The iMGP High Income Fund rose 1.53% in the third quarter, outperforming the 3.23% loss for the Bloomberg Aggregate Bond Index, and 0.53% gain for high-yield bonds (BofA Merrill Lynch US High-Yield Cash Pay Index). The fund also outperformed its Morningstar Nontraditional Bond category peer group, which rose 0.18% in the three-month period.
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.
Performance of Managers
During the third quarter, the two credit managers outperformed the Aggregate Bond index. BBH gained 2.52% and Guggenheim gained 2.21%. The High-yield Bond index was up 0.53% in the three-month period. Neuberger Berman slipped 0.57% compared to a 1.49% 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
U.S. Treasury rates rose during the third quarter. The U.S. economy appears to be on strong footing, and investors are capitulating to the view that the Fed will need rates to be “higher for longer.” The Fed hiked the target range of the federal funds rate by 0.25% to 5.25% – 5.50% at its July meeting. The Fed’s next announcement is scheduled for November 1st. 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.
On a duration-adjusted basis, nearly every credit index earned positive excess returns during the quarter, though agency mortgage-backed securities (MBS) were a noteworthy underperformer. Indexes tied to floating-rate investments and with shorter durations experienced positive total returns despite the rise in rates.
The strong recent performance of credit instruments has caused valuations to weaken. According to our valuation framework, the percentage of investment-grade corporate bonds that screened as a “buy” sat at 32% versus a recent high of 48%, while the percentage of high-yield corporate bonds that screened as a “buy” was 33% versus 49% earlier this year. Despite the waning overall attractiveness at the Index level, there remain an abundance of opportunities in select subsectors of the market. Senior bank loans continue to screen attractively, with over 90% of the universe screening as a “buy” candidate.
Despite the overall weakening of credit valuations, opportunities persist. We continue to find opportunities in intermediate maturity bonds of rated “single-A” and “BBB” in the investment-grade bond universe. 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. Opportunities are emerging in parts of the agency MBS market as valuations improve, and we are prepared to add positions opportunistically. 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.
Despite the challenging performance environment, the portfolio earned a positive return during the quarter. Security selection paced results during the quarter, and contributions were diversified by sector. Investments in bank loans impacted results favorably, with loans to healthcare, consumer services, and airline companies performed strongly. Investments in collateralized loan obligations and SASB CMBS contributed, as did high-yield corporate bonds issued by property and casualty insurers, midstream energy companies, and technology companies. Holdings of investment-grade corporate bonds issued by property and casualty insurers and asset managers enhanced selection results further. The portfolio’s sector and quality exposures contributed further to performance, as the portfolio emphasized investments in shorter duration and floating rate credit investments that gained during the quarter. Finally, the portfolio’s defensive duration posture was additive because shorter term fixed income gained despite the increase in interest rates.
We invested actively in attractive opportunities that emerged for the portfolio during the quarter. We purchased corporate bonds issued by banks, life insurers, property and casualty insurers, specialty real estate investment trusts (REITs), electric utilities, and cable satellite companies, to name a few. We also added positions in bonds from a billboard assets ABS deal, a small business loan ABS deal, and a triple net lease ABS deal during the quarter.
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 allocation to high-yield and non-rated instruments was 42%. The portfolio’s yield to maturity was 10.0% and remained elevated versus bond market alternatives. The portfolio’s option-adjusted spread was 480 basis points; for reference, the Bloomberg U.S. Corporate Index’s option-adjusted spread was 121 basis points and the Bloomberg U.S. Corporate High Yield Index’s option-adjusted spread was 394 basis points at quarter-end.
Ultimately, higher interest rates will bring higher returns for credit investors, but higher-for-longer interest rates will weigh on many borrowers as well. We caution that a strong economy should not be the basis for investor credit decisions. Instead, we focus on durable credits which is a hallmark of our process.
The economy has been resilient but a recession still looks likely. The U.S. economy remains resilient, with real GDP growth continuing to track over 3% and the unemployment rate remaining low. The economy has been 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. We continue to see a high probability of recession, with our base case seeing a recession starting in early 2024. Job growth should continue to slow as backlogs are worked through and it becomes more difficult to reduce the length of the workweek. Falling profit margins will also add to pressures for layoffs. Consumption also faces headwinds from dwindling excess savings buffers and the continued impact of higher interest rates, which bite more as time goes on. While near-term pressure on the banking sector has abated, the impact of a sharp tightening in credit standards and the resulting slowdown in credit growth has yet to be fully felt. Business investment is likely to slow further as a result. Because private sector balance sheets are generally healthy in aggregate and the economy lacks major imbalances, we expect a fairly mild recession, with unemployment peaking around 5%. Inflation should trend lower over the next year, helped by shelter inflation cooling. Services inflation outside of shelter is the main concern for the Fed, but a softening labor market and slowing wage growth should gradually bring this category down as well. We expect core inflation will fall close to 2% in 2024.
We are nearing the end of the Fed’s hiking cycle. Our base case sees no more hikes from the Fed, though there is some risk of one more hike in December if the data proves firmer than we expect. The bulk of the debate has shifted from how much to hike to how long to keep rates at restrictive levels. Even as they pause rate hikes, they will maintain a hawkish rhetoric and try to push back against market expectations for near-term rate cuts. However, 2024 rate cuts are likely in most scenarios. Even with no recession, lower inflation next year means the Fed will want to cut the fed funds rate to keep real rates from rising. In our baseline scenario of a mild recession, we see rate cuts starting in Q1 2024, ultimately taking rates down to around 2.5% by 2025, a deeper cutting cycle than the market expects. As the Fed starts cutting rates, we expect they will also pause balance sheet runoff, so that quantitative tightening is not offsetting the easing of policy from rate cuts. Despite recession risk, major fiscal stimulus is unlikely given inflation concerns. Divided government virtually ensures policy gridlock through 2024.
We are maintaining a defensive stance, but remaining opportunistic, as the credit cycle reaches an inflection point. As the economic cycle rolls over in 2024, Treasury yields should decline, but are unlikely to return to the lows of the last cycle. Defaults have been rising as U.S. companies cope with rising borrowing costs and limited credit availability. We believe we are tracking a broader pullback in the economy that will present downside risk to equity and high beta credit. Corporate fundamentals remain solid, but 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 and are reducing exposure to bank loans. 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.
In the third quarter, the sleeve posted a loss of 0.57%, which ended ahead of the CBOE S&P 500 2% OTM Putwrite benchmark, which was down 1.49%. As of August 1, 2023, the portfolio adjusted its average option notional exposure from the strategic target of 85% S&P 500 Index and 15% Russell 2000 Index to 100% S&P 500 Index. Please see “A Note on Strategy Adjustments” at the end of this section for more details. Over the quarter, the collateral portfolio’s 1.05% return captured a majority of the ICE BofA 0-3M US T-Bill Index return of 1.32%. Year to date, the collateral portfolio has accumulated 2.71% versus the T-Bill Index return of 3.68%.
It appears that the ‘Goldilocks’ economic conditions investors enjoyed in the first half of the year have started to pack up and move out. In one of the most obvious ‘not if, but when’ market scenarios, US economic resilience (i.e., inflation) and the US Federal Reserve’s historic target rate increases seem to finally be taking its toll on financial market expectations. Just as the market rally to begin the year seems to have caught investors by surprise, so has the realization that a reversal of the 40-plus year downward trend in 30-year US Treasury yields may stick around longer than previous periods and may ultimately dent the seemingly invincible US consumer.
Losses in both equity and investment-grade fixed income markets made for a challenging quarter. Interest rates continued their charge higher with the 10-year US Treasury yield rising from around 3.5% at the start of the quarter to roughly 4.5% at the end. Hence, the Bloomberg US Aggregate Bond Index declined -3.23% and the S&P 500 Index (“S&P 500”) fell a similar -3.27% with interest rate sensitive equity market sectors like Utilities, Consumer, Materials, and Real Estate lagging on the quarter. Meanwhile, Energy and Telecom were the only two sectors with positive results. The tech-heavy NASDAQ-100 fared marginally better with a loss of -2.86%. While enthusiasm around AI remains high, some of its shine seems to have dimmed during the quarter.
US Treasury Markets
Short-term US Treasury returns were in line with their higher yields that are now in the 5.0% to 5.5% range. 0-3 Month US T-Bills posted a positive 1.32% while 1-2 Year US Treasuries gained 1.16%. Higher rates will continue to offer investors more income from their investment portfolios, which in turn may dampen portfolio volatility levels. At current levels, we expect collateral portfolios to provide yields of 4.5% to 5.5% with little duration risk (approximately one year).
Option Implied Volatility Indexes
As expected, implied volatility levels snapped back during August and September after hovering around 2023 lows during the summer months of June and July. While we emphasize the average level of the Cboe S&P 500 Volatility Index (“VIX”) as the barometer for the price of market risk, we also view its ‘sensitivity’ and forward futures prices as indicators of investor complacency levels. Looking at the third quarter jumps from the low teens to the high teens, we believe the market remains appropriately nervous about the risks that are evolving in the financial and geo-political worlds. For the quarter, the Cboe S&P 500 Volatility Index (“VIX”) rose 3.9pts yielding an average 30-day implied volatility premium of 3.8. On the year, VIX is down -4.2pts with an average 30-day implied volatility premium of 4.5.
A Note on Strategy Adjustments
During the third quarter, the sleeve adjusted its average option notional exposure from the strategic target of 85% S&P 500 Index and 15% Russell 2000 Index to 100% S&P 500 Index. We believe the US small-cap public equity universe is evolving into a less productive investment opportunity for several reasons, including:
- Private equity capital has grown to material levels over the last two decades.
- With increased demand to find investments, private investors are holding investments until they reach larger market capitalizations than they have in the past.
- New investment vehicles such as Special Acquisition Corporations (SPACs) acquire or merge with smaller companies that results in the companies’ dropping out of small-cap indexes.
- Some small-cap indexes are relatively concentrated in a few names.
- Retail investors can now influence smaller company prices and create ‘meme’ stocks that may have an outsized effect on small-cap index performance.
We believe the challenges facing public US small-cap equities have contributed to the erosion in the risk efficiency of a Russell 2000 Index PutWrite strategy relative to a S&P 500 Index PutWrite strategy. Hence, we have currently removed the Russell 2000 equity exposure from the portfolio. We believe this adjustment has the potential to result in a reduction in strategy volatility levels and an overall increased level of risk efficiency.
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 September 30, 2023
|Brown Brothers Harriman Credit Value Strategy
|Guggenheim Multi-Credit Strategy
|Neuberger Berman Option Income Strategy
|Equity Index Put Writing