The iMGP High Income Alternatives Fund declined 1.34% in the third quarter, finishing well ahead of the Bloomberg U.S. Aggregate Bond Index (Agg), which fell 4.75% but slightly behind high-yield bonds (BofA Merrill Lynch US High-Yield Index), which lost 0.68%. The fund performed directly in line with its Morningstar Nontraditional Bond category peer group. Year to date, the fund was down 9.08%, outperforming both the Agg and high-yield bonds, which lost 14.61% and 14.62%, respectively, while trailing its category peer group (down 7.93%).
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.
This year has been one of the most difficult investment environments in recent memory. The equity market (defined by the S&P 500 index) was down nearly 24% through September, while the Bloomberg U.S. Aggregate Index was down 14.6%, suffering its worst nine-month decline in its history.
Market volatility remained high across the bond and equity markets. Persistently high inflation resulted in many central banks around the world raising interest rates and reducing liquidity. To combat inflation here in the U.S., the Federal Reserve (the Fed) made its third 75 basis points rate hike in late September, lifting the Fed Funds rate to a range of 3.00% to 3.25%. This was the biggest three-month increase (225 basis points) in the Fed Funds Rate since the early 1980s. More hikes are expected through year-end as the Fed has voiced its intention to continue combating inflation.
Following the October 13th Consumer Price Index (CPI) release of 8.2%, Fed Funds futures (provided by CME Group) indicate a 95% probability that the Federal Reserve (“Fed”) will announce a fourth consecutive 75 basis point(“bps”) hike at the Fed’s early November meeting. The latest “Dot Plot,” which the Fed uses to illustrate its expectations for future Fed Funds rates, recently showed the key rate reaching a level between 4.25% and 5.00% in 2023, while one dovish prediction shows rates topping out at 3.75%-4%. For 2024, the dot plot shows a wide dispersion of forecasts ranging from 2.75% to 4.75%.
Looking at the real economy, the Fed has cut its economic growth forecast for 2022 through 2024 as it seeks to bring aggregate demand and supply back into better balance — reducing the demand side of equation via tight monetary policy. Inflation-adjusted gross domestic product (GDP) in 2022 is now anticipated to be 0.2% compared with the 1.8% the Fed predicted in June. The Fed expects next year’s real GDP growth to be 1.0% vs. the 1.7% projected in June. For 2024, economic growth is now forecasted at 1.7% vs. the 2.0% estimate issued in June. In addition to rate hikes, the Fed has implemented Quantitative Tightening allowing $30 billion of Treasuries and $17.5 billion of mortgage-backed bonds to mature monthly. Beginning in September those levels increased to $60 billion and $30 billion per month, respectively.
Looking ahead, inflation and Fed policy will continue to be major drivers of the bond market. This year, there have been meaningful changes to the U.S. Treasury Yield curve. The curve has moved higher, flattened, and certain parts of the curve have inverted. The curve has shifted higher as the Fed has raised rates, lifting the front end of the curve, and the longer maturities have adjusted accordingly. As for the shape of the curve, the yield curve typically has an upward slope meaning that investors require more yield for holding longer-term securities. An inversion occurs when shorter-term securities offer higher yields than longer-term securities. While seemingly odd, as there is no additional compensation for holding longer-term securities, inversions happen periodically. Usually this is due to short-term rates rising due to Fed rate hikes, while yields for longer-term maturities are impacted due to concerns that the Fed tightening policy may hurt the economy. Typically, curve inversions are brief, and are perceived as a reliable indication of recession.
Within the credit market, there seem to be two competing forces as uncertainty remains prevalent. On one hand, investors are attracted by today’s higher yields, but simultaneously, they are concerned about inflation, a still-hawkish Fed, and a recession, all of which could push yields higher and spreads wider. Indeed, yields in the credit market have increased meaningfully throughout the year and are at levels not seen in years. This environment has created attractive opportunities for our credit managers, who have selectively added risk exposure, while still exercising caution. Both credit managers’ portfolios were yielding close to 9.0% at the end of the third quarter with a duration of 2.3. 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).
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 equity market declines of the quarter. The strategy’s 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 upper 20% range at the end of the quarter. Additionally, materially higher yields on short-term Treasuries, while a detractor during the quarter as yields rose and prices declined, will provide a longer-term benefit to the option sleeve’s collateral return; the collateral portfolio yielded 3.9% at quarter end. (The weighted average duration of the collateral is less than 1 year.)
The High Income Alternatives fund reached its four-year anniversary at the end of the quarter. This time-frame has allowed the fund to demonstrate its advantages, and we think it is poised to potentially produce attractive risk-adjusted returns and income, while diversifying core bond exposure. Over the trailing one-, two-, three, and since-inception 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. Brown Brothers Harriman declined 0.33% and Guggenheim was down 1.41%. Both outperformed the Aggregate bond index (down 4.8%) significantly, with BBH also beating the high yield index (-0.7%). Neuberger Berman fell 1.96% compared to a 5.76% 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 BBH sleeve reported performance of -0.33% in the third quarter and -6.22% for the first nine months of 2022. BBH continues to outperform other intermediate fixed-income market alternatives this year. For example, the Bloomberg U.S. Aggregate Bond Index fell 4.75% this quarter and is down 14.61% year-to-date by comparison.
For the quarter, adverse interest rate movements were the main driver of negative performance across fixed income. Actions by the Federal Reserve and the more aggressive policy statements made late in the quarter accelerated the time frame for additional interest rate increases to combat persistent inflation. As a result, 2-Year and 10-Year Treasury note yields increased by 132 bps and 81 bps, respectively. These movements brought total interest rate increases for the first nine months of the year to 355 bps for the 2-Year Treasury note and 232 bps for the 10-year Treasury note. We continue to manage the sleeve at a 2-year duration to protect capital against potential further adverse rate moves.
In contrast to the sharp movements in interest rates, the reaction of credit spreads to concerns about Federal Reserve actions and a potential recession were fairly muted this quarter after spreads widening significantly in 2Q. Investment grade BBB-rated credit spreads were essentially unchanged from the end of the second quarter, and high yield BB-rated credit spreads actually tightened by 50 bps from the wide levels experienced at the end of the second quarter.
Whether we are headed for a mild economic slowdown or full recession, we remain confident in our current investments and, as always, stress-test all of our purchases. It is our expectation that default rates will continue to rise off the abnormally low levels of less than 2% per year experienced over the past few years towards a more normal annual level of 4-5%. The increase in default rates is already being priced into credit spreads. Our focus has always been on owning durable credits at attractive valuations that can perform across a wide range of potential economic outcomes.
The outlook for the U.S. economy remains negative. Headline real GDP growth numbers have been impacted by volatile foreign trade and inventories but underlying domestic demand has been consistently slowing this year and is now contracting. High inflation has driven consumer sentiment near 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 will fade as pent-up demand is exhausted. Business investment is also weakening due to the sharp tightening in financial conditions and a more challenging outlook for economic growth. The housing sector is also subtracting from GDP as the spike in mortgage rates has cratered demand.
We now expect both 2022 and 2023 will see negative real Gross Domestic Product (GNP) growth (Q4/Q4), with a high probability of a recession starting by mid-2023. The only bright spot for the economy has been the labor market, with labor demand far outpacing supply despite weakening economic growth. Given hiring difficulties over the past two years, companies may be reluctant to shed workers even as the economic outlook worsens, but a continuation of weak economic growth will eventually lead to higher unemployment.
Inflation has broadened out from goods impacted by supply chain snags to housing and the services sector. Moderation in goods prices should bring inflation lower over the next several months, but housing and services inflation will remain elevated amid the tight labor market, keeping inflation above the Fed’s comfort levels until mid-2023, at the earliest.
The Fed is aggressively tightening policy and won’t be deterred by recession. This aggressive posture is meant 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 take policy well into restrictive territory. We expect the fed funds rate will reach a terminal level slightly above 5% by the second quarter of 2023. The Fed is looking for “clear and convincing” evidence that inflation is coming down before scaling back on restrictive policy. This high bar means that not only will they need to see several months of cooler inflation readings, they will also need to a see a weaker labor market to ensure wage growth moderates and takes pressure off underlying inflation. 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. Fed policy is unlikely to pivot to rate cuts as quickly as in the past, even amid rising unemployment. We don’t expect the first cuts until the end of 2023.
Despite recession risk, fiscal stimulus is unlikely given inflation concerns. The likelihood of divided government after the midterm elections will result in policy gridlock.
As for the portfolio, we are turning more defensive but remaining opportunistic as the credit cycle reaches an inflection point. Corporate fundamentals remain solid with manageable debt service, but defaults and bankruptcies are gradually increasing. We expect more defaults in the next 6-12 months as the lagged effects of tightening financial conditions are felt. Weakening corporate earnings growth expectations have triggered a net downgrade cycle for corporate credit ratings. Corporate bond valuations reflect the challenging environment ahead with most sector spreads near or above their 60th percentile levels historically, but spreads may widen a bit further.
We continue to find attractive relative value in leveraged loans, high-yield corporates, and asset-backed securities. Fixed-income yields look compelling and spreads compensate for likely defaults in the next year.The Fed’s aggressive rate hike campaign should cause the yield curve to invert further. As the economic cycle rolls over next year, Treasury yields should see a significant decline.
In the third quarter of 2022, the sleeve was down approximately 2%, slightly besting the PutWrite Benchmark, which consists of 40% Cboe S&P 500 PutWrite Index and 60% ICE BofA 0-3M US Treasury Bill Index, loss of 2.42%.
The S&P 500 Index jumped 9.2% in July and fell 9.2% in September. Normally, August’s 4.1% decline would seem more significant were it not sandwiched between two months pushing double-digits. Non-US developed equity markets (MSCI EAFE Index) did enjoy the gains of July but found its way to an August loss of 4.7% and a September decline of 9.3%. Emerging markets (MSCI Emerging Markets Index) marched to their own beat, as they often do, with roughly flat returns for July (-0.2%) and August (+0.5%), saving an 11.7% fall for September. Overall, the three markets posted third quarter returns of -4.9% (S&P 500), -9.3% (MSCI EAFE), and -11.4% (MSCI EM), respectively. In September, the S&P 500 Index (“S&P 500”) capitulated -9.2%, the Cboe S&P 500 2% OTM PutWrite (“PUTY”) dropped -5.0%, and the Cboe Russell 2000 PutWrite (“PUTR”) fell -5.8%. Over the Quarter, the S&P 500, PUTY, and PUTR lost -4.9%, -5.8%, and -4.7%, respectively.
US Treasury Markets
As short-term rates continue to rise on the back of the Fed’s inflation flight, we continue to reset collateral portfolios at historically attractive short-term US Treasury rates: 2-Year US Treasury rates pushed above 4.0% during the quarter reaching levels not seen since the third quarter of 2007. Over the month, short-term US Treasury rates (3M US T-Bill) rose 35bps while the long-term rates (10Y US Treasury) were up 64bps. In conjunction, on the quarter, short-term US rates were up 160bps and 10Y US rates gained 82bps.
Option Implied Volatility Indexes
As expected, implied volatility levels responded in kind with the Cboe S&P 500 Volatility Index (“VIX”) rising above 31 for the first time since June. While VIX’s quarter-over-quarter increase was modest, the intra-quarter period included a 50% increase from August lows below 20. VIX futures markets ended the quarter relatively unchanged despite losses in equity markets and remain well above their long-term averages. Higher levels of implied volatility over the quarter adequately anticipated increased realized volatility which yielded a positive average S&P 500 implied volatility premium. For the quarter, the Cboe S&P 500 Volatility Index (“VIX”) rose 2.9 pts yielding an average 30-day implied volatility premium of 3.1. (Higher levels of implied volatility premium are better for the strategy.)
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, 2022
|Brown Brothers Harriman Credit Value Strategy|
|Guggenheim Multi-Credit Strategy|
|Neuberger Berman Option Income Strategy|
|Equity Index Put Writing||100%|