MINC: 2nd Quarter 2021 Portfolio Manager Review
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The world continued to make progress against the COVID-19 pandemic during the second quarter as vaccine distribution broadened, not only geographically, but also among differing age groups. While financial markets arguably recognized these improvements were coming months ago, the signs of returning toward a pre-pandemic normal were welcome, nonetheless. Global economic activity expanded, corporate earnings forecasts improved, and the debate on the implications for inflation dominated market commentary and, at times, market direction. The broad improvements in activity have led some to question the need and size for additional fiscal stimulus from the new administration, while narrow majorities in Congress suggest difficult negotiations lie ahead.
The economic recovery remains on track and the Federal Reserve (Fed) has laid the groundwork to begin removing some of the extraordinary support it provided during the worst of the pandemic. It’s our expectation that the Fed will continue to moderate its support and announce a tapering of its asset purchase program in the second half of the year, most likely in August or September. The Fed remains committed to its communication strategy and has no desire to tighten financial conditions; and while a tapering should not be unexpected by financial markets, it’s possible that there is a knee jerk reaction that we expect would be short lived. Regarding inflation, we believe that base effects related to the disruptions of early 2020 and global supply chain issues will continue to lead to elevated inflation readings in the coming months but expect those data points to prove transitory and likely to fade over the course of 2022. Secular developments in technology and the effects of globalization continue to help keep prices contained and cyclical components, such as unemployment and broad resource slack, will help cap inflationary pressures as well. It is our expectation that policymakers globally will remain supportive of a continued economic recovery.
The FOMC left its target rate for Fed Funds unchanged at a range of 0-0.25%, the rate that was set in late March 2020 in response to the pandemic. The Fed completed a policy review in 3Q 2020 that resulted in the adoption of average inflation targeting. The policymakers are looking for inflation to average 2% over time. Despite the recent uptick in inflation due to transitory factors, persistent shortfalls versus the target suggest that the FOMC will be willing to allow periods of inflation above 2% to achieve their objective. This supports our view that policy rates are likely to stay lower for longer, as long as economic conditions warrant. During the quarter, U.S. Treasury rates increased marginally on the front end of the curve (3-years maturity and less) and decreased throughout the belly and the long end.
Financial markets generated mostly positive returns during the quarter, and we are continuing to find attractive investment opportunities across the many sectors of the bond market. We believe sector and issuer selection in this environment is critical and favors active over passive management. We expect elevated cash levels and a high degree of personal savings will be a tailwind to growth in the coming quarters. We continue to take advantage of periods of market volatility consistent with the same multi-sector investment approach we’ve implemented for close to three decades.
- Underweight U.S. Treasury and agency mortgage-backed securities (MBS), overweight spread sectors.
- Allocation to corporate high yield (HY) sector – the continuing economic recovery, strong Q1 earnings, and a rally in U.S. Treasury yields all contributed to a strong HY market. Fundamentals within the sector continue to improve with earnings exceeding expectations, upgrade/downgrade ratios rising, and default rates dropping.
- Issue selection within non-agency mortgage backed securities had a positive impact on the fund. Historically low mortgage rates, pandemic-related demand, and limited housing inventory continue as tailwinds for residential real estate.
- Allocation to asset backed securities (ABS) detracted, although the impact was partially offset by positive issue selection. Securitized credit delivered positive total and excess returns across almost all sectors, as rates rallied and spreads continued to grind tighter; however, ABS lagged more rate-sensitive sectors during the quarter. The U.S. consumer continues to perform extremely well as the ability to service debts remains strong, driven by the stimulus programs put in place, low rates, and access to credit. Technicals across securitized product remain favorable with new issue deal flow being met with insatiable demand.
- Underweight to corporate high-quality sector detracted – stabilization in rates brought calm to the sector and spreads have tightened back to their 15-year lows. The fundamental and technical environments are benign, making valuations the pain point.
Sector Changes: We reduced exposure to asset backed securities and corporate high yield, while increasing exposure to U.S. Treasuries and high yield bank loans.
Emerging Market (EM) debt and non-U.S. exposure: Over the quarter the overall non-U.S. exposure within the Fund remained relatively unchanged. Total non-U.S. exposure remains well below historical averages. This is due primarily to rich valuations as well as greater COVID-driven hits to economic activity in EM economies than developed economies. We continue to evaluate an optimal country mix and trade up in liquidity. We continue to favor sovereigns in larger capital structures and prefer hard currency over local market exposure.
Investment Grade (IG) Corporates: Spreads ended Q2 at a 15-year low; with duration at 8.6 vs. 5.75 in 2005, spread per unit of duration is about as low as it has ever been in the IG market. Rates, which spiked in Q1, were generally range-bound to moving lower throughout Q2. This encouraged foreign buyers to increase purchases, as the hedged pickup to global alternatives was highly attractive. Mutual fund flows have remained steadily positive throughout the rate volatility. Fundamentals are encouraging with consensus forecasts calling for full year sales and earnings growth of 12% and 35%, respectively. Valuations remain the constraining factor for the asset class and with spreads at all-time lows (duration adjusted) it is hard to be very bullish, especially given the rate sensitivity. We continue to steadily reduce exposure, though there are still areas within the BBB credit segment of the market, often in Covid-sensitive industries, where we see a little more room to run. The Fund remains overweight in these areas. Some of the industries the Fund is overweight include metals and mining, REITS, and life insurance.
Corporate High Yield: Performed strongly during the quarter with a 2.7% return. Spreads tightened 42 bps to a new post-financial crisis low of 269 bps. Lower credit quality continued to outperform—CCCs up 3.5% in Q2 with distressed energy names performing especially well given the strong oil price environment. The decline in risk-free rates also led BBs to outperform on a total return basis during the quarter (+2.8%). Performance across industries was generally consistent with a re-opening trade, as energy (excluding refining), metals & mining, retailers, automotive, and airlines outperformed. Underperformers were more idiosyncratic. The worst performers were pharmaceuticals, refining, and electric utilities. Supply was heavy again during Q2 at $135 billion, setting a record for the first half at $284 billion. Despite consistent retail outflows, institutional demand has been strong, which supported wide open capital markets. Fundamentals have improved dramatically, and defaults have dropped rapidly, with some banks now forecasting sub 1% default rates for the full year. While we maintain a positive view on the space, we felt it prudent to start to trim some exposure.
Securitized: We continue to emphasize the U.S. consumer and housing with respect to the securitized sectors. We have a significant overweight to agency backed securities (ABS) and non-agency residential mortgage-backed securities (RMBS). Over the past quarter, unemployment continued to trend lower (5.8%) and the current number of job openings sits just north of 8 million. Consumer confidence continues to trend higher and is back to 2019 levels. Lastly, households are sitting on $3 trillion of excess cash that, if deployed into the broader economy, will continue to drive growth and asset appreciation. With respect to housing, we also continue to see the tailwinds of low mortgage rates and limited supply. Housing also benefits from positive secular changes as more demand has been created from the pandemic. Unlike agency mortgage backed securities (MBS), non-agency RMBS offer direct exposure to real estate and mortgage credit.
|Security Description||Portfolio Weight %|
|US TREASURY N/B 0.375 12/31/2025||2.31%|
|AESOP 2021-1A A 1.38 8/20/2027||1.09%|
|CSMC 2021-NQM1 A1 FRN 5/25/2065||0.94%|
|XROAD 2021-A A2 0.82 3/20/2024||0.93%|
|EART 2021-1A C 0.74 1/15/2026||0.93%|
|CMLTI 2019-RP1 A1 FRN 1/25/2066||0.93%|
|BANK OF AMERICA CORP 1.734 7/22/2027||0.79%|
|NRZT 2017-2A A3 FRN 3/25/2057||0.79%|
|STAR 2020-3 A1 FRN 4/25/2065||0.74%|
|MORGAN STANLEY FRN 10/24/2023||0.73%|
As of 06.30.2021. Cash not included.
As always, we believe it is important to stay diversified, have granular positions, and emphasize liquid investments. COVID-19, like other events that trigger volatility in the market, can affect valuations and create opportunities that we can take advantage of while 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. Even with the recovery since the end of March, we remained focused on credits that would benefit from a continued economic recovery. We believe some of the best total return and yield opportunities in fixed income can be found in spread sectors. Some of the specific sectors where we are finding the best relative value opportunities include off the run ABS, non-agency RMBS, bank loans, corporate high yield, and BBB rated investment grade corporates.
Newfleet Asset Management
AdvisorShares Newfleet Multi-Sector Income ETF (MINC) Portfolio Manager
Past Manager Commentary