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.
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.
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.
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.
Asset-Backed Securities (ABS)
Financial securities backed by income-generating assets such as home mortgages, auto loans and home equity loans.
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%.
Collateralized Loan Obligations, or CLOs
Securities that are backed by a pool of debt, typically business loans, that are grouped by credit quality into tranches.
Consumer Price Index, or CPI
A widely used measure of inflation at the consumer level that helps evaluate changes in cost of living. The CPI is composed of a basket of consumer goods and services across the economy and is calculated by the US Department of Labor by assessing price changes in the basket of goods and services and averaging them. Core CPI is the same series, but excluding food and energy prices, which are considered to be volatile enough to distort the meaning and usefulness of so-called headline CPI. The absence of food and energy, means the core series reflects long-term inflation trends more accurately.
Mortgage-Backed Securities (MBS)
Pooled securities that are backed by mortgage loans. Agency mortgage-backed securities refer to securities backed by pools of mortgages issued by US government-sponsored enterprises, such as Government National Mortgage Association (GNMA), Federal National Mortgage Association (FNMA) and Federal Home Loan Mortgage Corporation (FHLMC).
Investing involves risk including the risk of loss of principal.
The views expressed in this material are the views of Loomis Sayles through the period ended December 31, 2022 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates rise bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
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The values of debt securities may increase or decrease as a result of the following: market fluctuations, changes in interest rates, actual or perceived inability or unwillingness of issuers, guarantors or liquidity providers to make scheduled principal or interest payments or illiquidity in debt securities markets; the risk of low rates of return due to reinvestment of securities during periods of falling interest rates or repayment by issuers with higher coupon or interest rates; and/or the risk of low income due to falling interest rates.
Foreign investments involve greater risks than U.S. investments, including political and economic risks and the risk of currency fluctuations, all of which may be magnified in emerging markets.
International Government bonds and corporate bonds generally have more moderate short-term price fluctuations than stocks, but provide lower potential long-term returns.
Investments in asset backed and mortgage backed securities are subject to prepayment risk which can limit the potential for gain during a declining interest rate environment and increases the potential for loss in a rising interest rate environment.
Because of their narrow focus, financial sector funds tend to be more volatile. Preferred Securities are subordinated to bonds and other debt instruments, and will be subject to greater credit risk. The municipal market can be affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities. The fund may contain interest rate risk (as interest rates rise bond prices usually fall); the risk of issuer default; inflation risk; and issuer call risk. The Fund may invest in U.S. dollar-denominated securities of foreign issuers traded in the United States.
Investing in high yield fixed income securities, otherwise known as "junk bonds", is considered speculative and involves greater risk of loss of principal and interest than investing in investment grade fixed income securities. These Lower-quality debt securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer.
Because of their narrow focus, sector investing tends to be more volatile than investments that diversify across many sectors and companies.
Issuers of convertible securities may not be as financially strong as those issuing securities with higher credit ratings and may be more vulnerable to changes in the economy. Other risks associated with convertible bond investments include: Call risk which is the risk that bond issuers may repay securities with higher coupon or interest rates before the security's maturity date; liquidity risk which is the risk that certain types of investments may not be possible to sell the investment at any particular time or at an acceptable price; and investments in derivatives, which can be more sensitive to sudden fluctuations in interest rates or market prices, potential liquidity of the markets, as well as potential loss of principal.
Non-diversified funds that focus on a relatively small number of securities tend to be more volatile than diversified funds and the market as a whole.
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