MINC: 1st Quarter 2021 Portfolio Manager Review
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The first quarter brought bursts of optimism as the world continued its uneven recovery from the COVID-19 pandemic and the economic lockdowns that dominated 2020. Tremendous progress in the development of a vaccine and a thus far effective delivery system of administering doses to a meaningful proportion of the population have put the U.S. on a path to normalcy. During the quarter, some of the uncertainties in domestic politics were resolved as the new administration accomplished the much anticipated next round of fiscal stimulus to keep the economic recovery on track. The $1.9 trillion American Rescue Plan Act was signed into law on March 11 and delivered another round of direct payments to individuals, enhanced unemployment benefits, and aid to states. Further stimulus measures may take shape in the months ahead as political dialogue turns toward infrastructure.
Markets have shifted their focus to the implications for the future, which included some rotation in U.S. equity markets and a renewed debate on the global outlook for inflation. We believe that base effects related to last year’s disruptions will lead to elevated inflation readings in the near term, but we expect those data points will be transitory and likely to fade into the second half of the year. 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. This view is reinforced by a U.S. Federal Reserve that remains dovish and committed to keeping policy accommodation in place until it achieves its mandates on both inflation and employment. We believe that policymakers globally will remain supportive of continued economic recovery.
In our view, economic activity and corporate earnings will continue to rebound over the course of the year. Financial markets were mixed during the quarter. We believe sector and issuer selection in this environment is critical and favors active over passive management. Elevated cash levels and a high degree of personal savings will be a tailwind to growth.
Most spread sectors outperformed U.S. Treasuries during the quarter led by those with less interest rate sensitivity such as corporate high yield, bank loans, and securitized product. While there was no clear performance trend between rating tiers, there were notable exceptions within high yield, bank loans, and most securitized sectors, where lower quality generally outperformed. Shorter duration also outperformed.
We continue to see value in spread sectors. While the pandemic has proven disruptive to economies, we have seen a robust response from policymakers and signs of a return to normalcy. 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, the asset-backed security (ABS) sector. Demand for short duration assets persisted throughout the quarter as interest rates increased during the period. The U.S. consumer continues to perform extremely well. Technicals across securitized product remain extremely favorable with new issue deal flow being met with insatiable demand.
- Allocation to the high yield bank loan sector. The sector benefited from the steepening interest rate curve and additional stimulus. The technical picture remains supportive as a combination of collateralized loan obligation (CLO) issuance and positive retail fund flows provided sufficient demand for new issuance net of repayments.
- Allocation to the corporate high yield sector. While all of the factors remain in place for a continued rally in high yield – vaccine availability, a supportive Fed, economic recovery, and stimulus – rising U.S. interest rates remain a hurdle. Fourth quarter earnings releases remain strong.
- Issue selection and the higher quality positioning within high yield bank loans. While allocation to the sector was beneficial, issue selection was a detractor relative to performance versus the index as lower quality within the sector outperformed.
Sector Changes: We reduced exposure to U.S. Treasuries and corporate high quality securities. We increased exposure to high yield bank loans, non-agency residential mortgage-backed securities (RMBS), and ABS.
Non-U.S. Exposure: We reduced the overall EM debt and non-U.S. exposure. During the quarter, EM debt returns were primarily U.S. Treasury rate driven. EM high yield, having a higher spread/carry, outperformed the investment grade component of the sector, which has more sensitivity to interest rates. We continue to favor sovereigns in larger capital structures and prefer hard currency over local market exposure.
Corporate High Quality: An 83 bps move higher in the 10-year Treasury rate, combined with a duration of 8.5 years, meant a difficult start to the year for the asset class. There simply was not enough initial spread to offset the rate move. Spreads were essentially flat quarter-over-quarter at +97 bps, thus remaining 30 bps through longer-term averages. Rate volatility caused a reduction in mutual fund inflows (though still surprisingly positive) and likely spooked foreign buyers as well. Supply, meanwhile, was equivalent to last year’s record pace as issuers continued to opportunistically tap the new issue markets. Fundamentals are the bright spot with strong fourth quarter earnings and a robust outlook (consensus earnings growth for 2021 is 25%). Valuations remain constrained and the asset class is highly sensitive to rates. We have steadily reduced exposure, though we still see attractive opportunities within the BBB segment of the market, often in the more COVID-19-sensitive industries.
Corporate High Yield: The corporate high yield market continued its post-vaccine rally into 2021. However, index returns peaked in mid-February and gave up half the gains in the second half of the quarter as rising risk-free rates cut into returns and offset carry income. Lower quality bonds continued to outperform, led by CCCs – a result of high spreads that grinded tighter and limited interest rate risk. With the sustained rally in crude prices, energy was the largest outperformer during the quarter while other COVID-19-impacted sectors such as airlines, aerospace & defense, and leisure also outperformed. Fundamentals remain at very poor levels in terms of leverage but liquidity positions are strong given high levels of cash on balance sheets. The outlook is favorable given expected earnings growth. We continue to view high yield constructively given the yield, lower interest rate risk, and economic expansion, despite spreads appearing rich relative to history and yields near all-time lows. We have maintained a meaningful allocation to the sector and have added to wider-trading industries such as energy, airlines, and cruise lines.
Securitized Product: We have positioned our securitized book of business to reflect the two areas of the economy where the fundamentals are strong – the U.S. consumer and housing. We have a significant overweight to ABS and non-agency RMBS. The U.S. consumer has several tailwinds at their back: low borrowing rates, record savings rates, unemployment trending lower, and the benefit of a third stimulus payment. The U.S. consumer debt service is near the lowest point in history. With respect to housing, we continue to see the tailwinds of low mortgage rates and limited supply. Housing also benefits from positive secular changes as the pandemic has increased demand. Both ABS and RMBS started out the year strong with spreads tightening during the first five weeks. Both sectors are invested in shorter-duration assets and have outperformed year to date versus longer-duration assets. For the remainder of 2021, we envision more of a coupon-clipping environment.
|Security Description||Portfolio Weight %|
|US TREASURY N/B 0.375 12/31/2025||1.53%|
|PROG 2018-SFR3 A 3.88 10/17/2035||1.06%|
|XROAD 2021-A A2 0.82 3/20/2024||1.01%|
|EART 2021-1A C 0.74 1/15/2026||1.01%|
|NRZT 2017-2A A3 FRN 3/25/2057||0.94%|
|CSMC 2021-NQM1 A1 FRN 5/25/2065||0.93%|
|STAR 2020-3 A1 FRN 4/25/2065||0.88%|
|VERUS 2021-R1 A1 FRN 10/25/2063||0.86%|
|MORGAN STANLEY FRN 10/24/2023||0.80%|
|BX 2018-GW B FRN 5/15/2035||0.79%|
As of 03.31.2021.
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 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 2021, 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 Fund. Even with the recovery since the end of March 2020, we remained focused on credits that would benefit the most 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 are out-of-index/off-the-run ABS, non-agency RMBS, high yield bank loans, corporate high yield, and BBB rated corporate investment grade.