The iMGP High Income Alternatives Fund gained 1.06% in the quarter, outperforming both the Bloomberg Barclays US Aggregate Bond Index (Agg), which was flat in the period, and the 0.71% gain for high-yield bonds (BofA Merrill Lynch US High-Yield Cash Pay Index). The fund also outperformed its Nontraditional Bond category peer group, which fell 0.21%. For the full 2021 calendar year, the fund’s 6.42% gain outperformed the Agg (down 1.54%), high-yield bonds (up 5.36%), and its category (up 1.50%).
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.imgpfunds.com.
The High Income Alternatives Fund rose 1.06% in the fourth quarter, closing out the year with strong absolute and relative returns. Over the three-month period, interest rates on the 10-year Treasury finished only slightly above where they started. But rates were somewhat volatile amid talks of an accelerated pace of Fed monetary policy tightening and mounting inflation pressures.
The challenges that fixed-income investors faced in the fourth quarter will most likely look similar for the year ahead. We continue to see elevated valuations across most of the credit market, historically low real U.S. Treasury rates, mounting inflationary/interest-rate pressures, and historically elevated durations in some high-quality segments of the credit market. We think this will result in muted returns (or even losses) in the coming year, depending on the segment of the bond market. Returns will likely be driven by coupon, not price appreciation.
In this environment, fixed-income investors are faced with the task of striking a balance between playing offense (generating positive real returns) and defense (providing portfolio ballast). As a reminder, this 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. These higher expected returns will very likely come with higher volatility than core bonds. However, over the long term, we believe returns will be comparable to high-yield bonds, but with lower volatility and downside risk. This is due to the fund’s diversified sources of income and flexible managers utilizing a wide opportunity set.
Amid the broad bond market headwinds, we continue to believe there are attractive credit opportunities, and our managers continue to identify attractive and durable, higher-yielding securities, often in niche, off-benchmark segments of the credit universe such as asset-backed securities (ABS). The benefit of a flexible opportunity set, combined with a complementary option income strategy, becomes apparent when we look at the portfolio’s characteristics. At the end of 2021, the portfolio had a 12-month distribution yield of 5.7% with a 1.81 duration. We think the portfolio is well-positioned relative to most other parts of the fixed-income market. This currently compares to an 1.75% yield and a 6.5 duration for the Agg, and a 4.3% yield and low 4.0 duration for the high-yield bond index.
As we look ahead, we believe our two credit managers’ wide opportunity set and flexible mandate bodes well for the strategy, as they can better navigate interest-rate and credit cycles. As an example, prior to the March 2020 downturn, the fund’s credit exposure was meaningfully lower than it is today due to valuation concerns. If the risk-reward ratio of credit markets again becomes that unattractive, we expect our managers’ exposure to reflect that with lower risk, more defensive portfolio construction.
Meanwhile, Neuberger Berman’s option strategy has continued to perform well (up over 5% in the fourth quarter, and over 15% year-to-date) benefitting from attractive premiums that result from market volatility flare-ups where the strategy can collect healthy income. As we start the year, implied volatility has increased slightly off of some of the stubborn lows we experienced for a big part of last year. And if short-term rates rise, this will provide a longer-term benefit to the option sleeve’s collateral return.
At the end of the fourth quarter, the fund finished in the top decile of its peer group over the trailing one- and three-year periods and achieved an Overall Morningstar Rating of 5-stars among 294 non-traditional bond funds based on risk-adjusted returns for the period ending 12/21/2021. We are pleased with that result, especially considering the inopportune timing of the fund’s 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. We appreciate your continued confidence in the fund.
Quarterly Portfolio Commentary
Performance of Managers
During the quarter, all three managers generated positive returns. Neuberger Berman returned 4.25%, Brown Brothers Harriman was up 0.39%, and Guggenheim gained 0.35%. (These returns are net of the management fees that each sub-advisor charges the fund.)
Brown Brothers Harriman
The BBH sleeve reported performance of 0.39% for the fourth quarter. During the three-month period, credit markets weakened briefly, only to rally as year-end approached leaving a mixed finish between credit ratings. For example, BBB and BB credit spreads ended the quarter 9 basis points (bps) wider and 9bps tighter, respectively.
The 10-year U.S. Treasury ended the quarter just 2bps wider at 1.51%, although trading in a 35bps range, which is almost identical to what happened in the third quarter of this year. The real movement was in shorter maturities as the 2-Year U.S. Treasury yield widened by 45bps in a continuous trend. The ongoing bond market debate about potential Federal Reserve actions in response to a strengthened U.S. economy, and inflationary pressures, was muddied by the resurgence of Covid-19 variants globally.
There was robust new issuance in the quarter across all sectors of credit as borrowers sought to lock-in borrowings before potential interest-rate increases, and the markets were very receptive to these deals. However, with such little movement in credit spreads during the quarter, corporate credit remained generally expensive, especially for on-the-run investment-grade. Our focus remained on staying invested in those sectors of the credit market with appropriate valuations, such as off-the-run and niche sectors of the bond market, securitized credit, and floating-rate loans.
The Omicron wave has caused disruptions to start the year and consumer sentiment has taken a hit from higher inflation, however, we expect the economy will expand by around 3.5% in 2022. While that is a step down from 2021 real GDP growth of over 5%, it is still more than double long-run potential GDP growth of 1.5%, meaning that the economy will continue to overheat. Consumption will benefit from the surge in household net worth and accumulated consumer savings over $2.4 trillion in excess of the pre-COVID pace of saving, helping to cushion the impact of fading fiscal support. Real GDP growth will get a further boost from rising business investment, as inventories are replenished from very low levels and firms respond to the strong demand outlook and easy borrowing conditions by raising capex.
Labor demand remains extraordinarily strong, as seen in record job openings. Labor supply has been a bigger challenge, leading to a rapidly tightening labor market. Labor supply should continue to gradually recover, but not fast enough to prevent a historically tight labor market, with the unemployment rate falling well below the 3.5% trough of the last cycle. Inflation has spiked due to supply chain disruptions, particularly in the auto sector. Port congestion, semiconductor shortages, and high shipping rates look set to continue for at least the next several months, pushing inflation up. By the second half of 2022, cooling demand and incremental supply chain improvements should help ease prices in the goods sector. Along with elevated base effects, this dynamic should help core inflation fall, though it is likely to remain above the Fed’s target as inflation has broadened out and the tight labor market will keep pressure on labor costs.
Fed officials are growing increasingly nervous about inflation given the impact of rising prices on public sentiment, and are now signaling that full employment will soon be reached. Given the strong inflation and labor market data, we now expect the Fed will hike four times this year as they begin to move policy back to a more neutral setting. We also expect balance sheet runoff will begin in the middle of the year, with the pace of runoff materially faster than last cycle, as the balance sheet is proportionally larger. We expect a terminal fed funds rate of 2 percent, higher than the market is pricing. The Fed needs higher rates and tighter financial conditions to help cool the unsustainably hot economy. Fiscal policy negotiations have broken down, making additional fiscal stimulus unlikely. The end of expanded child tax credits will weigh on household incomes and consumption, adding to headwinds for Q1 GDP growth. Keeping with historical experience and supported by polling, Republicans will likely take control of congress after the midterm elections, resulting in policy gridlock.
Corporate fundamentals have strengthened significantly. Although leverage remains high, we believe debt service is manageable given the trajectory for corporate earnings. Expanded Fed support for credit markets has significantly reduced tail risks, but high and rising debt loads means 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. Leveraged loans also offer compelling value versus corporate bonds. Though credit spreads have tightened below historical averages, history shows they can persist at low levels for years during periods of economic expansion. Ultimately, any pull back in risk assets will be a buying opportunity given our view that the credit cycle has a few more years to run. Long-term interest rates should trend higher over the next year as the market reprices for a higher terminal fed funds rate. But short-term rates should rise more, resulting in a flatter yield curve.
In December, markets rallied to end the year on a strong note making 2021 the third consecutive year of stellar performance in equity markets. Despite the prevalence of the Omicron variant and an overall seasonal increase in infections, markets were buoyed by initial studies out of South Africa and the UK that indicated a reduced severity compared to previous variants of COVID-19. While many companies posted strong earnings for the quarter, small-caps underperformed large-cap stocks amid growing uncertainty of future performance. In the fourth quarter, the S&P 500 soared 11.03%, Cboe S&P 500 2% OTM PutWrite Index (“PUTY,” the closest index proxy to the strategy in the fund) climbed 4.44%, and Cboe Russell 2000 PutWrite Index (“PUTR”) gained 0.53%. Over the quarter, the sleeve posted an attractive 5.0% gain, which exceeded both the PUTY’s return of 4.4% and the Bloomberg US High Yield Index‘s return of 0.7%.
Index Option Implied Volatility
With data around the severity of the Omicron variant solidifying, volatility fell from November levels in both US and non-US markets. Longer dated volatility index futures continue to remain elevated well into 2022, potentially signaling that market makers and investors still have plenty of concerns about equity markets over the coming year. For the month, the Cboe S&P 500 Volatility Index (“VIX”) was down -10.0 pts with an average 30-day implied volatility premium of 1.3. (Higher implied volatility premiums are better for the strategy.) In a like manner, the Cboe Russell 2000 Volatility Index (“RVX”) was down -13.0 pts with an average implied volatility premium of 0.4. For the quarter, the VIX fell 5.9 pts, yielding an average 30-day implied volatility premium of 5.4. In addition, RVX declined 5.3 pts, resulting in an average implied volatility premium of 4.4.
During the quarter, the Fed developed a hawkish stance as inflationary pressures mounted, and the labor market continued to tighten. While the federal funds rate remained stable during the quarter, the Fed announced they would increase the rate of tapering in January which likely indicates more rate hikes in 2022. For the quarter, short-term US rates were up 1bp and 10Y US rates gained 2bps. The Collateral Portfolio’s -0.22% return suffered modestly versus the T-Bill Index return of 0.02%.
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 December 31, 2021
|Brown Brothers Harriman Credit Value Strategy|
|Guggenheim Multi-Credit Strategy|
|Neuberger Berman Option Income Strategy|
|Equity Index Put Writing||100.0%|