MINC: June 2020 Portfolio Manager Review
Performance data quoted represents past performance and is no guarantee of future results. Current performance may be lower or higher than the performance data quoted. Investment return and principal value will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than original cost. Returns less than one year are not annualized. For the fund’s most recent standardized and month-end performance, please click www.advisorshares.com/etfs/minc.
The second quarter of 2020 witnessed an unprecedented global monetary and fiscal policy response to combat the most severe economic disruption since the Global Financial Crisis of 2008-2009 due to the COVID-19 pandemic. Policymakers responded forcefully with a series of maneuvers to restore function to financial markets and shield citizens from serious hardship as a result of the abrupt stop in economic activity. Programs were designed to support the newly unemployed, businesses of all sizes, states and municipalities, and several areas of the securitization markets. The ultimate human and economic toll is not yet known. However, our expectation remains that policymakers will fine-tune their response as warranted.
Stay-at-home orders and mandated business closings proved unambiguously damaging for local, regional, and global economic growth during the quarter; near-term corporate earnings results are likely to be negative. We are optimistic, however, that the trough in economic activity and corporate earnings will occur in the second quarter with a rebound in the second half of the year and into 2021. Progress has been made in restarting parts of the economy around the country and activity is rebounding, though a second disruptive shutdown remains a concern. Financial markets have reacted positively to the monetary and fiscal policy response, rebound in economic activity, and attractive valuations by moving aggressively higher during the period. We believe elevated cash levels and a high degree of personal savings will be a tailwind to growth in the coming quarters as everyone adjusts to a near-term new normal.
Spread sectors outperformed U.S. Treasuries during the quarter led by higher beta sectors such as corporate high yield, high yield bank loans, and emerging market (EM) debt. Within most sectors (with the exception of high yield), lower quality and longer duration outperformed. Corporate credit outperformed securitized sectors such as commercial mortgage-backed securities (CMBS), non-agency residential mortgage-backed securities (RMBS), and asset-backed securities (ABS).
We continue to see value in spread sectors. While there is no doubt that COVID-19 will prove disruptive to economies in the near term, we are confident that the crisis will be resolved with time. Our multi-sector approach to fixed income investing enables us to scan the bond market for the most attractive investment opportunities wherever they may be and is ideally suited for the current environment.
- Underweight U.S. Treasury and agency mortgage-backed securities and overweight spread sectors.
- Allocation to, and issue selection within, non-agency RMBS and ABS. Securitized sectors, like most credit sectors, experienced a strong recovery. Stimulus programs have kept consumers in better shape than initially feared as furloughed employees return to work. For many, stay-at-home orders have dramatically increased the intrinsic value of residential real estate. In addition, subscription levels have far exceeded pre-COVID-19 levels as investors have cash that needs to get to work.
- Allocation to the corporate high yield sector. The recovery in corporate high yield bonds extended through the quarter as easing restrictions and additional policy support reinforced expectations that global activity has bottomed and will recover. The high yield asset class saw robust inflows as well.
- Issue selection within investment grade corporate bonds. In the space, fund flows returned to positive territory, foreign demand picked up, and the Fed’s intervention has introduced a large buyer to the market.
- Issue selection and positioning within high yield bank loans and corporate high yield. While allocations to the sectors were beneficial, issue selection within both sectors was a detractor relative to benchmark performance.
Sector Changes: We reduced exposure to cash, non-agency RMBS, ABS, and CMBS. We increased exposure primarily to corporate high yield, high yield bank loans, and U.S. Treasuries.
Non-U.S. Exposure: Overall non-U.S. and EM debt exposure is relatively unchanged from last quarter. Given the global spread of COVID-19 and downward revisions to global growth, we have shifted our EM bias from buy to hold as we continue to evaluate an optimal country mix and trade up in liquidity. We are using this volatile and uncertain time in the markets to look for names we believe are undervalued yet can sustain the current macro backdrop. We continue to favor sovereigns in larger capital structures and emphasize high grade over high yield (though the high yield component has increased over the quarter where returns had lagged) and hard currency over local market exposure.
Corporate High Quality: Spreads within the sector retraced 80% of their first quarter widening. With the Fed serving as a backstop and incremental buyer of securities, the market completely opened up with second quarter issuance the highest on record with gross supply of $834 billion. The rating agencies, which have downgraded over $100 billion of securities to the high yield market, have paused their downgrade activity and appear to be giving issuers the time required to adjust to the new environment. We believe the Fed stepping in to eliminate a disorderly downgrade cycle fundamentally changes the equation for the high quality sector and we feel comfortable adding to risk positions in this sector. While we continue to favor BBB issuers, we are finding ratings to be less relevant amid the turmoil. Opportunities are materializing across the board and we are targeting names with strong liquidity, resilient earnings, and high free cash flows. While we are generally industry agnostic in this environment, the portfolio remains positioned with a heavy banking component and a quickly growing utility exposure.
Corporate High Yield: The market had a particularly strong quarter as a result of fiscal and monetary policy stimulus plus attractive valuations. While dispersion in valuations has been reduced, the market still remains bifurcated between names exposed to COVID and those that are not. We were very active in the new issue market given attractive new issue concessions and valuations, adding names both in industries that are exposed to COVID and those that are not. For COVID-exposed names, we generally targeted names with significant liquidity and/or had security attached to the bonds. We also increased exposure to energy, although generally in lower-risk parts of the industry such as midstream and refining rather than highly leveraged oil and gas producers. The Fund remains underweight energy in both aggregate exposure and riskiness of those exposures relative the corporate high yield index.
Securitized Product:. The recovery in the securitized sectors was driven by the swift and large actions of the Fed coupled with fiscal stimulus plans directly aimed to benefit consumers. However, not all components of the securitized space had a direct benefit. This allowed us to use the volatility to take advantage of dislocations due to the lack of a direct response from the Fed. This included sub-prime auto ABS and all non-agency RMBS. Valuations were attractive throughout most of the quarter as prices lagged the quick turnaround of investment grade corporate bonds. Many of the securities we own are first or second pay, meaning we receive all cash on a prioritized basis versus other classes in the deals. The securitized product component of the portfolio continues to offer a significant yield pickup to comparable U.S. Treasury securities. The portfolio is diversified by asset type, obligor, and geographic region. It is of higher quality and short term in nature.
|Security Description||Portfolio Weight %|
|US TREASURY N/B 1.75 6/15/2022||2.94%|
|US TREASURY N/B 0.125 5/31/2022||1.92%|
|US TREASURY N/B 2.25 3/31/2021||1.55%|
|ISHARES IBOXX HIGH YLD CORP||1.16%|
|BX 2018-GW B FRN 5/15/2035||1.13%|
|FN MA3692 3.5 7/1/2049||0.87%|
|TMCAT 2018-AA B 3.45 11/15/2024||0.85%|
|US TREASURY N/B 0.5 3/31/2025||0.80%|
|GCAT 2019-NQM1 A1 STEP-CPN 2/25/2059||0.80%|
|MORGAN STANLEY FRN 10/24/2023||0.78%|
As of 06.30.2020. Cash not included.
As always, we believe it is important to stay diversified, have granular positions, and emphasize liquid investments. The coronavirus, like other events that trigger volatility in the market, can affect valuations and create opportunities that we can take advantage of in the course of implementing our multi-sector relative value approach. We highlight the importance of credit selection and positioning in the current environment. Given the widening in spreads late in the first quarter of 2020, valuations had cheapened substantially and we continue to identify opportunities in spread sectors, including those within non-investment grade sectors that we have added to and may continue to add to in the portfolios. Even with the recovery since the end of March, valuations look attractive in many spread sectors that we believe offer some of the best total return and yield opportunities in fixed income. Some of the specific sectors where we are finding the best relative value opportunities are corporate high yield, investment grade corporates, EM debt, out-of-index/off-the-run ABS, and non-agency RMBS.