Total return approach, investing across full spectrum of the fixed income market including up to 20% in below investment-grade securities.
Dynamic Core Bond Strategy
- For the quarter, on a net asset value (NAV) basis, the Strategy’s class I shares underperformed the benchmark, the Bloomberg U.S. Aggregate index (the “index”).
- Sector allocation weighed the most on performance. Security selection also detracted, while duration and yield curve positioning did not impact performance.
- Allocations across corporate credit as well as many securitized credit sectors were reduced during the quarter, reflecting a desire to reduce risk and increase liquidity.
- The Strategy remains underweight U.S. Treasuries and neutral agency residential mortgage-backed securities (RMBS), while allocating risk across the corporate and securitized credit spectrum.
The 2Q22 was largely a continuation of 1Q22. Growth was slower than expected, inflation persisted, and Treasury yields continued to climb. A key difference was that in 1Q22, the rising rates were driven partially by a rise in inflation expectations while in 2Q22, the continued rise in rates was driven entirely by Federal Reserve (the “Fed”) hawkishness, since they, and the market, believe that inflation will move lower but will still be above their target.
Coming into the quarter, credit spreads were trending tighter, off their recent wides. The sell-off quickly resumed as incoming data pointed to slower growth. For example, retail sales turned negative in May and new and existing home sales have declined materially. But the Fed, while not ignoring weaker data, remained focused on combatting inflation and continued to raise the Fed funds rate, including a 0.75% at their June meeting. At the same time, the projection for the year end Fed funds rate, as indicated by the dot plot, went from 1.9% in March to 3.4% in June. In response to this sell-off, many corporate issuers, both investment-grade (IG) and high-yield (HY), choose to hold-off on new debt issuance. In HY specifically, some issuers even choose to buy back some of their existing debt as discounts became extreme. In commercial mortgage-backed securities (CMBS), while delinquencies continued to fall, this did not prevent spreads from widening as the overall risk-off sentiment overwhelmed the positive fundamentals. In fact, fundamentals across securitized credit subsectors remained strong as consumers, although facing higher prices, continue to be well supported by a tight-labor market, excess savings and increased home equity. One exception to this is the subprime space where consumers are more adversely affected by rising costs. Agency mortgage-backed securities (MBS) also struggled. This was driven almost entirely by fears of the reduction in the Fed’s holdings of MBS, which weighed most heavily on lower coupons. The good news for investors is that the prospect for the Fed selling MBS securities in 2022 has meaningfully decreased, with the risk of being discounted by markets.
During the quarter, changes to the portfolio in large part, reflected our preference to reduce risk and increase liquidity. Allocations across corporate credit as well as many securitized credit sectors were reduced during the quarter. We added to agency MBS, which was also a risk reduction, as our allocations became more in line with the benchmark and reflected our view that markets had largely discounted risks associated with balance sheet reduction by the Fed.
Even though we did reduce risk, with spreads wider, sector allocation weighed on performance for the period. In aggregate, our overweights in corporate and securitized sectors versus U.S. Treasurys were headwinds amidst the continued riskoff sentiment. While most sector allocations detracted, our overweight to asset-backed securities (ABS) contributed during the quarter, reflecting the sector’s lower beta characteristics, and positioning in agency MBS which included an increase in allocations during the quarter, modestly added. In security selection, negative contributions within ABS largely reflected allocations to higher-yielding collateralized loan obligations (CLOs), emerging-markets (EM) sovereigns and corporates that included Russian exposure also detracted, as did selection within IG corporates. This was offset by positive security selection within agency MBS — which included collateralized mortgage obligations (CMOs), and positive idiosyncratic news on selected CMBS. Duration and yield curve positioning which started the period with a defensive tilt and then move to neutral did not meaningfully impact performance.
Current Strategy and Outlook
For the second half of the year, it is important to keep an eye on the supply side. There are early signs supply chain bottle necks are easing and along with the declines in key commodity prices, this could take some pressure off the Fed. If these trends don’t continue, it’s possible the Fed could tighten past neutral in trying to avoid a 1970s type error, when the Fed reversed course prematurely in response to recession and set the stage for an inflation surge in the late 1970s. While some areas of the market may have some long-term value, currently we do not believe spreads are properly discounting the short-term risks associated with the market debate on the risk for a recession. As a result, we are being patient with the liquidity we have built year-to-date (YTD), and will continue to monitor the market for tactical opportunities.