The iMGP High Income Alternatives Fund gained 6.49% in the quarter, compared to the 0.67% gain for the Bloomberg Barclays U.S. Aggregate Bond Index (Agg), and 6.48% gain for high-yield bonds (ICE BofA Merrill Lynch U.S. High-Yield Cash Pay Index). For the full year 2020, the fund was up 5.62%, while the Agg was up 7.51% and high-yield gained 6.17%.
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 strong gains in the quarter, finishing the year with a respectable 5.6% return. All four of the fund’s sub-advisors were once again positive for the quarter, led by the Ares portfolio’s 22.58% gain. This brings the Ares portfolio’s total return for the year into the black (+2.85%), more than fully recovering from the dramatic volatility in the March crisis period. The other three sub-advisors all posted good positive performance in a relatively narrow range between 4.1% and 5.2% for the quarter. For the year, they are up 6.10% (BBH), 6.52% (Neuberger Berman), and 8.85% (Guggenheim).
We were pleased to see the flexibility we encourage our managers to use pay off this year. They all entered the year fairly conservatively positioned (excluding Neuberger Berman, which is essentially systematic) relative to their benchmarks and/or long-term expected positioning. They then became more aggressive, to varying degrees, during the credit market dislocation in the first quarter. This contributed to the strong performance the last three quarters (up 22.52%). Further, the fund enters 2021 with what we believe to be still-attractive return potential relative to both high-yield bonds, which yield below 4%, and the Agg, yielding slightly more than 1% with a duration of 6.2 years. Our flexible credit managers both carry yields approaching 5%, with effective durations of under 3.5 years. Neuberger Berman’s put-write strategy is also collecting significant option premia, well above historical averages, with 3% out-of-the-money one-month puts on the S&P 500 (a decent approximation of the strategy in the fund) producing an annualized yield of approximately 18% at the beginning of 2021. That level can change very rapidly of course, and the strategy is typically subject to higher volatility than the credit managers, but it still gives a good idea of the tailwind the current environment provides. (For context, the annualized yield a year ago was less than half of the current level.)
As we have communicated publicly, we have recently removed the Ares strategy from the fund following the firm’s decision to narrow their focus solely to business development companies (BDCs). We maintain tremendous respect for Ares as a firm and for the team that managed that sleeve of the fund, and we thank them for their contributions. We have no immediate plans to replace Ares, but we are actively working with BBH and Guggenheim on modestly broadening their opportunity sets (staying within their range of expertise, of course) in order to potentially increase the portfolio’s yield without materially increasing risk. (See the Strategy Allocations section below for details on the new manager allocations.)
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.
Thank you for your continued confidence in the fund. We wish everyone a healthy, happy, and prosperous new year.
Performance of Managers
During the quarter, all four managers once again delivered attractive positive performance. Ares gained 22.58%, Neuberger Berman returned 5.16%, Guggenheim rose by 4.73%, and Brown Brothers Harriman was up 4.12%. Even after an extremely challenging first quarter, all four managers finished the year in the black, led by Guggenheim’s 8.85% return, followed by Neuberger Berman at 6.52%, BBH at 6.10%, and Ares at 2.85%. (These returns are net of the management fees that each sub-advisor charges the fund.)
Following a muted September and October, performance during the latter part of the fourth quarter was strong as global risk assets rallied in November and December on the back of positive vaccine news, increased clarity of U.S. election results and positive third-quarter earnings reports. The portfolio’s BDC allocation led performance, as the industry experienced stronger-than-expected third-quarter earnings, and portfolio credit quality continued to stabilize and improve. As the liquidity and leverage backdrop improved, we deployed the majority of our cash position and tactically rotated the portfolio into investments still trading at attractive discounts. The portfolio’s Midstream and real estate investment trust (REIT) exposure also performed well during the quarter, as both sectors were buoyed by vaccine developments and investors looked through to a potential return to (modified) normalcy in 2021.
Brown Brothers Harriman
The recovery from the steep March sell-off gained more traction this quarter from positive vaccine news, better-than-expected financial performance from many industry sectors, and reduced U.S. election uncertainty. A light has been ignited at the end of the tunnel and it is getting brighter. As a result, credit spreads tightened 52 basis points (bps) for BBB-rated corporate bonds in the quarter, completing a full circle that brought 2020 year-end credit spreads right back to the same 2019 year-end level of 124 bps. The recovery in credit spreads for BB-rated corporate bonds involved a tightening of 117 bps for the fourth quarter, which brought 2020 year-end spreads to 265 bps and set a new record low yield of 3.2% for what we once called “high-yield bonds.” Securitized sectors such as asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS), however, are starting 2021 at wider spread levels than last year. The sleeve seeks to achieve absolute return performance from investing in credit, not anticipating interest rate moves, and the 2.2-year duration of the portfolio limited potential gains this year from the sizable drop in Treasury yields. For context, the 2020 total return of the 1- to 3-year maturity segment of the Bloomberg Barclays U.S. Aggregate Bond Index was only 3.1% versus the 7.5% return for the whole index. In addition, the excess return over Treasuries for the 1- to 3-year segment and the index in 2020 was just 0 and 28 bps, respectively. In light of our duration positioning, we were pleased to produce such solid full-year results for clients.
In our quarterly letters this year we have reiterated our confidence that credit fundamentals would eventually recover as the world economy began to evolve past the shock of COVID-19. We made no predictions on the timing of that rebound but felt that our focus on investing in durable businesses at appropriate valuations would see the portfolio through the incredible turmoil of the first half. The recovery in the second half of this year supported our conviction, as the reported financial results of our credits outpaced generally pessimistic market expectations. Credit markets also grew increasingly comfortable with the potential U.S. election outcome and the manageability of a second wave of virus infections. As we write this letter in early January, credit spreads are tightening further as Treasury yields are moving higher on expectations of additional fiscal stimulus actions, which is already impacting the performance of long duration bonds. We continue to find attractive opportunities in off-the-run and niche sectors of the corporate credit and structured product markets, while maintaining our valuation discipline in both purchases and sales. The sleeve has a yield of 4.59% and we feel optimistic about the return potential of the portfolio in 2021.
We continued to find attractive values during the fourth quarter and were actively trading to acquire higher yielding credits from new or repeat issuers, generally with shorter durations. Credit sales in the quarter were mainly executed to swap into these more attractive opportunities. Included below are descriptions of some notable additions to the portfolio.
In the energy sector, we initiated positions in Apache and Ovintiv, which were both downgraded to high yield credit ratings earlier this year (i.e., “fallen angels”) with the decline in oil prices. However, both companies are large scale producers with diversity of operations and low-cost structures that can withstand significant oil price volatility. These companies also maintain strong liquidity profiles with very manageable maturity schedules. The senior notes of both companies have solid BB+ ratings, five years or less to maturity, and were acquired at spreads of 525 bps and 592 bps for yields of 5.6% and 6.2%, respectively. We also bought Occidental Petroleum at attractive spreads and yields. In the related pipeline sector, we purchased bonds of Enlink Midstream, which is a diversified pipeline operator that has maintained low leverage through the pandemic due to minimum volume commitments from customers. We have followed the credit for years, and we were pleased to add BB+ rated senior bonds to the portfolio at a spread of 484 bps for a 5.4% yield.
In the insurance sector, we purchased the first-time debt issuance from Ascot Group, a Bermuda-based underwriter of property and casualty insurance. The company meets our credit criteria of having a long track record of underwriting performance from a diversified book of business with deep support from a AAA rated owner. As this was the first offering of bonds from the company, the 10-year senior notes were priced attractively for a BBB- rated credit at a spread of 385 bps for 4.3% yield. Fidelis Insurance Holdings was an existing portfolio holding that brought a new BB+ rated subordinated note to market in the quarter at a spread of at 632 bps for a yield 6.6%. We swapped our senior bonds for the subordinated bonds for a yield pick-up of over 200 bps in a company with a strong credit profile.
BDCs are a sector that has been offering significant value all year, and during the quarter we rotated into two new BDC holdings. Gladstone Capital is a public and externally managed BDC that focuses on offering loans to lower middle market companies. The company has 20 years of experience in sourcing and underwriting loans to this market segment and has experienced no credit losses through this pandemic episode. We purchased the new 5-year notes with an implied rating of BBB- at a spread of 473 bps for a 5.1% yield. Capital Southwest is a public and internally managed BDC that has been focused on middle market borrowers for the last 30 years. The company has experienced low credit losses in recent years and has also experienced no credit losses to date this year through the pandemic. The new 5-year senior notes were purchased at a conservative BBB- implied rating and a spread of 433 bps or 4.5% yield.
The new-issue market for structured products continued to rebound in the quarter and we purchased debt from well-established credit manager Pennant Park. PNTPK 2020-2A is comprised of newly issued middle market loans. These loan portfolios were intentionally structured with limited exposure to COVID-19 affected industries and have reinvestment periods of four years or less. The floating-rate bonds were rated BBB- and we purchased them 650 bps over 3-month London Interbank Offering Rate (LIBOR), respectively.
GCPAF 2020-1 and ABDLF 2020-1 are securitizations of recurring revenue loans issued by private credit managers to high growth businesses that are between the venture capital and middle market business growth phases. The seasoned credit managers involved in this kind of lending are focused on the contractual, or sticky, nature of the revenues coming from software, technology, and digital infrastructure growth businesses. Golub Capital and Alliance Bernstein have strong track records in this lending space with minimal credit loss experience. There is considerable credit support for our securitized notes in the form of subordination and overcollateralization, which allows our investments to remain unimpaired even in severe hypothetical loss scenarios. The purchased notes are rated BBB, have a weighted average life expectation of 4 years on average and offered spreads of 415 bps and 470 bps for yields of 4.6% and 5.1%, respectively.
The volatility in financial markets this year was clearly driven by the unique nature of a pandemic spreading quickly across the globe. Not only were people focused on the financial effects of societal lockdowns, but that was exacerbated by the human health aspect that was affecting all of us. At BBH, we have experienced similar market drawdowns over our long careers, although the drivers of these episodes are always different. This period should serve as reminder to market participants that broad and steep market declines are a long-term feature of financial markets that tends to fade from memory during periods of stability. Our investment process, seeking durable credits with an appropriate margin of safety in valuations, served clients well this year. Doing the disciplined work of stressing investments at the time of purchase, rather than as the events are unfolding, gives our investment team the confidence to lean into the volatility to take advantage of attractive opportunities where others are hesitant. Multiple COVID-19 vaccines are beginning to be administered globally and credit markets have responded strongly to these developments. Whether a complete recovery in credit spreads and low levels of Treasury rates can be maintained is an open question that may drive volatility in 2021. We feel well positioned to take advantage of broad opportunities that this volatility may present, while still finding attractive individual and niche opportunities at current levels.
The recovery from the COVID shock has been faster than expected, with consumer confidence holding up well as massive fiscal support drove positive personal income growth and a swift monetary policy response led to gains in household net worth. However, the latest COVID wave is the largest yet, which has led to renewed lockdowns and a setback in the recovery this winter. The recovery will resume with more fiscal support being deployed, and with vaccinations now underway. Vaccinating the elderly first should dramatically cut the fatality and hospitalization risk, allowing for higher economic activity even amid high cases. We expect herd immunity will be reached sometime this summer, depending on the pace of vaccinations. Virus mutations remain a risk to this timeline. Gains in income, net worth, and over $1.5 trillion in excess savings should lead to strong consumption growth by the second half of the year as spending opportunities normalize. Real GDP growth will get a further boost from a continuation of housing market strength supported by low inventories and low borrowing costs, and with rising business investment as uncertainty is reduced post-election and post-COVID. While the labor market recovery has slowed, accelerating economic growth, a high share of layoffs classified as temporary, and job openings at high levels mean we should see unemployment fall significantly this year. While inflation readings will be volatile over the next several months due to base effects from 2020 and a shift in spending from goods to services, we expect core inflation will trend downward by the end of the year, as inflation lags GDP growth by 18 months.
We expect a continuation of ultra-accommodative monetary policy as the Fed seeks to demonstrate the credibility of its new inflation strategy, especially with inflation continuing to undershoot the 2% target. The Fed is unlikely to taper asset purchases this year and rate hikes are years away. The $900 billion COVID relief bill passed in December is already being deployed, which will support incomes and cushion the economy even amid high growth in COVID cases. With Democrats controlling the Senate, more fiscal stimulus is on the way. We expect over $1 trillion in addition COVID relief will be passed in the first quarter, including more stimulus checks, extended unemployment benefits, and state and local government aid, with the possibility of a package closer to $1.5 trillion. Later in the year we expect another sizable fiscal package focused on infrastructure, climate, and healthcare. This new spending is likely to be paired with tax increases, but the need to get the support of moderate Democrats will limit the size. We expect tax changes will include raising the top marginal individual income tax rate, raising the corporate tax rate a few percentage points, and possibly raising the capital gains tax.
Though credit spreads have tightened below historical averages, history shows they can persist at low levels for years during periods of economic expansion. With continued economic improvement, lower rated credit should tighten against higher rated credit. Expanded Fed support for credit markets has significantly reduced tail risks, but high and rising debt loads will lead to defaults and downgrades, so security selection remains paramount. We are finding attractive relative value in structured credit, which has higher yields compared to corporate credit, lower duration risk, and less volatility and correlation. With the Fed set for a protracted period at the zero lower bound, Treasury yields at the front end and belly of the yield curve will remain low. Risk assets will continue to benefit from supportive monetary and fiscal policy and a strengthening recovery. We view any weakness as a buying opportunity.
2020 was simply one of the most physically, socially, politically and financially destructive years in a generation, in our view. A year from which the collective “us” will most likely take a long time to recover. Remarkably, equity markets shrugged off the negative prospects and were buoyed by hope for prolonged monetary and fiscal stimulus well into 2021. Given equity markets supposedly look to the future when setting valuations, one must assume, at some point in time, they will be forced to ponder a future without unlimited stimulus. However, until that day arrives, we expect the equity market pendulum will remain tilted towards greed. Fittingly, equity markets closed out 2020 with another strong month following one of the best Novembers for the S&P 500 Index (S&P 500) on record. In December, The S&P 500 gained 3.84% while the Russell 2000 Index (R2000) rose a materially higher 8.65%. Concurrently, the CBOE S&P 500 2% OTM PutWrite Index (PUTY) returned 1.54% and the Bloomberg Barclays U.S. High Yield Index (BB HY) rallied 1.88%. Over the fourth quarter, the S&P 500 gained 12.15% and the R2000 gained an awe-inspiring 31.37%. In a like manner, the PUTY earned 5.73% and the BB HY jumped 6.45%. Equity markets performance on the year is just plain surprising to us. Social unrest, political regime changes in the United States and a global pandemic that crippled all aspects of the global economy are not your run-of-the-mill financial challenges. Yet, equity investors ultimately dragged markets from the depths of a first quarter drawdowns to record levels by year-end. A truly astonishing nine month rebound, in our opinion.
Index Option Implied Volatility
U.S. equity implied volatility levels rose in December while non-U.S. equity implied volatility remained relatively unchanged. Realized volatility was well contained during the month as equity markets rallied to end the year. Hence, implied volatility premiums were well above average going into year-end which resulted in modestly positive average implied volatility premiums. The CBOE S&P 500 Volatility Index (VIX) rose 10.60% to end the month at 22.8. Likewise, the CBOE R2000 Volatility Index (RVX) increased a modest 2.55% to 30.5. Over the period, 30-day implied volatility premiums averaged 14.0 and 11.8, respectively.
On the quarter, the VIX is down 3.6 points (pts) with an average 30-day implied volatility premium of 9.5. Of equal importance, RVX was down 4.0 pts with an average implied volatility premium of 9.4. 2020 brought record levels of both implied volatility and realized volatility. After the severity of the first quarter market drawdown, implied volatility levels rapidly adjusted higher. Overall, implied volatility levels continue to oscillate around elevated levels and are expected to remain above long-term averages well into 2021, which should provide a good environment for the strategy.
Over the quarter, the sleeve posted an attractive return of approximately 5.2%, which captured the majority of the PUTY return of 5.7%. The large cap (S&P 500 PutWrite Strategy) component returned 4.8%, while the small cap (Russell 2000 PutWrite Strategy) segment returned 9.1%. 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. Over the quarter, the collateral portfolio’s 0.03% return tied the T-Bill Index return of 0.03%. Extraordinary monetary policy measures have pinned short-term rates near zero for most of the year, which provided a tail wind for collateral portfolio performance. The above average gains in 2020 will likely result in muted collateral gains in the coming quarters as lower yields provide less collateral income. However, expectations for additional fiscal stimulus and U.S. government spending from Democratically controlled executive and legislative branches are cause for investors’ concerns about untenable debt levels and inflation. Hence, short-term rates may slowly reset higher in a manner controlled by the U.S. Federal Reserve, which will allow the sleeve’s laddered, short duration collateral portfolio to reset yields higher in an orderly manner.
The fund’s new 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 December 31, 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%|