The iMGP High Income Fund rose 4.99% in the fourth quarter, trailing the Bloomberg Aggregate Bond Index (the Agg), which gained 6.82%, and high-yield bonds (BofA Merrill Lynch US High-Yield Cash Pay Index), which rose 7.08%. The Fund outperformed its Morningstar Nontraditional Bond category peer group’s 4.09% gain. For the full year, the Fund returned 12.32%, beating the category’s 6.93% gain and the Agg’s 5.53% increase, while slightly trailing the 13.46% return of high-yield bonds.
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. Investment performance reflects fee waivers in effect. In the absence of such waivers, total return would be reduced.
Quarterly Review
Performance of Managers
During the fourth quarter, all three subadvisors produced solid performance. Neuberger Berman was up 6.38%, BBH gained 5.45% and Guggenheim returned 4.58%. (All sub-advisor returns are net of the management fees that each sub-advisor charges the Fund.)
Manager Commentaries
Brown Brothers Harriman
U.S. Treasury rates declined further in December. Investors’ predictions for forward-looking Fed interest rate decisions shifted during the month to earlier and more aggressive easing in 2024. The Fed met on December 13th and kept the target range of the federal funds rate unchanged at 5.25% – 5.50%. The Fed’s next announcement is scheduled for January 31st, 2024. In addition, the Fed’s campaign of shrinking its portfolio of assets acquired through open market operations by a maximum of $95 billion per month continues.
Fixed income indexes experienced positive returns amid the decline in interest rates. Risk spreads narrowed significantly throughout the credit markets and provided an additional boost to the performance of credit indexes. Indexes of intermediate maturity investment-grade corporate bonds, ABS, CMBS, high yield corporate bonds, senior bank loans, and CLO debt all outperformed Treasury alternatives during the month. The agency MBS Index also posted notably strong performance after three consecutive months of underperformance. One segment that lagged during December were long maturity corporate bonds, a market segment that we tend to avoid over valuation concerns.
Narrowing risk spreads caused valuations to weaken during the month. According to our valuation framework, the percentage of investment-grade corporate bonds that screened as a “buy” decreased to 23% versus 28% at the start of the month, while the percentage of high yield corporate bonds that screened as a “buy” was 24% versus 29% at the start of the month. Senior bank loans continue to screen attractively, with over 90% of the universe screening as a “buy” candidate.
There remains an abundance of opportunities in select subsectors of the market. We continue to find opportunities in intermediate maturity investment-grade bonds issued by banks and life insurers. Several “BB” and “B” rated bonds from smaller issuers screen attractively in the high yield bond universe. Away from the corporate credit markets, we observe a continuing disconnect between wider credit spread levels and solid credit performance. We are finding an abundance of attractively valued opportunities in non-traditional ABS issuances and collateralized loan obligation (CLO) debt. We believe that opportunities in the CMBS market will arise as stronger properties come to market with single asset single borrower (SASB) securitizations that facilitate strong transparency. Valuations of agency MBS weakened amid strong spread compression during the fourth quarter, and only small segments of the market screen as a “buy” candidate to us. We continue to avoid non-agency RMBS due to poor technical factors and weak fundamentals underpinned by weak housing affordability, low inventory of homes for sale, and stable-to-declining home prices.
The portfolio gained amid the strong performance in the fixed income markets during the quarter. The portfolio’s duration posture was additive to performance as interest rates declined. The portfolio’s emphases on strong-performing segments of the credit markets, including positioning in investment-grade corporate bonds, high yield corporate bonds, senior bank loans, and ABS were also notable contributors. Security selection results impacted performance positively across several sectors. Positions that contributed included senior bank loans to electric utilities, high yield corporate bonds issued by technology companies, investment-grade corporate bonds issued by life and property and casualty insurers, CLOs and collateralized fund obligations, and SASB CMBS. Selection results of loans to diversified manufacturing companies and technologies companies and chemicals companies hindered performance slightly.
We found several attractive opportunities for the portfolio during the quarter. We purchased corporate bonds issued by companies in the technology, aerospace/defense, financial technology, retail, asset management, and electric utility sectors. We purchased positions from CLO and aircraft equipment ABS deals. We also purchased a position in a senior bank loan to a midstream energy company.
At the end of the quarter, the portfolio’s duration was 2.2 years and remained near levels consistent with long-term capital preservation. The portfolio’s weight to corporate debt increased slightly while the portfolio’s weight to reserves decreased by a similar amount. The portfolio’s allocation to high yield and non-rated instruments increased slightly to 44% from 42% last quarter. The portfolio’s yield to maturity was 9.2% and remained elevated versus bond market alternatives. The portfolio’s option-adjusted spread was 455 basis points; for reference, the Bloomberg U.S. Corporate Index’s option-adjusted spread was 99 basis points and the Bloomberg U.S. Corporate High Yield Index’s option-adjusted spread was 323 basis points at quarter-end.
Several forces promise to influence credit markets in 2024, and the way credit markets will behave is uncertain. Valuations, potential defaults and recession, the prospect of Fed easing, heightened refinancing needs, and fund flows in a higher Treasury rate environment can cause the market to behave in funny ways in any given year, and this year promises to be no different. That is why strong valuation and credit disciplines are imperative to performing in the market we observe.
Guggenheim Investments
The U.S. economy has been resilient to tightening monetary policy, helped by falling inflation boosting real incomes and consumer sentiment, a big expansion in the fiscal deficit over the past year, and a supply-side boost as labor force participation improves. These tailwinds are likely to fade going forward which will pressure growth. Job growth has been cooling and increasingly concentrated in less cyclical sectors. Consumer spending also faces headwinds from dwindling excess savings buffers.
However, there are some growing and offsetting positives for the outlook. While hiring is slowing, layoffs remain extraordinarily low as memories of the labor shortage from a few years ago lead to “labor hoarding”. Additionally, the economy has been through a series of rolling recessions, with different industries seeing downturns at different times. Beaten down industries like housing could see some upside in 2024.
The Fed-induced easing of financial conditions, with interest rates falling and stock prices rising, takes pressure off the economy and helps bring down recession risk. While recession risk has come down, it is still materially higher than very optimistic market expectations. We see an increasingly bifurcated economy, with stress concentrated in small businesses, small banks, commercial real estate, and low-income consumers. Inflation is already at the 2% target by some measures, and the full suite of indicators should approach 2% by the second half of 2024. Shelter inflation will continue to cool as it catches up with more timely measures, and broader services inflation will benefit from slowing wage growth. We continue to believe getting inflation durably back to target will require slower economic growth. If growth remains above 2% (not our base case), inflation risk will rise.
We believe Fed cuts are coming soon as it seeks a soft landing. Inflation has come in softer than the Fed expected, boosting their belief that the supply side of the economy is healing. At the same time, they are reporting increased signals of downside risk to economic growth.
With this backdrop, the Fed firmly opened the door to near-term rate cuts at the December meeting. We expect the first cut will be in March, followed by 25 bps cuts at each following meeting this year. Even with no recession, lower inflation means the Fed will want to cut the fed funds rate to keep real rates from rising. Balance sheet runoff will likely go on even after the Fed starts cutting rates, but will likely stop in the second half of 2024. The 2024 election will add to volatility and uncertainty this year. No matter the outcome, there is little appetite to address fiscal sustainability, meaning large deficits will continue.
Looking ahead, high-quality credit presents great opportunities as the Fed pivots policy. We expect Treasury yields to decline more than the market currently anticipates this year, though they are unlikely to return to the lows of the last cycle. Meanwhile, credit defaults have been rising and we expect them to stay elevated as U.S. companies cope with rising borrowing costs and limited credit availability, but the stress will become increasingly bifurcated between large and small companies.
While aggregate corporate fundamentals remain solid, investors should remain selective as downgrades and defaults increase in the next 6-12 months. We are finding attractive value in high-quality corporate and structured credit where attractive yields provide an income cushion that could reduce the impact if spreads should widen from here.
We are using market strength as an opportunity to rotate, seeking diversification, and adding structured credit exposure that we find attractive. Higher yields at the short end of the curve have lowered the opportunity cost of short-term investments; building our allocation to such holdings not only maintains our return profile, but it also provides the necessary dry powder for us to become a source of opportunistic capital at the appropriate time.
Neuberger Berman
Market Commentary
Equity Markets
Despite multiple wars, Silicon Valley Bank’s collapse, rampant price inflation, immigration, political controversies, labor union strikes, and budget brinksmanship, the S&P 500 Index (“S&P 500”) closed 2023 out with an 11.7% return in the fourth quarter, which brought its annual total return to 26.3%. The ‘Magnificent Seven’ posted a staggering 76% return as the AI narrative went mainstream and investors began to price in Fed easing in 2024. Notably, three S&P 500 sectors finished the year up more than 40%: Information Technology (+56.4%), Consumer Discretionary (+54.4%), and Communication Services (+41.0%); while three interest rate sensitive sectors were down on the year: Utilities (-10.2%), Consumer Staples (-2.2%), and Energy (-4.8%).
US Treasury Markets
Fixed income markets fared relatively well in the fourth quarter with expectations that the Fed’s rate policy was shifting to a more dovish stance, but were no match for stock market narratives. The Bloomberg US Aggregate and Bloomberg US High Yield Indexes were up 6.8% and 7.2% in the fourth quarter, which boosted their 2023 results to 5.5% and 13.5%, respectively. On the quarter, short-term US Treasury Rates (3M US T-Bill) were down -11bps and long-term rates (10Y US Treasury) declined -69bps. Year to date, short-term US rates increased 97bps while 10Y US rates remained approximately flat.
Option Implied Volatility Indexes
With the positive equity market momentum and the expectation that the Fed will begin a rate cutting cycle in 2024, implied volatility levels declined into year end and put skew levels were depressed as investors leaned into call buying for upside participation versus put buying for risk mitigation. Investor FOMO was driven by the prevalence of ‘big up days’ vs. ‘big down days’. Specifically, 2023 saw seven days with S&P 500 gains greater than 1.75% versus just two days with S&P 500 losses of more than -1.75%.
The Cboe S&P 500 Volatility Index (“VIX”) averaged 16.9 for the year, which is well below its 2022 average of 25.6 but only a few points off its long-term average. In 2023, S&P 500 realized volatility fell to 13.3 versus 24.6 in 2022. The S&P 500 Index option market kept its positive implied volatility premium streak going with an average premium of 3.7 in the fourth quarter resulting in a 2023 average of 4.3. (As a reminder, positive (and high) implied volatility premia are better for the strategy.)
Looking ahead to 2024, S&P 500 Index option markets are pricing implied volatility levels slightly below longer-term levels, which we think is probably underestimating all the potential risk in the global economic and political landscape. A small-but-real chance for a US recession, Ukraine falling to Russia, Trump election mania, simmering China relations, and the ongoing war between Israel and Hamas remain risks. Even without these major risks, every year offers unexpected events—except for maybe 2017—that can result in rapid repricing of equity market risk and present opportunities for elevated premium capture.
Strategy Allocations
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 targeted allocation should differences in shorter-term relative performance cause divergences.
Sub-Advisor Portfolio Composition as of December 31, 2023
| Brown Brothers Harriman Credit Value Strategy | |
| ABS | 19.6% |
| Bank Loans | 23.3% |
| Corporate Bonds | 50.2% |
| CMBS | 3.5% |
| Cash & Equivalents | 3.5% |
| Guggenheim Multi-Credit Strategy | |
| ABS | 30.1% |
| Bank Loans | 14.1% |
| Corporate Bonds | 22.2% |
| CMBS (Non-Agency) | 2.6% |
| Preferred Stock | 2.5% |
| RMBS (Non-Agency) | 8.2% |
| RMBS (Agency) | 9.7% |
| Other | 6.2% |
| Cash | 4.4% |
| Neuberger Berman Option Income Strategy | ||
| Equity Index Put Writing | 100% |