MINC: 1st Quarter 2022 Portfolio Review
The Fed and other major central banks shifted to a more sharply hawkish tone in response to elevated inflation metrics. As expected, the FOMC completed its asset purchase program and raised its policy rate for the first time since 2018, with more rate increases likely to come. It also signaled that the Fed is likely to begin reducing its $8.9 trillion-dollar balance sheet as soon as its next meeting in May.
Markets have priced in significant Fed monetary tightening over the rest of the year. As a result, the U.S. Treasury curve shifted higher and flattened, which inflicted losses on fixed income assets. The 5-year Treasury yield jumped up 160 basis points (bps), the 10-year Treasury yield went up by 83 bps, and the 30-year Treasury yield moved 55 bps higher.
Spread sectors underperformed U.S. Treasuries, and volatility in the fixed income markets increased both due to a more hawkish Fed policy and the Russian invasion of Ukraine. With the spike in U.S. Treasury yields, less interest rate-sensitive sectors such as high yield bank loans and other shorter-duration asset classes, including asset-backed securities, generally outperformed on a total return basis.
Despite the quarter’s volatility, we see value being restored across most of the fixed income sectors in which we invest. Economic growth is expected to remain above-trend, corporate earnings are expected to keep growing, unemployment remains low, and the consumer and housing markets remain well supported. Near-term recession is not our base case. It’s our expectation that supply chains will heal over time and the Fed will be successful in restoring price stability.
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’ve 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
Allocation to and issue selection within the asset backed security sector had a positive impact on performance. The sector benefited from demand for shorter duration assets and strength from the U.S. consumer. Securitized product continued to soften from a credit spread perspective throughout the period, primarily driven by inflation and global macro concerns. Due to the fundamental backdrop, we remain positive on the U.S. consumer. As a result, our portfolios emphasize a strong overweight to the sector.
• High Yield Bank Loans
Allocation to the high yield bank loan sector had a positive impact on performance during the quarter. Loans held in relatively well as the demand for floating rate assets remains strong in the face of persistently high inflation, increasing hawkish rhetoric from the Fed, and rising U.S. Treasury yields. Demand, while slowed, remains positive, and the net forward calendar is very manageable.
• High Yield Bank Loans
The Fund’s allocation to the non-agency RMBS sector over agency mortgage-backed securities (MBS) had a positive impact on performance. We continue to see the tailwinds of limited supply within housing, and unlike agency MBS, non-agency RMBS offers direct exposure to real estate and mortgage credit.
Underweight to U.S Treasuries.
Current Fund Strategy and Positioning
- Reduced exposure to corporate high yield and corporate high quality securities.
- Increased exposure to asset-backed securities and non agency residential mortgage-backed securities.
- In addition to changes to the Fund’s sector allocation during the quarter, we continue to look for the best relative value, which includes optimizing positions within sectors.
Emerging Market (EM) debt and non-U.S. exposure: Albeit small, the Fund’s EM exposure ticked slightly lower this quarter and remains at historical lows. We began 2022 with continued volatility in the rates market as central banks faced persistent inflation pressures. To make matters worse, we were plunged into a geopolitical event as Russia invaded Ukraine in February, exacerbating those pressures globally. Our Fund had minimal direct impact to this event, as we did not have any Russia exposure during this time. We continue to reiterate our preference for hard currency debt over local market instruments, but again see some potential opportunities arising as the Fed begins to lift rates amid a tightening cycle that has been well underway for the past 12 months at numerous EM central banks.
Investment grade (IG) corporates: The asset class produced massively negative total returns of -8.8% at the index level in the first quarter, with rates and spreads both moving higher. Spreads began the year at 92 bps, hit an intra-quarter peak of 144 bps in mid-March, and quickly retraced 55% of the YTD spread widening in the final two weeks of March to end the quarter at +115 bps – right on top of the five-year average. Technicals have softened as issuers hit the market hard in the first quarter to secure financing ahead of potentially higher rates and potentially more volatility induced by the Russian invasion of Ukraine. Fundamentals have fully retraced their Covid-driven weakness and consensus earnings estimates for 2022 have remained stable at ~9% (S&P 500). Underlying the ‘stable’ earnings forecast is rising expectations for energy, materials, and tech, while consumer discretionary estimates are falling sharply. As with other asset classes, the market is keenly focused on the Russia/Ukraine situation, inflation numbers, and the expected pace of Fed tightening. Our exposure to the asset class is near a five-year low, which positioned us to take advantage of some of the recent spread weakness. We are positioned in the sector with an overweight to the BBB segment of the market, favor financials over industrials, and took advantage of elevated concessions in the new issue market during the quarter.
Corporate High Yield: The High Yield Index moved lower as rates rose and spreads widened, with a total return of -4.8%. Spreads hit a peak north of +400 bps in the middle of March before rapidly grinding lower into quarter-end and retracing about two-thirds of the spread widening. High yield has greater exposure to commodity-related firms, which helped drive some relative outperformance versus other fixed income sectors. Energy-related names and leisure sectors outperformed due to a jump in oil and gas prices and increased consumer spend on travel and leisure, respectively. The wireless and food & beverage sectors lagged due to long-dated maturities from large issuers such as T-Mobile and Kraft Heinz. We’ve become less positive on the asset class given that spreads are at +326, despite an expected aggressive tightening from the Fed and the potential fallout from the Russia/Ukraine war.
Securitized: The massive move in U.S. Treasury rates (2-year notes went 90 bps wider) over the last month of the quarter has reset pricing for all securitized products. These price adjustments have enabled us to purchase new assets at wider spreads and higher yields, which should benefit the portfolios in the long run. We continue to focus on the U.S. consumer and the housing sector, maintaining a significant overweight on ABS and non-agency RMBS. This is supported by strong fundamentals in both sectors: this past quarter, unemployment continued to trend lower (3.6%), and job openings remain high. Consumer confidence and consumer sentiment have trended lower, driven both by the overseas war and inflation fears. After record-low delinquencies in 2021 driven by an improving job picture and federal stimulus, consumer fundamental performance has started to normalize. Although delinquencies and losses have trended a bit higher, they are still near all-time lows. On the housing side, we continue to see the tailwinds of limited supply. Unlike agency MBS, non-agency RMBS offers direct exposure to real estate and mortgage credit. Mortgage credit continues to be judiciously offered. We continue to overweight both.
|Security Description||Portfolio Weight %|
|US TREASURY N/B 1 12/15/2024||1.48%|
|US TREASURY N/B 1.75 6/15/2022||1.42%|
|US TREASURY N/B 0.125 3/31/2023||1.02%|
|EART 2021-1A C 0.74 1/15/2026||0.92%|
|BANK OF AMERICA CORP 1.734 7/22/2027||0.74%|
|BX 2018-GW B FRN 5/15/2035||0.72%|
|TPMT 2018-6 A1A FRN 3/25/2058||0.72%|
|CMLTI 2019-RP1 A1 FRN 1/25/2066||0.70%|
|EART 2019-2A E 4.68 5/15/2026||0.69%|
|CAALT 2021-2A A 0.96 2/15/2030||0.69%|
As of 03.31.2022. Cash not included.
- Out-of-index/off-the-run asset-backed securities
- Non-agency residential mortgage-backed securities
- High yield bank loans
- Corporate high yield
- BBB-rated investment grade corporates
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.