MINC: 3rd Quarter 2020 Portfolio Manager Review
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The rebound in global economic activity continued in the third quarter following the COVID-19-led contraction of the first half of the year. The unprecedented global monetary and fiscal policy response to combat the most severe economic disruption since the Global Financial Crisis of 2008-2009, as well as the easing of government-imposed lockdowns, have to date proven successful in restoring economic activity. Policymakers responded forcefully to combat the economic shock with a series of maneuvers designed to restore function to financial markets and shield citizens from severe 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. As these initiatives have expired or reached their limitations, central bankers have urged politicians to continue to support the recovery with more fiscal assistance. We are confident that such aid will be forthcoming, though the November election makes the timing uncertain. We expect that policymakers will continue to fine-tune their response to the crisis as warranted.
We believe that the trough in economic activity and corporate earnings occurred in the second quarter and that the rebound will be evident as we finish 2020 and enter 2021. Financial markets continued to push higher during the third quarter and we are still finding attractive investment opportunities across the many sectors of the bond market. Sector and issuer selection in this environment is critical and favors active over passive management. We expect that 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 EM debt), lower quality and longer duration outperformed. Corporate credit outperformed most securitized sectors such as 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 has proven disruptive to economies, 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, the ABS and RMBS sectors. Securitized sectors, similar to most credit sectors, experienced a strong recovery. Thus far, federal stimulus programs to aid consumers and small business have had a positive impact on fundamental performance.
- The allocation to the corporate high yield sector. A supportive Fed, continued progress toward a vaccine, and better-than-expected earnings all contributed to demand for the asset class for most of the quarter. Late in the quarter, however, flows turned negative and a risk-off sentiment emerged.
- Issue selection within corporate high quality bonds. The Fund’s overweight to BBBs contributed to performance as lower quality outperformed within the sector.
- The allocation to the high yield bank loan sector. Loans rallied with other risk assets for most of the quarter on continued central bank support, progress on a treatment/vaccine, better-than-feared second quarter earnings, and a firm technical. It has now retraced the March COVID-related losses from a total return perspective. The loan market technical remains supportive driven by a very light new issuance calendar, voluntary prepayments, and healing, albeit low, demand.
Issue selection and the higher quality positioning within high yield bank loans. While the allocation to the sector was beneficial, issue selection was a detractor relative to the bank loan index performance. Consistent with the overall risk-on backdrop for most of the quarter, lower quality within the sector outperformed during the period.
Sector Changes: We reduced exposure to cash, corporate high quality, and corporate high yield. We increased exposure to ABS, non-agency RMBS, and bank loans.
Non-U.S. Exposure: Over the quarter the overall non-U.S. exposure is slightly higher, however, emerging market exposure within the Fund remained relatively unchanged. 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 and hard currency over local market exposure.
Corporate High Quality: In the third quarter, spreads within the investment grade corporate sector were largely range-bound as heavy supply counterbalanced heavy demand. Issuers ended the quarter with both record levels of cash and debt while earnings declined, but by less than expectations. No issuers have tapped the Fed’s Primary Lending Facility, a testament to how accessible the capital markets have been since March. We continue to be comfortable with an elevated risk positioning in the sector with an overweight to the BBB segment and are targeting names with resilient cash flows and substantial liquidity.
Corporate High Yield: The corporate high yield market experienced another strong quarter with an over 4% total return. The main theme of the quarter was tremendous new issuance by corporations as they continued to shore up balance sheets or refinance debt to lock in low rates. This heavy supply weighed on performance later in the quarter as recent flows have been flattish. The outlook remains mixed as accommodative monetary policy and an economic reopening are countered by a lack of additional fiscal stimulus, the ramifications of the presidential election, and concerns of additional shutdowns due to virus outbreaks. Meanwhile, valuations have returned to historical averages despite elevated leverage due to a combination of poor results and debt-funded liquidity raises from earlier in the year. The Fund ended the quarter with a modest net reduction in its high yield allocation having added to the asset class throughout the quarter prior to a reduction in late August on spread tightening.
Securitized Product: Our allocation to the securitized sectors (non-agency RMBS, ABS, and CMBS) continued to benefit overall performance of the portfolio as credit spreads tightened materially versus risk-free assets. At the beginning of the third quarter, we continued to take advantage of the dislocation in spreads by adding to the ABS and RMBS sectors within the portfolio via the secondary market. We also took advantage of a new issue market that offered investors a concession with respect to pricing and more robust deal protections as rating agencies took a more conservative approach to underwriting driven by COVID-19. The fundamental performance of the U.S. consumer also continued to improve as delinquencies and forbearance numbers trended lower, which positively impacted the valuation of our securities. We finished the quarter with securitized product valuation levels approaching pre-COVID-19 levels.
|Security Description||Portfolio Weight %|
|US TREASURY N/B 1.75 6/15/2022||3.27%|
|US TREASURY N/B 0.125 5/31/2022||2.40%|
|US TREASURY N/B 2.25 3/31/2021||1.52%|
|BX 2018-GW B FRN 5/15/2035||1.14%|
|MORGAN STANLEY FRN 10/24/2023||0.77%|
|GCAT 2019-NQM1 A1 STEP-CPN 2/25/2059||0.74%|
|NRZT 2016-3A A1 FRN 9/25/2056||0.73%|
|JPMORGAN CHASE & CO FRN 11/1/2168||0.73%|
|SOFI 2017-C A2B 2.63 7/25/2040||0.72%|
|LFT 2018-2A A 4.23 4/20/2027||0.69%|
As of 9.30.2020. 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 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 Fund. Even with the recovery since the end of March, valuations look attractive in many spread sectors and 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 investment grade corporates.