The second quarter of 2022 was a difficult period for all fixed income markets.
The second quarter of 2022 was a difficult period for all fixed income markets. Investors turned decidedly “risk-off” as they weighed the impact of aggressive tightening by the US Federal Reserve (Fed) against the macro backdrop of an economic slowdown on the horizon. With potential for a recession increasing substantially, corporate credit risk sold off materially.
The majority of the Fund’s underperformance vs. the benchmark is attributable to below investment-grade asset classes that have more spread risk than the benchmark. Yet, even the Bloomberg U.S. Aggregate posted a negative total return for the quarter (-4.69%) as the Treasury rate rose 60 bps during the period.1
The Fund had an average allocation of 27% to Bank Loans which modestly underperformed the benchmark. However, the 30% allocation to High Yield significantly underperformed, returning -8.8% over the period. June, in particular, was very harsh as High Yield performance was -6.5% as spreads widened meaningfully on potential recession fears. A 10% allocation to securitized assets performed better than the benchmark, yet still down about 4% for the second quarter.2
A “below benchmark” duration profile added to relative performance, but it was not sufficient to overcome the drawdown from higher spread sectors.
Quarter in Review
During the second quarter, markets faced a challenging environment and elevated volatility amid historically high inflation. The Fed, in response, raised interest rates by 50 bps in May and another 75 bps in June. This brought the Fed Funds target rate to a range of 1.50% to 1.75%, with futures markets pricing in further increases during the second half of the year.3
US high yield corporate bond spreads significantly widened during the second quarter, reflecting risk-off sentiment driven by challenging macroeconomic and technical dynamics. Within the portfolio, our allocation to the sector negatively impacted performance. Energy and communications names were mostly responsible for the negative impact.4
Despite supportive fundamentals, US investment-grade corporate bond spreads meaningfully widened over the second quarter amid uncertainty around inflation and the pace of central bank tightening. For the portfolio, investment-grade corporates detracted from performance with financial, communications, and technology names being primarily responsible.5
During the period, key risks for bank loans shifted to emphasize the path of inflation and central bank actions aimed at mitigation. Issuers have largely been able to control costs and pass along price increases despite margin pressure in select sectors. For the portfolio, our allocation to bank loans weighed on performance, with individual technology and consumer cyclical issues detracting in particular.
Securitized credit spreads broadly widened in sympathy with broader credit markets, but lower interest rate sensitivity and lesser direct impact from geopolitical instability helped the asset class outperform other similarly rated fixed income asset classes. Within the portfolio, our allocation to securitized assets negatively impacted performance. The allocation to collateralized loan obligations (CLOs) was primarily responsible for the sector’s negative impact on quarterly performance.6
Portfolio Positioning and Outlook Commentary
Global Investment-Grade Credit: Recession fears are picking up in the market; we acknowledge risks given tighter financial conditions and elevated food/ energy prices, but believe the economy will remain resilient through 2022 given sold consumer and corporate health. Investment-grade corporate credit valuations have become more attractive and fundamentals remain solid. We continue to focus on 2-3 year front end paper and long duration discounted bonds of high quality companies. Biased more toward US names given the growth challenges associated with Europe.
Global High Yield/Convertibles/Preferreds: Although we have maintained an underweight stance for much of the year, yields and spreads are now enticing. Pricing has become more attractive relative to company fundamentals. We believe that the market is finally pricing in (at least) a mild recession over the next 12-18 months and valuations are close to fair value now. Over the next 1-3 months we will likely increase exposure to high yield overall, with a clear bias for certain sectors with pricing power, defensible margins and solid liquidity profiles.
Banks Loans: Where bank loans were our preferred asset class for much of the year, we believe the dynamics have changed over the second quarter and they are less compelling now. This is predicated on the fact that we believe we are closer to the end of the hiking cycle than the start in terms of market pricing (the floating rate nature of the asset class is not as desirable as it was earlier in the year) and that demand for the asset class, particularly from CLOs, has fallen away as yields have risen. To be clear, we are not throwing in the towel on banks loans. We are merely taking some risk down on the basis that we see more compelling risk-adjusted opportunities elsewhere, principally within high yield.
Securitized Debt: CLO pricing, particularly for high quality tranches, looks attractive relative to equivalent rated corporate credit, but we believe CLOs may remain under pressure given waning demand for the bank loan asset class. We maintain modest securitized exposure for diversification. In general, we look to increase the quality of holdings, and look for exceptional specific opportunities.
Duration and Yield Curve: The Fed has made it clear that it is focused on controlling inflation and with strong economic data continuing to show up, there is a sense that the ”data dependent” Fed will hike aggressively. This risks inducing a recession, which capital markets could make self-fulfilling. Europe is in a torrid state of affairs. Let’s not forget that the Russia-Ukraine war and the associated implications for commodities, remain ongoing. China growth/unlocking may be one of the few bright spots to this narrative. We can make strong arguments for being both long and short duration at the moment. In what has been a volatile period for rates and as we approach the summer months (with associated thin liquidity), we think it is prudent to remain agile and react as events unfold.
Basis Point (bps)
A unit of measure for interest rates, investment performance, pricing of investment services and other percentages in finance. One basis point is equal to one-hundredth of 1 percent, or 0.01%.
Bloomberg US Corporate High Yield Index
An unmanaged index that is comprised of issues that meet the following criteria: at least $150 million par value outstanding, maximum credit rating of Ba1 (including defaulted issues) and at least one year to maturity.
Bloomberg US Credit Index
An index that measures the investment grade, US dollar-denominated, fixed-rate, taxable corporate and government related bond markets.
Bloomberg US Dollar Floating Rate Note Index
An index that measures the performance of floating rate bonds issued by the US Treasury.
Bloomberg US Treasury Bellwether 3-Month Index
An unmanaged index representing the on-the-run (most recently auctioned) US Treasury bill with 3 months’ maturity.
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