MINC: 4th Quarter 2022 Portfolio Review
The final quarter of 2022 saw a recurrence of negative macro themes that dominated this year: inflation, geopolitical tensions, China’s COVID policy, and an uncertain growth outlook. However, we may be starting to see the first signs of green shoots. Global central banks moved policy rates higher during the quarter amid consistent messaging on their efforts to return inflation levels to target. The market’s debate on central bank policy is now focused on the pace of rate increases, the ultimate terminal rate, and how long it stays at that level. A few bright spots of economic data released during the quarter – including U.S. CPI – implied inflation may have peaked, leading markets to expect friendlier central bank policy going forward. As a result, most risk assets have rebounded during the period.
Despite some signs of improvement in the inflation outlook, the Federal Reserve (Fed) and other major central banks maintained a hawkish tone. The Fed raised its main policy rate 125 basis points (bps) during the quarter in two jumbo moves of 75 bps and 50 bps. We end 2022 with the federal funds rate at 4.5% versus 0.25% when we began. The Fed continues to shrink its balance sheet in a well-telegraphed and substantially passive exercise, and we do not expect changes to this policy in the near term.
The European Central Bank (ECB) also raised its policy rate 125 bps over two meetings to end the year at 2.5% − 2022 saw the ECB’s first increases off zero since 2016. In addition to managing the start of its own balance sheet run-off, the ECB will have to manage the complex task of preventing financial fragmentation among its member countries. Though the Bank of Japan (BOJ) is still a relative dove given local economic conditions, it announced a change in its yield curve control that would permit a rise in the 10-year yield from 25 bps to 50 bps. Global central banking has a complicated task ahead, but we are confident in its ability to contain inflation and return price pressures to target over time.
Financial markets have begun to expect positive changes to monetary policy in 2023, and this was reflected in total returns during the period. The U.S. Treasury curve shifted higher on maturities inside of two years and longer than ten years, with yields in the belly of the curve declining: the 1-year Treasury yield increased 72 bps, the 5-year Treasury yield fell by 9 bps, the 10-year Treasury yield increased by 5 bps, and the 30-year Treasury yield moved 19 bps higher. Most spread sectors outperformed U.S. Treasuries with the shifting economic conditions.
Despite the quarter’s volatility, we see value being restored across most of the fixed income sectors in which we invest. We expect supply chains will heal over time and the Fed will be successful in returning inflation to acceptable levels. We continue to watch the economic data to inform our views on the possibility of recession. While our base case is still that any contraction would be mild, recession risks have risen.
As the markets digest global developments, we continue to believe active sector and issuer selection is critical to take advantage of market volatility as it arises. Our approach to fixed income – the approach we have implemented for close to three decades – enables us to scan the bond market for the most attractive investment opportunities and is ideally suited for the current environment.
Underweight to U.S. Treasuries
High Yield Bank Loans – Allocation and issue selection within high yield bank loans had a positive impact on performance. The Morningstar LSTA U.S. Leveraged Loan index gained early in the period, but sentiment weakened over the quarter as the Fed reiterated its firm commitment to fight inflation at the expense of economic growth. As investor angst increases around slowing growth and its impact on credit markets, our current up-in-quality position has performed well.
Corporate High Yield – Allocation and issue selection within corporate high yield had a positive impact on performance. A supportive technical environment, along with better-than-expected inflation data and third quarter earnings results, drove outperformance.
Corporate Investment Grade – Issue selection within corporate high quality had a positive impact on performance. Investment grade staged a rally in the quarter, clawing back nearly 4% of its YTD performance, though the sector still posted record annual losses. Yields, spreads, prices, and returns all pulled back from the tail end of the distribution on a confluence of favorable inflation data, resilient company earnings, and improving sentiment for the asset class.
Non-agency residential mortgage-backed securities (RMBS) – The Fund’s allocation to non-agency RMBS over agency mortgage-backed securities (MBS) had a negative impact on performance. Agency MBS outperformed as the market reacted positively to the softer-than-expected CPI report, causing a grab for yield during the month. The non-agency market lagged the broader agency MBS market move as money managers, the biggest buyer of non-agency RMBS, remained on the sidelines instead, tending to their fund redemptions. We continue to prefer non-agency residential exposure as credit performance is still stable, prepayments are muted, and spreads are still wide versus alternative fixed income sectors.
Asset-Backed Securities (ABS) – Allocation to ABS had a negative impact on performance during the quarter. The primary drivers were modest spread underperformance relative to most other fixed income sectors, and U.S. Treasury underperformance on the short end of the curve. The spread widening was due to some softening in consumer fundamentals. However, low unemployment and a high number of job openings mitigate the effects of higher rates on the consumer. Workers continued to benefit from wage gains, especially for the lower quintile of earners. Our emphasis continues to be on the front end of the yield curve, where we look to put dollars to work in investment grade amortizing assets and in deal structures that lead to de-leveraging.
Current Fund Strategy and Positioning
- Reduced exposure to corporate investment grade, RMBS, and corporate high yield.
- Increased exposure to U.S. Treasuries.
- In addition to changes to the Fund’s sector allocation, we continue to optimize positioning within sectors based on our view of the best relative value.
Emerging Market (EM) Debt and Non-U.S. Exposure: Our exposure was largely unchanged during the quarter, with high yield EM outperforming investment grade. While we feel as though USD strength has peaked, we have not yet added non-USD exposure to the Fund. Our exposure to EM has stayed at historically low levels.
Corporate Investment Grade: After declining more than 20% at the lows, the investment grade market rallied in the fourth quarter, with total returns of 3.63%. The full year total return of -15.76% is still the worst on record. Spreads rallied 25 bps up to the 130s, a level that hits the 75th percentile over a five-year range, but just 10 bps north of the five-year average. Yields are still at post-Global Financial Crisis (GFC) highs, though they compressed more than 80 bps off the YTD highs. As fundamentals improved throughout the post-COVID period and interest coverage levels stay at decade highs, we are constructive on the asset class. Higher rates will have minimal immediate impact to issuer fundamentals because the average maturity is over eleven years in length. We are overweight financials and commodities and find banks to be the most attractive industry. We are positioned with an overweight to the BBB segment of the market because we are constructive on the market’s fundamentals, and view fallen angel risk as broadly low.
Corporate High Yield: The high yield market rallied over 4% during the quarter as spreads tightened over 80 bps. Spreads rapidly tightened in October before becoming range-bound in November and December. Better-than-expected inflation data was the primary driver of the rally. Third quarter results also came in better than expected, and fundamentals are in a strong starting point ahead of this year’s projected slowdown in growth. Lastly, the technical environment has improved – issuance was light again for the quarter while fund flows improved, leading to a net negative supply. Investors are still cautious on CCC-rated bonds that appear cheap in the context of historical averages versus higher-quality parts of the market. However, we believe CCCs should trade cheap because of recession risks, and the meaningful downside that still exists from current levels. During the quarter, we trimmed exposure to corporate high yield as valuations tightened; we still view its downside risks as being greater than its upside potential at current valuations. Within the space, most purchases were via the new issue market, where concessions are still elevated. We trimmed some lower-quality energy exposure during the quarter following strong outperformance. Our allocation remains below our long-term average, and the mix within the sector is still up-in-quality, with a very small exposure to CCC-rated bonds.
Securitized: All securitized sectors saw positive returns, driven by the rate rally and tighter credit spreads. We still see yield opportunities not seen in many years. In the near term, low unemployment, strong consumer savings, and real wage growth suggest that the U.S. consumer will stay timely with its debt service payments. However, we are selective with our transactions, as we believe unemployment will tick higher, which may result in higher consumer delinquencies. We believe the risk/reward of higher quality, short duration securitized products is extremely attractive. Most securitized products we invest in are being scrutinized using the GFC as a measure, and our thesis continues to be driven by good fundamentals. On the mortgage side, delinquencies are at historical lows, with limited to no affordability products compared to the market in the last housing crisis. With higher mortgage rates and a subsequent fall in housing activity, we will see less supply for the new year. This should set up a favorable technical for the mortgage-backed securities market. As a result, our portfolios have an overweight to the sector.
|Security Description||Portfolio Weight %|
|US TREASURY N/B 0.125 8/31/2023||5.38%|
|US TREASURY N/B 4.25 9/30/2024||3.63%|
|US TREASURY N/B 0.625 12/31/2027||3.00%|
|CSMC 2021-NQM1 A1 FRN 5/25/2065||1.54%|
|VFI 2022-1A B 3.04 7/24/2028||1.28%|
|AQFIT 2020-AA B 2.79 7/17/2046||1.25%|
|DFS 2021-RTL1 A1 STEP-CPN 7/25/2027||1.21%|
|STAR 2021-1 A1 FRN 5/25/2065||1.20%|
|MSBAM 2013-C10 A4 FRN 7/15/2046||1.16%|
|HERTZ 2022-1A C 2.63 6/25/2026||1.11%|
As of 12.31.2022. Cash not included.
Our multi-sector relative value approach enables us to take advantage of opportunities when events that trigger volatility, such as inflation worries or the Russian invasion of Ukraine, affect valuations. In the current environment, we believe some of the best total return and yield opportunities can be found in spread sectors. However, given the increased risk of a recession, we have reduced some exposure to spread sectors that would typically be more negatively impacted, such as corporate high yield and bank loans. Credit selection and positioning remain key. Specific sectors that demonstrate the best relative value for us include:
- Out-of-index/off-the-run ABS
- Non-agency RMBS
- Corporate investment grade
The Fund maintains its higher quality focus and short duration to limit both spread and interest rate volatility. As always, we aim to stay diversified, maintain granular positions, and emphasize liquid investments.
Newfleet Asset Management
AdvisorShares Newfleet Multi-Sector Income ETF (MINC) Portfolio Manager
Past Manager Commentary
A 10-Year Treasury Note is a debt obligation issued by the United States government that matures in 10 years. A 10-year Treasury note pays interest at a fixed rate once every six months and pays the face value to the holder at maturity. An advantage of investing in 10-year Treasury notes, and other federal government securities, is that the interest payments are exempt from state and local income tax. However, they are still taxable at the federal level.
An Asset Backed Security is a financial security backed by a loan, lease or receivables against assets other than real estate and mortgage-backed securities. For investors, asset-backed securities are an alternative to investing in corporate debt.
A basis point is one hundredth of a percentage point (0.01%).
The Bloomberg Barclays Capital Aggregate Bond Index measures the performance of the U.S. investment grade bond market. One cannot invest directly in an index.
A Commercial Mortgage Backed Security is a type of mortgage-backed security that is secured by the loan on a commercial property. A CMBS can provide liquidity to real estate investors and to commercial lenders. As with other types of MBS, the increased use of CMBS can be attributable to the rapid rise in real estate prices over the years.
Correlation is a statistical measure of how two securities move in relation to each other.
Coupon is the interest rate stated on a bond when it’s issued. The coupon is typically paid semi-annually.
Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. Duration is expressed as a number of years. Rising interest rates mean falling bond prices, while declining interest rates mean rising bond prices.
Fundamentals are the qualitative and quantitative information that contributes to the economic well-being and the subsequent financial valuation of a company, security or currency. Analysts and investors analyze these fundamentals to develop an estimate as to whether the underlying asset is considered a worthwhile investment.
Investment Grade is a rating that indicates that a municipal or corporate bond has a relatively low risk of default. Bond rating firms, such as Standard & Poor’s, use different designations consisting of upper- and lower-case letters ‘A’ and ‘B’ to identify a bond’s credit quality rating. For example, ‘AAA’ and ‘AA’ (high credit quality) and ‘A’ and ‘BBB’ (medium credit quality) are considered investment grade. Credit ratings for bonds below these designations (‘BB’, ‘B’, ‘CCC’, etc.) are considered low credit quality (speculative), and are commonly referred to as “junk bonds.”
A Residential Mortgage-Backed Security is a type of mortgage-backed debt obligation whose cash flows come from residential debt, such as mortgages, home-equity loans and subprime mortgages. A residential mortgage-backed security is comprised of a pool of mortgage loans created by banks and other financial institutions. The cash flows from each of the pooled mortgages is packaged by a special purpose entity into classes and tranches, which then issues securities and can be purchased by investors.
Spread is the difference between the bid and the ask price of a security or asset.
Spread sectors include all non-Treasury investment grade sectors including federal agency securities, corporate bonds, asset-backed securities, mortgage-backed securities and commercial mortgage-backed securities.
Volatility is a statistical measure of the dispersion of returns for a given security or market index. Volatility can either be measured by using the standard deviation or variance between returns from that same security or market index. Commonly, the higher the volatility, the riskier the security.
Yield is the income return on an investment. This refers to the interest or dividends received from a security and is usually expressed annually as a percentage based on the investment’s cost, its current market value or its face value.
Before investing you should carefully consider the Fund’s investment objectives, risks, charges and expenses. This and other information is in the prospectus, a copy of which may be obtained by visiting www.advisorshares.com. Please read the prospectus carefully before you invest. Foreside Fund Services, LLC, distributor.
There is no guarantee that the Fund will achieve its investment objective. An investment in the Fund is subject to risk, including the possible loss of principal amount invested. The Fund’s investment in fixed income securities will change in value in response to interest rate changes and other factors, such as the perception of the issuer’s creditworthiness. Fixed income securities with longer maturities are subject to greater price shifts as a result of interest rate changes than fixed income securities with shorter maturities. The Fund’s investments in high-yield securities or “junk bonds” are subject to a greater risk of loss of income and principal than higher grade debt securities. Emerging and foreign market investments can be more volatile than U.S. securities and will expose the Fund to adverse changes in foreign economic, political, regulatory and currency exchange rates. See prospectus for details regarding specific risks.
Shares are bought and sold at market price (closing price) not NAV and are not individually redeemed from the Fund. Market price returns are based on the midpoint of the bid/ask spread at 4:00 pm Eastern Time (when NAV is normally determined), and do not represent the return you would receive if you traded at other times.
Holdings and allocations are subject to risks and change.
The views in this commentary are those of the portfolio manager and many not reflect his views on the date this material is distributed or any time thereafter. These views are intended to assist shareholders in understanding their investments and do not constitute investment advice.