MINC: 3rd Quarter 2022 Portfolio Review
Global central banks continued to fight inflation during the quarter with a series of unusually large policy rate increases. Their messaging has been consistent: they will stay focused on returning high inflation levels to target. The backdrop clouded the outlook for global and regional economies, with the probability of recession rising. This has resulted in negative total returns for most assets. The pandemic is still a global issue, with China’s zero-COVID policy continuing to delay the normalization of supply chains, though the rigid policy may be eased in the coming months. 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 Fed raised its main policy rate 150 basis points (bps) during the quarter in two jumbo moves of 75 bps each and signaled its resolve to restore price stability. The Fed is also set to increase the pace of its $8.9 trillion balance sheet run-off in September. While we still expect this to be a largely passive exercise, the market is watching for signs that the Fed may be open to selling off its mortgage-backed securities (MBS) when caps are not met. The European Central Bank (ECB) also joined the inflation fight and raised its policy rate to 125 bps over two meetings, marking the first increases off zero since 2016. In addition to managing the start of its own balance sheet run-off, the ECB will have to manage the complex task of preventing financial fragmentation among its member countries. The Bank of Japan is still 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 banks have a complicated task ahead, but we are confident in their ability to contain inflation.
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 105 bps, the 10-year Treasury yield went up by 82 bps, and the 30-year Treasury yield moved 59 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 ABS had a positive impact on performance during the quarter. We are still positive on the U.S. consumer as low unemployment and excess savings continue to create a solid backdrop over the near term, driving our investment thesis and overweight to the sector. We continue to focus on the front end of the yield curve, where we look to put dollars to work in investment grade (IG) amortizing assets, and in deal structures that lead to de-leveraging.
High Yield Bank Loans Issue Selection — Allocation to the HY bank loan sector had a positive impact on performance as the index gained early in the period. However, sentiment weakened over the quarter, especially around the Fed’s Jackson Hole meeting, as a very vocal Fed reminded markets of its firm commitment to fight inflation at the expense of economic growth. As investor angst increases around slowing growth and its impact on credit markets, our current up-in-quality position has performed well.
Non-agency residential mortgage-backed securities (RMBS) — The Fund’s allocation to the non-agency RMBS sector over MBS had a positive impact on performance during the quarter. We are still positive on mortgage credit, which drives our investment thesis and overweight to the sector. We feel RMBS is priced attractively for the risks and continue to add up-in-quality residential exposures as prepayments remain muted. Housing prices are slowing as sharply higher mortgage rates raise affordability questions.
Underweight to U.S Treasuries – An underweight to U.S. Treasuries hurt performance as most spread sectors underperformed with the shifting economic conditions.
Current Fund Strategy and Positioning
- Reduced exposure to to RMBS and U.S. Treasuries.
- Increased exposure to asset backed securities.
- 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: EM exposure was relatively flat during the quarter. Spreads had an overall tightening bias through August, only to retrace come September. Spreads on the EMBI Global were marginally wider for the quarter, with HY underperforming. Topics driving the EM market in the third quarter included rising inflation and tightening monetary policy, continued focus on the Fed’s comments and next moves, the war in Ukraine, China’s zero-COVID policy, and country-specific elections. We continued to look for relative value swaps within curves, or between sovereigns and quasi sovereigns. We maintain our preference for hard currency debt and have no local currency exposure in the Fund. While we remain involved in the EM debt market, overall exposure as a percentage of the Fund’s total assets remains near the lowest levels it has been for the past 10 years.
Investment Grade (IG) Corporates: Returns were pushed to modern era lows (down 18.7% YTD) in the third quarter as rates continued to rise. Dollar prices are down 20 points for the average bond in the index to a post-Global Financial Crisis (GFC) low of $86.62. Meanwhile, yields are now at post-GFC highs (~5.69%). Spreads widened 2 bps during the quarter to +158 bps. Fundamentals are holding in quite well with leverage returning to below pre-COVID levels while interest coverage ratios have been improving as EBITDA grows. The average coupon has been falling despite the rise in rates YTD. We find earnings estimates for the next six quarters to be too optimistic and believe the market is highly skeptical of these figures as well (they both call for solid growth). We are currently overweight financials and commodity sectors, which we believe perform well in a rising 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: The HY market experienced a small loss as rising rates offset some tightening credit spreads. However, this misses the volatility seen during the period – the HY index was up 7.75% through August 15th before fully retracing in the second half of the quarter. CCCs outperformed on a total return basis, though this was solely driven by having less duration. Meanwhile, BB/B credit spreads tightened – consistent with portfolio managers high-grading their funds ahead of economic weakness. The technical environment is mixed as a light calendar helps support the market despite poor fund flows. Somewhat concerning is both the lack of CCC issuance and financings for LBOs that are struggling to clear the market. Valuations have improved from mid-August levels but are still well inside of recessionary levels. Volatility combined with the usual seasonal slowdown in summer has made trading more challenging. Consequently, we had less activity than normal during the quarter. We remain cautious on the sector and have a low allocation and up in quality bent, with an overweight to BBs and underweight to CCCs relative to the index.
Securitized: All securitized sectors saw negative returns as the Fed continued to tighten monetary policy. On the upside, we see yield opportunities not seen in many years. In the near term, low unemployment, strong consumer savings, and real wage growth are signs that the U.S. consumer will stay timely with its debt service payments. However, we are being selective with our transactions as we believe unemployment will tick higher, which may result in higher consumer delinquencies. We believe the risk/reward of higher quality short duration securitized products is extremely attractive after the rate back-up during the quarter. 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. 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 higher mortgage rates, we expect a significant drop in activity will lead to less supply for the back half of the year, which should allow credit spreads to respond favorably. As a result, our portfolios have an overweight to the sector.
|Security Description||Portfolio Weight %|
|US TREASURY N/B 0.125 8/31/2023||2.37%|
|US TREASURY N/B 0.125 3/31/2023||1.62%|
|CSMC 2021-NQM1 A1 FRN 5/25/2065||0.93%|
|TPMT 2017-1 A2 FRN 10/25/2056||0.83%|
|KIND 2021-KDIP C FRN 12/15/2037||0.81%|
|VEROS 2021-1 B 1.49 10/15/2026||0.79%|
|MFIT 2020-AA A 2.19 8/21/2034||0.76%|
|VISIO 2019-2 A1 FRN 11/25/2054||0.75%|
|UPST 2021-3 B 1.66 7/20/2031||0.71%|
|MLANE 2021-A A 1.59 9/15/2026||0.70%|
As of 09.30.2022. 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 HY 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