SPDR® Loomis Sayles Opportunistic Bond ETF (OBND) – Q4 2022 Commentary
OBND outperformed its benchmark by 165 basis points (bps). Allocations to multiple sectors, including bank loans and high yield, were all additive during the period. They benefitted more from the risk-on tone during October/November.
Performance
Indications that inflation has peaked does not mean the battle is over. Still in the early innings with consumer price index (CPI) nowhere near what the Federal Reserve (Fed) is seeking; inflation won’t get under control until economic growth slows and labor markets weaken. These factors do not usually create great market conditions and we took the opportunity to move higher in quality. We have added investment grade exposure at the expense of riskier assets such as bank loans and high yield. We are looking for income from issuers with good track records, consistent cash flow and appropriate market positioning. Our favorable view of the asset class has remained stable over the quarter and we have sought a barbell approach allowing us to hold some duration of longer dated lower priced issuers and at the same time, retain attractive income from shorter dated, lower quality investment grade (IG) issuers. Lastly, we have been watching for opportunities in non-US-dollar assets if the Fed pauses its rapid tightening cycle and other countries continue to hike, keeping a cautious eye on valuations.
Standard Performance
Quarter in Review
Signs of cooling inflation, coupled with slightly more dovish indications from Fed officials, allowed global fixed income markets to recapture some of the calendar year’s lost ground during the fourth quarter. Although inflation data came in above expectations towards the beginning of the fourth quarter, subsequent figures came in only moderately positive; indicating that the effects of the Fed’s aggressive rate hiking program may be having effect. By December, global growth concerns had served to temper some of the optimism felt earlier in the period.
US investment grade corporate bond spreads tightened over the fourth quarter as the emergence of more subdued inflation metrics suggested that we may be past “peak inflation” and allowed central bankers to provide more dovish guidance for the rate hiking cycle. Within the portfolio, investment grade corporates contributed to performance with financial, technology, and consumer cyclical names being primarily responsible.
During the early part of the fourth quarter, the bank loan market broadly benefitted from the rising rate environment that created challenges for other fixed income sectors for much of the calendar year. For the portfolio, our allocation to bank loans aided performance, with individual technology, consumer cyclical, and communication issues adding in particular.
US high yield corporate bond spreads tightened during the fourth quarter, as the rebound in markets for risk assets contributed to yield spread compression. The category was broadly helped by lower interest rate sensitivity and larger benefit from income relative to investment grade corporates. Within the portfolio, our allocation to the sector positively impacted absolute performance. Consumer cyclical, industrial, and energy names were mostly responsible for the positive impact.
Securitized credit market spreads tightened in sympathy with broader credit markets. A reduction in rate volatility from recent, historic highs provided a tailwind for relevant subsectors. Within the portfolio, our allocation to securitized assets buoyed performance. The allocation to collateralized loan obligations (CLO) issues was primarily responsible for the sector’s positive impact on quarterly performance, with asset backed securities (ABS) and non-agency residential mortgage backed securities (NARMBS) also contributing.
Portfolio Positioning and Outlook Commentary
Global Investment-Grade Credit: With recession risks increasing and IG credit offering all in yields that we have not seen for a long time, the asset class is compelling. However, given the resiliency of the US jobs markets, we believe it is too early to give up on (higher quality) high yield. We are also expecting huge issuance, which acts as a modest headwind. Biased to increase allocations at the margin. Continue to focus on 2-3 year front end paper and longer duration discounted bonds of high quality companies, where we can source them. Favor Financials.
Global High Yield/Convertibles/Preferreds: If 2022 was all about interest rates driving miserable capital returns across the board, we expect 2023 to be about growth and employment affecting corporate profits and that margins will come under pressure. Good credit underwriting will be paramount as we expect individual company fundamentals will matter more in terms of driving pricing. No pronounced sector or geographic biases at this time - balancing attractive carry with deteriorating fundamentals and striving to avoid losers. With this in mind, we expect to continue to steer clear of the vulnerable CCC-rated/ distressed cohort despite the huge yields on offer given the associated default and liquidity risks. Expect to trim positions as we see more signs of the monster rate hikes of this year work through the system.
Banks Loans: After a stellar year, particularly when compared to high yield, we regard bank loans as vulnerable, particularly loan only issuers are heading into a recession with much higher costs of capital for their businesses. The technicals are also unfavorable - ok issuance is likely to stay low but the floating rate characteristic of the asset class is not attractive if the Fed is close to peak rates. We are not the only ones allocating to other asset classes. We are not ditching bank loans just yet as the Fed still has some hiking to do and high quality loans offer attractive carry versus fixed rate debt. However, the prospects going forward are not compelling.
Securitized Debt: We believe that commercial real estate is vulnerable as working from home patterns become entrenched and demand for office space is structurally lower. While cities such as New York continue to see robust demand, the same cannot be said across the rest of the country. How can we make money from this trend though? Through careful security selection, we expect to see quality issuers survive and are on the lookout for short dated paper. We expect to maintain our single digit exposure to securitized debt but see potential opportunities in high quality, short dated assets. Continue to favor high quality CLO debt as well.
Duration and Yield Curve: It would appear as though we may now be past 'peak inflation' but all eyes are now on the speed with which inflation recedes from here. The curve is deeply inverted and has been for some time. Historically this is an indicator of a pending recession although timing is imprecise at best. We expect the economy is likely to show more and more signs of recession as we progress through 2023. Overall, our duration is in line with the benchmark. However, we are now positioned for a steepening of the yield curve as the front end offers attractive carry and the back end is vulnerable to selloffs as recession risks increase.