MINC: 2nd Quarter 2022 Portfolio Review
Global central banks intensified their fight with inflation during the quarter, signaling they will remain vigilant until inflation objectives are met. This backdrop clouded the outlook for global and regional economic growth, resulting in negative total returns for most assets. The pandemic remains a global issue, with China’s zero-COVID policy continuing to delay the normalization of supply chains. Meanwhile, the war between Russia and Ukraine is an ongoing economic shock to food and energy prices. These unresolved issues make economic forecasting and modeling a challenge and will likely contribute to a volatile investing environment for the next several quarters.
The Federal Reserve (Fed) and other major central banks shifted to a more hawkish tone in response to elevated inflation metrics. The Fed raised its main policy rate 125 basis points (bps) during the quarter and indicated its resolve to restore price stability while relying on economic data to form future policy action. The Fed has also begun to shrink its $8.9 trillion-dollar balance sheet in what we expect to be a largely passive exercise. As the European Central Bank is also poised to signal interest rate increases and its own balance sheet run-off, it will have to manage the complex task of preventing financial fragmentation among its member countries. The Bank of Japan remains a relative dove given local economic conditions, but it remains to be seen how much Yen weakness will be tolerated, given the policy divergences. Global central banking has a complicated task ahead.
Financial markets have priced in significant changes to the economic and earnings landscape during the quarter, as shown by total returns. The U.S. Treasury curve shifted higher: the 5-year Treasury yield jumped up 58 bps, the 10-year Treasury yield went up by 68 bps, and the 30-year Treasury yield moved 74 bps higher. Most spread sectors underperformed 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. It is our expectation that 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 remains 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.
Asset-Backed Securities (ABS) — Allocation to the ABS sector had a positive impact on performance during the quarter. The sector benefited from demand for shorter duration assets and strength in the U.S. consumer. Securitized product continued to soften from a credit spread perspective, primarily driven by inflation and global macro concerns. Due to the fundamental backdrop, we remain positive on the U.S. consumer, though recent sentiment is showing signs of weakness. Inflation continues to chip away at purchasing power short term, but real wage growth is a positive, particularly for the lower quintile consumer.
High Yield Bank Loans Issue Selection — Issue selection and positioning within the high yield bank loan sector had a positive impact on performance. The higher quality focus of the bank loans in the Fund benefited performance as BB risk continued to outperform lower quality cohorts. Loans held in relatively well as shorter duration asset classes generally outperformed in the face of persistently high inflation, increasing hawkish rhetoric from the Fed, and rising U.S. Treasury yields. After 17 months of inflows, demand for the asset class turned negative, driven by elevated growth concerns. The net forward calendar remains manageable.
Non-agency residential mortgage-backed securities (RMBS) — The Fund’s allocation to the non-agency RMBS sector over agency mortgage-backed securities (MBS) had a positive impact on performance during the quarter. We continue to see the tailwinds of limited supply and judiciously offered mortgage credit, and unlike agency MBS, non-agency RMBS offers direct exposure to real estate and mortgage credit. However, record-setting housing values and sharply higher mortgage rates bring about future affordability questions.
Underweight to U.S Treasuries
Corporate High Yield Securities — Allocation to the corporate high yield sector had a negative impact on performance. Factors that have plagued the high yield market for the last few months persist: the war in Ukraine rages on, supply chain issues persist, and U.S. Treasury yields continued to rise as the market tries to handicap the levers the FOMC will pull to quell inflation. Fundamentals within the sector, while weakening, are holding strong as headwinds from supply chain issues, labor inflation and slowing growth persist, resulting in margin erosion. Despite another quarter of outflows, a muted primary market coupled with few fallen angels created a supply shortfall.
Current Fund Strategy and Positioning
- Reduced exposure to high yield bank loans and corporate high yield securities.
- Increased exposure to U.S. Treasuries, RMBS, and ABS.
- In addition to changes to the Fund’s sector allocation during the quarter, we continue to optimize positioning within sectors based on our view of the best relative value.
EM Debt and Non-U.S. Exposure: The Fund’s EM allocation remains at historical lows. Volatility in global markets, rising inflation in many EM countries, and tighter monetary policies support our minimal allocation. The Fed’s rate hikes further rattled jittery markets and raised fears about a recession in the near future. Spreads on the EMBI Global are 113 bps wider, with investment grade names 34 bps wider and HY names nearly 260 bps wider. We continue to maintain our preference for hard currency debt and have no local currency exposure in the Fund.
Investment Grade (IG) Corporates: Total returns were worse than -7% for the second consecutive quarter to open 2022, bringing total returns near -15% in one of the worst stretches on record for the market. Companies started to deploy excess cash in the second quarter to repurchase beaten-up shares, but fortunately this shareholder-friendly activity has been more prevalent for the highest ratings tiers, while riskier IG credits have been more conservative. Earnings estimates for 2022 have risen over this year and sit north of 10% currently, though there is considerable angst that estimates are too high, and we find such estimates often lag behind changes in the economy. We are currently overweight commodity sectors and financials as we believe they are best positioned for a higher-rate environment. We are positioned with an overweight to the BBB segment of the market and favor taking part in the new issue market as its concessions remain at extreme levels.
Corporate High Yield: High yield had a terrible quarter as a combination of widening spreads and higher Treasury yields drove the index return to -10%. While credit fundamentals have been improving, these metrics have likely peaked, with margins already showing deterioration in the first quarter. The technical picture remains negative as retail funds continue to see significant outflows ($33 billion year-to-date). However, this has been somewhat offset by supply as issuance remains muted with just $68 billion issued this year. During the quarter, we reduced both absolute exposure to and risk within high yield as we felt spreads were not compensating for recession risk, as recessionary periods generally see high yield spreads north of 800 basis points. Trades during the quarter trimmed risk to the consumer via reductions in cruise line and airline industries, to Europe via a packaging firm sale, and to an issuer with possible refinancing risk. Purchases were focused on high quality energy and metals firms where we still have a favorable outlook, despite an overall more negative macro view.
Securitized: All securitized sectors saw negative returns as the market reacted to the Fed’s monetary tightening. The upside going into the second half of 2022 is that we see yield opportunities that have not been seen in many years. We are still constructive on both short duration credit backed by the U.S. consumer, and mortgage credit. We feel the risk/reward of higher quality securitized products is attractive. Most securitized products we invest in are being scrutinized using the Great Financial Crisis as a measure, and our thesis continues to be driven by good fundamentals. Low unemployment (3.6%), strong consumer excess savings, and real wage growth – especially for the lower quintile borrower – are all signs that the U.S. consumer will stay timely with its debt service payments. On the mortgage side, delinquencies are at historical lows, with limited to no affordable products compared to the market in the last housing crisis. With mortgage rates much higher, we expect a significant drop in activity leading to less supply for the back half of the year. This technical should allow credit spreads to respond favorably as we end the year. As a result, our portfolios have an overweight to the sector.
|Security Description||Portfolio Weight %|
|US TREASURY N/B 0.125 3/31/2023||2.63%|
|US TREASURY N/B 1 12/15/2024||1.68%|
|US TREASURY N/B 2.5 4/30/2024||1.66%|
|BX 2018-GW B FRN 5/15/2035||0.81%|
|EART 2019-2A E 4.68 5/15/2026||0.79%|
|CMLTI 2019-RP1 A1 FRN 1/25/2066||0.73%|
|TPMT 2018-6 A1A FRN 3/25/2058||0.72%|
|BANK OF AMERICA CORP 1.734 7/22/2027||0.67%|
|PRPM 2021-RPL1 A1 STEP-CPN 7/25/2051||0.66%|
|CSMC 2021-RPL3 A1 FRN 1/25/2060||0.63%|
As of 06.30.2022. 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
- BBB-rated 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