MINC: 3rd Quarter 2021 Portfolio Review
However, the Delta variant and some regionalized economic lockdowns have caused growth forecasts to decline over the remainder of the year, though most forecasters remain optimistic on the growth outlook for 2022 and beyond. 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.
As the economic recovery remains on track, the Federal Reserve (Fed) has begun removing some of its monetary support, announcing the completion of the wind-down of its secondary market corporate credit facility during the quarter. We expect the Fed will continue to moderate its support and announce a tapering of its asset purchase program ($120 billion of U.S. Treasuries and mortgage-backed securities per month) in the near term, most likely in November. The Fed remains committed to its communication strategy and has no desire to tighten financial conditions. While a tapering should not take markets by surprise, a knee jerk reaction is still possible, though we expect it would be short lived.
During the quarter, U.S. Treasury rates increased marginally both on the front end and the belly of the curve, and decreased on the long end. The 5-year Treasury yield increased 8 basis points, the 10-year Treasury yield was 2 basis points higher, and the 30-year Treasury yield was 4 basis points lower.
The Fed held course on rates at its September meeting, leaving its target for federal funds unchanged at a range of 0.00% – 0.25% — the rate set in March 2020 in response to the pandemic. Despite the recent uptick in inflation, persistent shortfalls versus this target suggest the FOMC will allow periods of inflation of over 2% to achieve its objective. This supports our view that policy rates are likely to stay lower for longer if economic conditions warrant.
Regarding inflation, we believe that base effects related to the global supply chain disruptions stemming from early 2020 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 keep prices contained, while cyclical components such as unemployment and broad resource slack will also cap inflationary pressures. We expect the world’s policymakers to remain supportive of a continued economic recovery.
Financial markets have grown accustomed to “living with the virus,” and despite late-quarter volatility most spread sectors were able to generate modestly positive returns during the period, outperforming U.S. Treasuries during the quarter. They were led by higher beta, less rate-sensitive sectors such as high yield bank loans and corporate high yield securities. During the quarter, we did not see any rating or duration performance themes across sectors.
While the pandemic has undoubtedly disrupted economies, the robust response from policymakers and signs of a return to normalcy are encouraging. Our Multisector approach to fixed income investing is ideally suited for the current environment and enables us to scan the broader bond market for the most attractive investment opportunities.
- Underweight U.S. Treasury and agency mortgage-backed securities and overweight spread sectors.
- High Yield Bank Loans
- Allocation to the high yield bank loan sector had a positive impact on performance during the third quarter. Ongoing monetary policy accommodation and additional fiscal spending, coupled with a strong macroeconomic rebound, created a very constructive backdrop for risk assets. The technical environment remains healthy as the picture around tapering monetary policy and its potential impact on interest rates comes into focus. Loan demand from both retail and institutional investors has increased with September marking the tenth straight month of retail inflows and CLO issuance reaching a record.
- Corporate High Yield
- Allocation to the corporate high yield sector contributed positively during the quarter. The asset class was able to outperform most spread sectors during the period due to the seasonal drought of supply, easing concerns around the impact of the Delta variant on the global economy, and hints that a Fed taper may not come until later this year. Overall, fundamentals within the sector continue to improve and valuations are reflective of that.
- Asset-backed Securities
- Issue selection within the ABS sector contributed positively during the quarter. The U.S. consumer continues to perform extremely well – the stimulus programs, low rates, and access to credit strengthened its ability to service debts. The shorter duration of securitized products lends itself perfectly to a positive technical backdrop, driven by an anemic yield curve and the threat of the back end of the yield curve steepening in the future.
- Positioning within High Yield Bank Loans
- Higher quality positioning within the high yield bank loan sector was a slight detractor relative to the sector index performance. Riskier loans continued to outpace quality as investor search for yield continues.
Current Fund Strategy and Positioning
- Reduced exposure to high yield bank loans, non agency residential mortgage-backed securities (RMBS), and corporate high yield.
- Increased exposure to asset backed securities, corporate high quality, and U.S Treasuries.
- In addition to changes to the Fund’s sector allocation during the quarter, we continue to look for the best relative value within sectors, which includes optimizing positions within sectors.
- EM debt and non-U.S. exposure: Over the quarter, emerging market (EM) and non-U.S. exposure within the Fund was relatively unchanged. Both rich valuations for EM and the disproportionate impact of COVID on emerging market economies compared with developed economies make US growth-sensitive assets more attractive, even though absolute spreads were tighter. 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. Despite the rough start to 2021, we still expect positive returns in EM debt, as any potential for further increases in G-3 rates should remain small enough to be more than fully offset by the benefit of decent coupon income.
- Investment grade (IG) corporates: Spreads were range-bound in the third quarter and wound up back near the 15-year low reached in June. Technicals were favorable – net supply was manageable, while inflows from domestic and foreign buyers remained firmly positive. Strong second quarter earnings saw 25% revenue growth and 96% earnings growth on easy COVID-19-impacted comparisons. Earnings beat forecasts by 16%, one of the highest such beats on record. Net leverage returned to pre-Covid levels and is set to decline in the fourth quarter as consensus forecasts call for 22% earnings growth with further 10% growth in 2022. As we look to the final quarter of the year, valuations remain the constraining factor for the asset class. On a duration-adjusted basis, spreads are at all-time lows. With the Fed set to taper at the end of the year, there is a risk that investors turn bearish on a longer duration asset class. We have reduced exposure to the asset class significantly over the past year, though there are still areas within the BBB segment of the market that we like including REITS, Insurance, and Metals/Mining.
- Corporate High Yield: The theme of the quarter was the underperformance of the CCC rating tier. Concerns around the Delta variant of COVID, timing of tapering by the Federal Reserve, and US GDP growth estimates moving lower for the second half of the year and 2022, all drove CCC spreads wider. After widening over a 100 bps from a low of +444, CCCs spreads ground back down to +503. Meanwhile, BBs outperformed, and spreads are at this cycle’s lows, though the high levels of expected rising stars are pulling the aggregate BB spreads lower. The aggregate BB spread should be split into two groups: names that investors expect to stay at BB, and future rising stars (names that will move back to investment grade). Activity for the fund was more muted in the quarter due to lighter supply and general seasonal slowness, though the technical environment improved slightly, with retail funds flows going positive. We maintain a favorable outlook on the space, but the Fund reduced risk during the quarter. Most sales stemmed from idiosyncratic issues related to specific companies, with most purchases comprising higher quality companies that seemed attractively priced despite yielding less than the overall market.
- Securitized: We continue to emphasize the U.S. consumer and the housing sector, maintaining a significant overweight on asset-backed securities and non-agency residential mortgage-backed securities. This is supported by strong fundamentals in both sectors: this past quarter, unemployment continued to trend lower (5.2%), and job openings remain high. Consumer confidence has trended lower, but driven by virus fears rather than a cooling labor market. The U.S. consumer’s debt service is also near the lowest point in history, while the savings rate remains historically high. 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. On the housing side, we continue to see the tailwinds of low mortgage rates and limited supply. Housing also benefits from demand driven by the pandemic. Unlike agency MBS, non-agency RMBS offers direct exposure to real estate and mortgage credit. We continue to overweight both.
- Our Multisector relative value approach enables us to find and take advantage of opportunities when events that trigger volatility, like COVID-19, affect valuations. In the current environment, we believe some of the best total return and yield opportunities can be found in spread sectors. Since last year’s pandemic crash, we have focused on credits that benefit from a continued economic recovery. Within that broad opportunity set, we think credit selection and positioning is key to finding the best opportunities. Specific sectors that demonstrate the best relative value for us include:
- 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.
|Security Description||Portfolio Weight %|
|US TREASURY N/B 0.375 12/31/2025||2.14%|
|AESOP 2021-1A A 1.38 8/20/2027||1.01%|
|EART 2021-1A C 0.74 1/15/2026||0.86%|
|XROAD 2021-A A2 0.82 3/20/2024||0.86%|
|CMLTI 2019-RP1 A1 FRN 1/25/2066||0.81%|
|CSMC 2021-NQM1 A1 FRN 5/25/2065||0.75%|
|VERUS 2021-3 A1 FRN 6/25/2066||0.75%|
|BANK OF AMERICA CORP 1.734 7/22/2027||0.73%|
|PRPM 2021-RPL1 A1 FRN 7/25/2051||0.72%|
|NRZT 2017-2A A3 FRN 3/25/2057||0.69%|
As of 09.30.2021. Cash not included.