The iMGP High Income Alternatives Fund declined 2.44% in the first quarter, outperforming both the Bloomberg Aggregate Bond Index (Agg), which fell 5.93%, and high-yield bonds (BofA Merrill Lynch US High-Yield Cash Pay Index), which posted a 4.51% loss. The fund also outperformed its Morningstar Nontraditional Bond category peer group, which fell 2.55%.
Performance quoted represents past performance and does not guarantee future results. 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 funds may be lower or higher than the performance quoted. To obtain standardized performance of the funds, and performance as of the most recently completed calendar month, please visit www.imgpfunds.com.
Over the past four decades, investors have benefited from the tailwind of falling interest rates, tame inflation, globalization, and for the most part, peace among world superpowers. In 2022, these trends reversed and suddenly markets were faced with rising rates, surging inflation, supply chain pressures, and war. In this environment, both stocks and bonds declined.
In prior commentaries, we noted that some investors may be unprepared for losses that could occur in asset classes that have traditionally been perceived as ‘safe.’ Indeed, the first quarter was historically bad for the bond market. In the month of March alone, U.S. Treasuries suffered their worst monthly performance since 2003 with the 10-year Treasury yield touching a three-year high of 2.49%. The increase was in part due to an increasingly hawkish Fed, which made its first interest-rate hike since 2018 and stated its commitment to fighting inflation. Headline inflation rose to 8.5% year over year in March, the highest level since 1982. Looking ahead, futures markets are now forecasting a fed funds rate of 2.75% or higher by year-end.
Indeed, there is much uncertainty in the world, and of course in financial markets. We believe this environment plays well for our two credit managers who have wide opportunity sets and flexible mandates, enabling them to better navigate interest-rate and credit cycles. The recent pullback is creating higher-yielding opportunities for our managers, who are selectively taking advantage of more attractive yields, while still maintaining caution. Both credit managers were yielding close to 5.5% at the end of the quarter with a low duration of approximately 2. We believe this higher yield, shorter duration combination is attractive relative to most fixed-income asset classes, especially given where we are in the interest-rate cycle. 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 first quarter, the High Income Alternatives fund had a 12-month distribution yield of 5.8% with a sub-2 duration. Specific to Neuberger Berman’s option strategy, it continues to play an important, complementary role in the fund. Currently, it’s providing high option income from still-elevated implied equity market volatility. The annualized yield can change fairly quickly due to the Neuberger’s laddered approach to portfolio construction, and was in the low to mid-teens (before any potential losses due to sharp, short-term index declines) at the end of the quarter. Additionally, materially higher yields on short-term Treasuries (the 1-Year Treasury yield increased by over 120bps during the quarter), while painful during the quarter, will provide a longer-term benefit to the option sleeve’s collateral return.
The passage of time has allowed the fund to demonstrate its advantages, and we think it is poised to continue producing attractive risk-adjusted returns and income, while diversifying core bond exposure. Over the trailing one-, two-, and three-year periods, the fund is ahead of both the high-yield and Aggregate bond benchmarks and has earned four stars in Morningstar’s Nontraditional bond category. We appreciate your continued confidence in the fund.
Quarterly Portfolio Commentary
Performance of Managers
During the quarter, the fund’s two credit managers outperformed the Aggregate Bond (down 5.93%) and high-yield bond (down 4.53%) benchmarks. Brown Brothers Harriman declined 1.52% and Guggenheim declined 3.58%. Neuberger Berman fell 1.40% compared to a 4.08% gain for the CBOE S&P500 2% OTM PutWrite benchmark. Specific to Neuberger’s recent underperformance, it is due to a combination of factors. First, the path dependency of the index worked largely in its favor relative to Neuberger’s active, diversified approach, as the dates of the index rolls coincided with fairly high levels of implied volatility (generating good levels of option income) but not significant drawdowns from the last roll date. Over time, we believe Neuberger’s approach of active diversification and risk management tend to work better and Neuberger has meaningfully outperformed since inception. But in any given month, quarter, or even year, a more concentrated, less-diversified, passive strategy can perform better. Additionally, despite maintaining a short duration of approximately one year, Neuberger’s collateral portfolio was a noticeable drag on performance due to the sharp increase in short term Treasury yields. Meanwhile, the index has its collateral in one-month T-bills. (All sub-advisor returns are net of the management fees that each sub-advisor charges the fund.)
Brown Brothers Harriman
The BBH sleeve reported a loss of 1.52% for the first quarter. We don’t like reporting any period with negative performance. However, this was arguably the worst-performing quarter for bonds in over 40 years. When the sleeve’s performance is viewed in this context, it becomes evident that our differentiated investment approach outperformed most fixed-income sectors or benchmarks.
Accelerating increases in U.S. interest rates, soaring energy prices, and the specter of a deepening global conflict weighed heavily on fixed-income returns in the first quarter. Turning to the credit markets, investment grade BBB-rated credit produced a 7.9% loss in the first quarter, while high-yield BB-rated credit produced a loss of 5.9%.
A large driving factor for the negative fixed-income performance this quarter was the sharp flattening of the yield curve as 2-Year and 10-Year Treasury bond yields rose 160bps and 83bps, respectively. Having just 2-years of duration in the sleeve was a significant buffer against this sharp rise in interest rates.
While interest rates were climbing, BBB- and BB-credit spreads also widened 26bps and 38ps, respectively. Credit spread widening was significantly greater mid-quarter before tightening towards the end of March.
During the quarter we continued to follow our time-tested investment process and leaned into the stress by slowly adding to both existing and new credits at these more attractive valuations. We expect these additions will be additive to future performance for the sleeve. It is during these extreme events that our disciplined bottom-up and valuation-focused credit process shines by producing this kind of differentiated performance result over credit cycles versus traditional fixed income benchmarks and our competitors.
Our U.S. economic outlook is for slower GDP growth in 2022, while inflation stays elevated. First quarter GDP is on track for a weak print due to temporary drags from trade and inventories. But underlying demand is growing at a solid pace; we expect 2.3% real GDP growth this year. While that rate is a step down from 2021, it is well above long-run potential growth of 1-1.5%, meaning the economy will continue to overheat.
Inflation has broadened out from goods impacted by supply chain snags to housing and other services. While inflation is near the peak on a year-over-year basis it will remain well above the Fed’s comfort levels given supply shocks from the war in Ukraine and Covid lockdowns in China, as well as high wage costs keeping pressure on services inflation. High inflation is weighing on real incomes and causing a sharp drop in consumer sentiment, creating a more subdued outlook for real GDP growth.
The Fed is aggressively tightening policy to try to rein in inflation. Given the historically tight labor market, public angst over inflation, and the continuation of inflationary supply shocks, the Fed is now racing to get policy to a more appropriate setting. We see a high likelihood that the Fed will raise rates by 50bps at each of the next three meetings, as they have referenced their desire to get policy back to a neutral setting “rapidly.” The Fed will also begin running off its balance sheet as soon as mid-May.
The Fed will need to keep hiking into restrictive territory, which means policy tightening to at least 3% (inclusive of balance sheet effects), if not higher. The Fed is aiming for a soft landing, where policy becomes restrictive to cool the economy and bring down inflation, followed by cutting rates back to a neutral stance to avoid cooling the economy too much.
Historically soft landings are rare, and the Fed’s attempt in this cycle will be complicated by high inflation, volatile macro data, and uncertain impacts of balance sheet runoff. These dynamics raise the risk of policy miscalibration and an eventual recession, though that is more of a concern for late 2023 or early 2024.
Solid corporate fundamentals underpin credit demand, but some caution is warranted, as cost pressures and supply imbalances caused by the war in Ukraine will affect industries unevenly. Revenue exposures to Europe and Asia will be prudent to monitor as well, given downgrades to growth expectations in those regions. Although leverage remains high, we believe debt service is manageable given the trajectory for corporate earnings. Floating rate sectors have been less volatile than fixed rate this year as investors position for the Fed tightening cycle. We are finding attractive relative value in floating rate structured credit and leveraged loans.
Domestic equity markets managed to claw back a portion of their losses in the final month of the quarter but remained in negative territory on the year. The Federal Reserve has set a course for an aggressive rate policy to fight inflation levels that haven’t been seen for a generation. Layer on low unemployment, large government deficits, a changing geopolitical landscape, shifting environmental and social priorities, and relatively high equity valuations and the odds of a ‘soft landing’ for equity markets seem incredibly low to us. In March, the S&P 500 Index (“S&P 500”) gained 3.71%, the Cboe S&P 500 2% OTM PutWrite (“PUTY”) was up 2.93%, and the Cboe Russell 2000 PutWrite (“PUTR”) rose 3.54%. Over the first quarter, the S&P 500 lost -4.60%, the PUTY climbed 4.08%, and the PUTR gained 0.43%.
Index Option Implied Volatility
The events of the first quarter certainly caught markets off guard and drove realized volatility levels higher. Yet, implied volatility levels were enough to weather the storm and remained flat to slightly positive. Despite volatility falling during March, we believe that inflation, or the fight against inflation, will continue to promote elevated levels of equity market volatility. In support of our views, the VIX futures markets seem to have a reasonable amount of skepticism about the future state of market volatility. While not quite as high as a year ago, longer dated VIX futures remain at levels well above their long-term averages. For the month, the Cboe S&P 500 Volatility Index (“VIX”) was down 9.6pts with an average 30-day implied volatility premium of 1.5. Similarly, the Cboe Russell 2000 Volatility Index (“RVX”) was down 7.7pts with an average implied volatility premium of 3.5. For the quarter, VIX rose 3.3pts yielding an average 30-day implied volatility premium of 2.2. Meanwhile, RVX rose 3.4pts resulting in an average implied volatility premium of 3.9.
Over the quarter, the sleeve posted a -1.48% return, which ended well below the PUTY’s return of 4.08% but exceeded the BB US HY’s return of -4.84%. The S&P 500 PutWrite component lost -1.38% and ended well below the PUTY return .of 4.08%, while Russell 2000 PutWrite component lost -1.74%, compared to the PUTR return of 0.43%.
At the end of last year, we suggested the real interest rate would be the most important stat of 2022, and inflation data and the US Fed’s comments have not disappointed. During March, the Federal Reserve initiated a rate hike of 25bps, which is expected to be the first of many for the year. Global central banks are now faced with the dilemma of whether to combat inflation or support global growth as Russia’s invasion of Ukraine intensifies and continues to have widespread effects. For now, inflation remains the priority. Over the month, short-term US Treasury rates (3M US T-Bill) rose 19bps while the long-term rates (10Y US Treasury) were up 51bps. Concurrently, on the quarter, short-term US rates were up 45bps and 10Y US rates gained 83bps. For the month, the Collateral Portfolio dropped -0.49%, lagging the ICE BofA 0-3M US T-Bill Index (“T-Bill Index”) return of 0.02% by -51bps. Over the quarter, the Collateral Portfolio’s -0.95% return lost more than the T-Bill Index return of 0.03% by -98bps.
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 March 31, 2022
|Brown Brothers Harriman Credit Value Strategy|
|Guggenheim Multi-Credit Strategy|
|Neuberger Berman Option Income Strategy|
|Equity Index Put Writing||100%|