The iMGP High Income Alternatives Fund declined 5.55% in the second quarter, slightly underperforming the Bloomberg Aggregate Bond Index (Agg), which fell 4.69%, but outperforming high-yield bonds (BofA Merrill Lynch US High-Yield Index), which lost 9.97%. The fund trailed its Morningstar Nontraditional Bond category peer group, which fell 4.24%. For the first half of the year, the fund was down 7.85%, outperforming both the Agg and high-yield bonds, which lost 10.35% and 14.04%, respectively, while trailing its category peer group (down 6.68%).
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2022 has been one of the more difficult years in recent memory. Equity markets are down approximately 20% through the first half of the year and perceived lower risk bond markets have registered double-digit losses. Over the past few months, the economic backdrop has worsened with sustained levels of inflation not seen since the 1970s, and slowing growth, as the Federal Reserve and other global central banks aggressively tighten monetary policy. Exogenous shocks – the Russian war on Ukraine and China’s zero-COVID lockdowns – continue to further disrupt the global economy and financial markets. Against this backdrop, it was another brutal quarter for bond investors. Although not quite as bad as the bruising 6% loss suffered in the first quarter, the Agg plunged another 4.7% in the second quarter. That produced the worst first-half performance in the history of the Agg, down 10.4%. Losses were widespread, with every sector posting a negative total return. Credit was crushed with high-yield plunging a staggering 10% in the quarter, leaving the asset class down 14% for the first half of the year. Even floating-rate loans lost 4.5% after being essentially flat in the first quarter.
The June year-over-year headline CPI inflation rate came in at 9.1%, following an 8.6% increase in May. At present, all measures of inflation are well above the Fed’s 2% target. Moreover, long-term inflation expectations, which are key to Fed policy have started to creep up as well. In response to unexpected inflation data, the Fed turned even more hawkish, hiking the federal funds rate a larger-than-expected 75 basis points in June. The Fed also sharply raised their median forecast for the year-end Fed funds rate to 3.4% from a 1.9% forecast at their March meeting, implying another 175bps of rate hikes over the next several quarters. Meanwhile, they also sharply downgraded their median forecasts for U.S. real GDP growth for 2022 and 2023. A sharp economic growth slowdown is likely this year and the risk of recession over the next 12 months continues to rise.
With this negative outlook for growth, credit spreads have widened in addition to the increase in yields on “risk-free” Treasuries, producing a challenging environment for credit-sensitive assets. High-yield bond spreads ended the quarter at almost 600 basis points (bps), several hundred bps below the levels seen in the early days of the COVID pandemic or the growth scare of early 2016, but above the average of the last decade (less than 500 bps). Combined with the higher Treasury yields, the yield on high-yield ended the quarter at about 9.0%, actual high yield for an asset class that seemed to have been mis-labeled for much of the last decade. In the last ten years, high-yield bonds have only yielded more during the two periods previously mentioned, peaking at about 11.4% and 10.1%, respectively. Defaults are still extremely low. The trailing 12-month default rate is just over 1%, year-end forecasts are 1.25%, and estimates for 2023 are below 2.0%. For context, the long-term 12-month average for defaults is 3.2%.
This environment has created attractive opportunities for our managers, who have selectively added risk exposure, while still maintaining caution. Both credit managers were yielding close to 7.0% at the end of the quarter with a duration of just over 2.0. We believe this higher yield, shorter duration combination is attractive relative to most fixed-income asset classes. We would remind investors that our credit managers focus on identifying 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 our flexible credit managers, combined with the option income strategy, becomes apparent when we look at the portfolio’s characteristics. At the end of the quarter, the High Income Alternatives fund had a 12-month distribution yield of 6.1% with a 2 duration. Neuberger Berman’s option strategy continues to play an important, complementary role in the fund. The high option premiums collected helped somewhat offset losses from the sharp equity market declines of the quarter. The annualized yield changes quickly due to the Neuberger’s laddered approach to portfolio construction and the options market repricing risk, but it was in the low 20% range at the end of the quarter after starting the quarter in the low teens. Additionally, materially higher yields on short-term Treasuries, while painful during the quarter as yields rose and prices declined, will provide a longer-term benefit to the option sleeve’s collateral return, as the collateral portfolio yielded 2.8% at quarter end.
The passage of time has allowed the fund to demonstrate its advantages, and we think it has the potential to produce attractive risk-adjusted returns and income, while diversifying core bond exposure. Over the trailing one-, two-, and three-year periods, the fund remains ahead of both the high-yield and Aggregate bond benchmarks, as well as the Morningstar Nontraditional Bond category. We appreciate your continued confidence in the fund.
Quarterly Portfolio Commentary
Performance of Managers
During the quarter, all three managers posted losses. Both credit managers posted losses but significantly outperformed the 9.9% loss for the high-yield index. Brown Brothers Harriman declined 4.46% and Guggenheim was down 5.86%. Relative to the Aggregate bond index (down 4.7%), Brown Brothers outperformed while Guggenheim trailed. Neuberger Berman fell 6.25% compared to a 6.90% loss for the CBOE S&P500 2% OTM PutWrite benchmark. (All sub-advisor returns are net of the management fees that each sub-advisor charges the fund.)
Brown Brothers Harriman
The continued rise in interest rates in the second quarter was in response to the much higher inflation data being reported and the expectation of a more aggressive policy response from the Federal Reserve. The 2-Year and 10-Year Treasury bond yields rose this quarter by 61bps and 67bps, respectively. We maintained just two years of duration in the sleeve this year, which remains an important defense against further interest rate volatility.
The higher inflation data and interest-rate movements pulled forward concerns that the U.S. economy will tumble into a recession with the potential build-up of credit stress being reflected in the widening of credit spreads. For example, investment grade BBB-rated credit spreads widened 19bps in the second quarter, which is compounded by the average spread duration during the period of 8.1 years for this rating category. High-yield credit spreads experienced a more exponential move wider as recession risk, rather than inflation risk, became a market focus. High yield BB-rated credit spreads widened 173bps this quarter against an average spread duration of 4.6 years.
The silver lining to all this volatility and abrupt movements in rates and spreads is how quickly valuations are resetting for attractive durable credits. With the potential for an economic slowdown or full-blown recession we are continuously reviewing our existing positions and feel confident that these investments have the potential to perform across the wide range of economic outcomes facing the country.
The outlook for the U.S. economy continues to worsen. Real GDP growth in the first half of the year was negative, partly reflecting temporary drags from foreign trade and inventories, but also reflecting a slowdown in domestic demand. High inflation has driven consumer sentiment to all-time lows, as real incomes and accumulated savings are eroded. We are well past the peak in real goods spending, and the rebound in spending on services has been slower than many anticipated. Business investment is also weakening due to the sharp tightening in financial conditions and more challenging outlook for economic growth. The housing sector is also contracting from GDP as the spike in mortgage rates has cratered demand. We now expect both 2022 and 2023 will see negative real GDP growth (Q4/Q4), with a high probability of a recession starting as soon as the end of the year.
The only bright spot for the economy has been the labor market, with labor demand far outpacing supply. Forward-looking indicators point to a slowdown in hiring, and we won’t be in a recession until employment is falling. Inflation has broadened out from goods impacted by supply chain snags to housing, airfares, and other services. Additionally, the spike in energy and food prices will continue to be passed through into broader prices in the coming months. We expect core inflation will moderate by the end of the year as supply chains continue to unsnarl, wage growth cools, and shelter inflation moderates. But it will remain well above the Fed’s comfort levels until early 2023 at the earliest.
The Fed has pivoted to an aggressive posture in an attempt to reassure markets and the public that it will do whatever it takes to ensure price stability. We see a high likelihood that the Fed will raise rates by 50-75 basis points at the next few meetings, as they aim to get policy to a restrictive setting “expeditiously.” The fed funds rate is likely to get to around 3.5% by the end of the year. The Fed is looking for “clear and convincing” evidence that inflation is coming down before scaling back on tightening. This high bar means they will be responding to backward looking and lagged inflation data, while forward-looking signals show a slowing economy and rising risks of a financial accident. Fed communication has made it clear they are aware of elevated recession risk, but they see the risks of letting inflation expectations become unanchored as far more dangerous, so policy will be almost entirely driven by inflation data in the near term, until economic and market conditions become bad enough to cause a pivot, which could occur by early 2023. Fiscal policy has also turned to a significant drag, and negotiations over more spending have broken down over inflation concerns. Republicans will likely take control of congress after the midterm elections, resulting in policy gridlock.
The credit backdrop is shifting with net rating migration moving from net upgrades to net downgrades as slowing growth hits corporate earnings expectations. Corporate fundamentals remain solid with manageable debt service, but defaults and bankruptcies are gradually increasing. We expect more defaults in the second half of the year as the Fed moves ahead with rate hikes. Corporate bond valuations look attractive with most sectors near or above the 70th percentile levels historically. Our tactical indicators also indicate bonds are oversold. We continue to find attractive relative value in floating-rate structured credit and leveraged loans where coupons reset higher as the Fed raises interest rates. The highest fixed-income yields in over a decade also offer compelling long-term value. The Fed’s aggressive rate-hike campaign should cause the yield curve to flatten, with some curves inverting deeply. As the Fed’s inflation fighting commitment is cemented and the economic cycle rolls over, Treasury yields should see a significant decline heading into the next downturn.
During the quarter the portfolio was down about 6.2% as it fell more than the PutWrite Benchmark return (-3.5%), which consists of 40% CBOE S&P 500 PutWrite Index (PUT) and 60% ICE BofA 0-3M US Treasury Bill Index. However, it managed to avoid a significant portion of the loss of the Bloomberg US High Yield Index (-9.9%), and also outperformed the CBOE S&P 500 2% OTM PutWrite’s (“PUTY”) loss of -6.9%.
Every financial market ‘regime change’ is different, but each tends to be characterized by a few simple catalysts that manifest through markets in less predictable ways. This time around it’s unanticipated (anticipated) inflation and the Fed’s aggressive rate policy and, in our opinion, there isn’t much left to debate. US equity (S&P 500 Index) and bond (Bloomberg US Aggregate Index) markets just had their worst combined (60% equity / 40% fixed income) six-month period since the inception of the US Aggregate in 1976. Ironically, one simplifying explanation for the steep sell-off is that investors decided to heed the modern market wisdom of ‘don’t fight the Fed’. If everyone knows that asset prices decline when the Fed raises rates, well, then investors need to sell their assets. But who buys them? Voila, a good old-fashion liquidity event that smooshes almost all risks assets except commodities.
With this theory in mind, we believe that U.S. recession concerns are likely overdone, and the labor market’s relative strength is a more relevant indicator than gross domestic product measures that are currently influx due to an unprecedented global pandemic and related inventory effects. Over the second quarter, the S&P 500 Index (“S&P 500”) declined a dramatic 16.1%, the CBOE S&P 500 2% OTM PutWrite slid 6.9%, and the CBOE Russell 2000 PutWrite tumbled 7.4%.
So far, inflation has shown no signs of stalling in our view despite monetary policy actions taken by the Fed to-date. At this point, the Fed has indicated they will likely need to increase rates to 3.5% to 3.8% by next year in order to get a handle on inflation. During the quarter, short-term US Treasury rates (3-month US T-Bill) were up 117bps and long-term rates (10-year US Treasury) gained 68bps.
Index Option Implied Volatility
For the quarter, the CBOE S&P 500 Volatility Index (“VIX”) rose 8.2pts, yielding an average 30-day implied volatility premium of -0.6. In concert, the CBOE R2000 Volatility Index (“RVX”) rose 7.0pts resulting in an average implied volatility premium of 0.8. VIX futures markets ended the quarter notably higher with the characteristic ‘contango’ relationship between shorter and longer dated futures evaporating. Price moves in VIX futures have historically followed a pattern of shorter-dated futures rising as investor concerns mount. Then, longer-dated futures have historically risen if investors begin to sense that market risks are proving potentially structural rather than temporary. This dynamic played out in the second quarter as investors began to price in a higher probability of a US recession.
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 June 30, 2022
|Brown Brothers Harriman Credit Value Strategy|
|Guggenheim Multi-Credit Strategy|
|Neuberger Berman Option Income Strategy|
|Equity Index Put Writing||100%|