in early August, and then increasing at the end of quarter. For the period, the Aggregate bond index return was essentially flat, while credit segments extended their gains against the backdrop of still supportive monetary and economic policies, a continued reopening of the economy, global growth, and an appetite for yield. High-yield bonds rose 0.9% and floating-rate loans gained 1.1%. Year to date, the Aggregate bond index was down 1.8%, while high-yield bonds and floating-rate loans were up 4.6% and 4.4%, respectively. We still like the relative positioning of the fund compared to the Agg, with the fund’s higher yield and lower duration providing a nice tailwind for most scenarios except outright deflation. Although we can’t rule that out, it seems like a less likely outcome given the persistence of “transitory” inflation.
Overall, we remain constructive on credit. In our view, fundamentals remain healthy, and the risk of spiking defaults is low. However, valuations of investment-grade bonds are expensive while below-investment-grade segments are vulnerable to a shift in sentiment. Furthermore, peak liquidity and central bank support are likely behind us, which could result in a headwind for lower-quality bonds. The “easy money” from rebounding markets following the March 2020 collapse seems to have been made, and now generating good risk-adjusted returns will depend more on patience, sound judgment, and credit selection. Fortunately, our flexible credit managers excel here and benefit from the ability to invest in less mainstream areas of the credit markets.
Against this backdrop, BBH and Guggenheim outperformed the high-yield index in the quarter. This was accomplished through the identification of attractive and durable higher-yielding securities, often in niche, off-benchmark segments of the credit universe such as asset-backed securities (ABS). Going forward in this environment of tight spreads, income (as opposed to price appreciation) will be the driver of performance, and we think the wide opportunity set and flexible mandate bodes well for our credit managers and the overall strategy. Meanwhile, Neuberger Berman’s option strategy has continued to perform well
(up over 9% year-to-date) benefitting from attractive premiums following the spike in volatility due to Covid and the economic shutdowns. Even as implied volatility has trended down from the extreme levels seen last year, there have been enough minor flare-ups in volatility for the strategy to collect healthy premiums while avoiding sustained drawdowns. Today the VIX remains slightly elevated compared to its pre-pandemic levels.
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 will be comparable to high-yield bonds, but with lower volatility and downside risk because of the diversified sources of return and manager flexibility. At the end of the quarter, the fund reached its three-year anniversary and received a Four Star Overall Morningstar RatingTM among 310 Non-traditional Bond funds based on risk-adjusted return. We are pleased with that result, especially considering the inopportune timing, given the fund’s strategy, of its launch (just before the sharp “risk-off” period in late 2018 followed immediately by a simultaneous strong rally in low-quality credit and duration in 2019). The passage of time has allowed the fund to begin to demonstrate its benefits, and we think it is poised to continue to generate attractive risk-adjusted returns while diversifying core bond exposure. Thank you for your confidence in the fund.
Quarterly Portfolio Commentary
Performance of Managers
During the quarter, all three managers produced positive performance. Brown Brothers Harriman was up 1.23%, Guggenheim gained 1.11%, and Neuberger Berman returned 0.86%. (These returns are net of the management fees that each sub-advisor charges the fund.)
Brown Brothers Harriman
The BBH sleeve reported solid performance of 1.2% for the third quarter net of fees. Performance was achieved without much input from changes in credit spreads or interest rates. Credit spreads remained virtually flat during the quarter as BBB and BB spreads widened just 3bps and 4bps respectively. The 10-year U.S. Treasury bond ended the quarter just 1bp wider at 1.49%, although trading in a 37bps range as the debate continued about the strength of the U.S economy, the potential duration of inflationary pressures and possible actions from the Federal Reserve in response to these factors. Our disciplined credit-focused approach and consistent 2-year duration positioning continues to produce differentiated returns from traditional fixed-income benchmarks, as the Bloomberg Aggregate Index has not achieved positive performance in 2021 or on a trailing one-year basis.
As corporate credit remained expensive throughout the quarter, our investing efforts continued to locate the best values in floating-rate loans, securitized ABS, and more off-the-run and niche sectors of the bond markets. The sleeve’s interest income, or carry, remains an important component of performance in this market due to the lack of movement in credit spreads. Heading into the fourth quarter the sleeve’s yield is 4.5% and we remain cautiously optimistic for continued solid performance.
The preeminent question of when valuations may begin to reset in credit markets remains difficult to estimate as recent volatility in interest rates and equity markets did not result in much movement in the pricing for credit. Throughout the third quarter and for the first nine months of 2021, we are pleased that the investment team has been able to identify a consistent pipeline of new opportunities for portfolio consideration. Although finding attractive opportunities in expensive markets is not easy, we remain committed to our disciplined investment process and believe that BBH clients will be well served by this approach when volatility returns to the broader credit markets.
Valuations were again generally expensive in the third quarter, yet we continue to succeed by focusing on locating new, niche, or recovering credit investments that differentiate our process and performance from competitors. We remain comfortable in the sleeve’s positioning heading into the remainder of the year and the durability of our credits. It is possible that the current valuation dynamic can continue further into 2022. However, bursts of volatility in interest rates and equity markets seem to be increasing as investors grapple with assessing the trajectory of economic growth and Federal Reserve policy. These events may portend a better valuation environment in coming years for fixed-income investors and we look forward to a possibly wider opportunity set.
Real GDP for the third quarter is tracking towards just 1.4%, down significantly from tracking nearly 8% in early August. The decline reflects the impact that the Delta outbreak has had on consumption, which should start to improve with the decline in cases. We still expect real GDP for the full year (2021) to be approximately 5% and about 3.5% in 2022. Continued supply chain problems have delayed the normalization of price pressures we had expected. Heading into third-quarter corporate earnings season, we expect that supply chain disruptions and cost pressures will be frequently cited problems for many companies.
We expect that the Federal Reserve (Fed) will announce plans to taper QE purchases in November or December, but do not expect a strong market reaction from this announcement or during the process of reducing purchases. Longer term, we continue to expect that the Fed will remain accommodative for a long period of time, which should support credit conditions and keep default activity low. In July, the Fed’s quarterly Senior Loan Officer Survey showed a record net share of 32.4% of banks eased underwriting standards for large/medium C&I loans in Q2 2021. Recent survey results continue to support our view that the high-yield corporate bond default rate will fall. Over the last six months, 16% of the ICE BofA High Yield Index has seen a rating upgrade versus 4% downgrades. We expect the trend of more upgrades than downgrades to continue. We believe we are still in the early stages of the credit cycle, in which we anticipate strong earnings growth, low default volumes, upward ratings migration, and tight spreads.
The high-yield market has continued to rally, and we are becoming more cautious after twelve consecutive months of positive returns since fall 2020 and spreads near their historical tights. All-in yields in high-yield remain relatively attractive compared to other fixed-income assets considering a low expected forward default rate. Primary new issuance in September was below expectations and roughly in line with the monthly average for the year. New issuance volumes were impacted by the market volatility and the move higher in interest rates towards the end of the month. With rates on the rise, we expect issuance to pick up as issuers try to take advantage, which could pressure secondary pricing. We continue to look for reverse inquiry opportunities in credits we like where we can seek to generate value for portfolios and the underlying issuers.
We expect the volatility in market performance caused by energy this year is largely behind us. Natural gas is up well over 100% and oil is up almost 70%. The spread between energy credits and the rest of the market is now less than 50bps. While the level of distressed assets and expectations of future defaults have come down markedly, we believe credit selection will be key to achieving performance going forward.
September ended the quarter on a volatile note as the S&P 500 Index experienced its worst monthly return since March 2020, breaking its seven-month positive return streak. However, strong performance in the first two months of the quarter kept the S&P 500 slightly positive for the third quarter. While small-cap stocks outperformed large-cap stocks during the September drawdown, losses in the first month of the quarter resulted in disappointing performance for the Russell 2000 Index in Q3. In September, the S&P 500 Index fell a meaningful -4.7% while the CBOE S&P 500 2% OTM PutWrite (“PUTY”) returned a modest 0.4% and the CBOE Russell 2000 PutWrite (“PUTR”) managed a positive return of 0.2%. Over the quarter, the S&P 500 gained 0.6%, the PUTY rallied 2.5%, and the PUTR gained 0.7%.
Index Option Implied Volatility
September brought about volatility for the quarter as the CBOE S&P 500 Volatility Index (“VIX”) increased, ending the quarter slightly higher than the previous quarter. During September, VIX was up 6.7 pts with an average 30-day implied volatility premium of 7.5. (A higher implied volatility premium is better for the strategy.) Meanwhile, the CBOE R2000 Volatility Index (“RVX”) was up 5.0 pts with an average implied volatility premium of 6.6. For the Quarter, VIX rose 7.3 pts yielding an average 30-day implied volatility premium of 7.2. Moving in lock step, RVX rose 6.6 pts resulting in an average implied volatility premium of 5.3.
In the third quarter, the portfolio posted a gain of approximately 0.9%, which lagged the PUTY return of 2.5% and finished in-line with the U.S. HY’s return of 0.9%. The S&P 500 PutWrite component of the strategy (85% weighting) gained a modest 0.9% and lagged the PUTY return of 2.5%. However, the Russell 2000 PutWrite allocation’s (15% weighting) gain of 0.8% surpassed the PUTR return of 0.7%.
During the quarter, short-term 2-Year U.S. yields declined slightly. On the longer end, the U.S. 10-Year yield picked up from June levels and ended the month at 1.49%. For the quarter, the collateral portfolio’s 0.03% return surpassed the T-Bill Index return of 0.01%.
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 targets should differences in shorter-term relative performance cause divergences.
Sub-Advisor Portfolio Composition as of September 30, 2021
|Brown Brothers Harriman Credit Value Strategy|
|Guggenheim Multi-Credit Strategy|
|Neuberger Berman Option Income Strategy|
|Equity Index Put Writing||100.0%|