Actively managed, ultra-short duration floating-rate income strategy that invests primarily in privately syndicated, below investment-grade senior secured corporate loans.
- Despite the uncertain environment, both the leveraged loan and the high yield (HY) bond markets performed strongly, although HY outperformed given the strong decline in government bond yields.
- Class I shares of the Fund outperformed the benchmark, the 50% Bloomberg High Yield Bond—2% Issuer Constrained Composite Index/ 50% Morningstar LSTA US Leveraged Loan Index (benchmark) on a net asset value (NAV) basis during the quarter.
- In the short term, we expect leveraged finance markets to remain impacted by myriad of macro developments, evolving Fed policy, inflation and payroll data, fallout from regional banks and tighter financial conditions, and most importantly — corporate fundamental factors, 1Q23 earnings and forward guidance.
The financial markets were positive in the first quarter, but volatile as concerns over inflation and interest rates tugged asset prices up and down. Early in 1Q23, investor optimism regarding US Federal Reserve policy was underpinned by signs of falling inflation and weaker economic data. However, resilient economic data released in February diminished any hopes of a potential pause in a rate hikes, causing a sell-off in rates. In the final month of the quarter, financial markets came under pressure due to the failure of three regional US banks, with two being taken into receivership by the Federal Deposit Insurance Corporation (FDIC). The banking crisis had spread across the Atlantic, as Credit Suisse was acquired by UBS in a government-backed deal. These developments heightened recession concerns and worsened the outlook for lending, as rates rallied to end the quarter lower.
Despite the uncertain environment, both the leveraged loan and the high yield bond markets performed strongly, although high yield outperformed given the strong decline in government bond yields. Starting with the loan market, the Morningstar® LSTA ® US Leveraged Loan Index (loan index) returned 3.23% during the quarter. The average loan Index bid price increased by 94 bp to 93.38, primarily attributable to strong performance in the first two months of the quarter. By ratings, lower-rated loans outperformed higher quality in 1Q23, as BB, B and CCC rated loans returned 2.08%, 3.81% and 3.92%, respectively. In HY, the Bloomberg U.S. High Yield 2% Issuer Constrained Index (high yield Index) returned 3.57% for the period. Credit spreads for high yield bonds tightened meaningfully to start the quarter, widened post banking crisis, and remained inside of 4Q22 levels at the end of the quarter. On an option-adjusted spread (OAS) basis, spreads finished the period 14 bp tighter at 455 bp. The HY market produced positive returns across the credit stack, with BB rated bonds returning 3.44%, B-rated bonds returning 3.47% and CCC rated bonds returning 4.96%, represented by securities within the Index.
New-issue supply was relatively light in both markets given the difficult backdrop for new issuance, while investor demand was stronger in the loan market given persistent CLO bid. LCD reported institutional loan volume of roughly $50 billion during the quarter, while HY bond issuance was modestly lower at about $41 billion in aggregate across both secured and unsecured volumes. CLO issuance totaled a robust $33.6 billion in 1Q23, while measurable retail fund flows were negative in both markets.
Class I shares of the Fund outperformed the benchmark on a NAV basis. The Fund’s allocation to loans and high yield bonds ended the quarter roughly evenly split across the two asset classes. Within the individual allocations, the loan allocation benefited selection in software and telecommunications. In the HY allocation, our positioning in the wireline space led performance, as an underweight in the sector coupled with credit selection contributed. Credit selection in media and entertainment and pharmaceuticals were also strong contributors, while the underweight in leisure and credit selection in cable and satellite both detracted from performance. Away from investment-level performance, the Fund’s use of leverage helped boost returns given the increase in average loan and bond prices experienced during the period.
Current Strategy and Outlook
In the short term, we expect leveraged finance markets to remain impacted by myriad of macro developments, evolving Fed policy, inflation and payroll data, fallout from regional banks and tighter financial conditions, and most importantly — corporate fundamental factors, 1Q23 earnings and forward guidance. On the flip side, valuations appear reasonable and fundamental health of leveraged borrowers remains generally adequate. Nonetheless, we expect dispersion in performance among borrowers to continue and pockets of stress to emerge as the cycle matures. As a result, careful credit selection and monitoring continues to be warranted, as risks remain skewed to the downside.