• Yields continued to zig-zag in 4Q22, with bond markets influenced by inflation and US Federal Reserve actions.
• For the quarter, the Fund underperformed its benchmark, the Bloomberg U.S. Securitized MBS/ABS/CMBS Index (the Index). Security selection in CMBS (commercial mortgage-backed securities) led this detraction.
• In the United States, easing inflation pressures should allow the Fed to halt the rapid rate rise, but we do not expect rate cuts until labor markets rebalance.

Yields continued to zig-zag in 4Q22, with bond markets influenced by inflation and Fed actions. The start of 4Q22 saw a continued rise in interest rates, driven primarily by additional upside surprises in inflation and payroll reports. The Fed hiked rates an additional 75 basis points (bp) in November but then laid the groundwork for smaller hikes going forward. The more dovish comments fueled a rally across rates and credit markets which was extended when November Consumer Price Index (CPI) data came in better than expected adding to the optimism that inflation may have finally peaked. Going into year-end, yields retraced the intra-quarter rally after the Bank of Japan surprised markets by adjusting their yield curve control policy, highlighting the fact that risks can come from unexpected disruptions.

CMBS was the worst performing sector for the quarter with the allocation contributing –268 bp to the portfolio total. Idiosyncratic underperformance from a subset of seasoned subordinate positions weighed on returns. Collateralized loan obligations (CLOs) were the best performing sector on the quarter adding 73 bp to portfolio excess returns. BBB rated tranches provided most of the positive contribution. Non-agency residential mortgage-backed securities (RMBS) was a negative contributor to excess returns, reducing the portfolio total by 17 bp. Jumbo 2.0 was the main underperformer while credit risk transfer (CRT) contributed positively. ABS contributed –20 bp to aggregate excess in 4Q22. Student loans and solar drove the largest share of underperformance. On duration, the US Treasury curve continued to flatten in 4Q22 with shorter maturities leading the sell-off. 2–10s yields inverted another 10 bp during the quarter, finishing the year at –55 bp. The performance impact was positive from a portfolio standpoint and relative to benchmark.

CMBS allocation was 40% at quarter-end. CLOs finished the quarter with roughly 15% allocation. We maintained our allocation to non-agency RMBS with roughly 26% exposure at quarter end. In asset-backed securities, we finished the quarter at roughly 13% allocation. On duration, we finished the quarter with 2.5 years of duration. The Fund was approximately 3.6 years short its benchmark at quarter end.

In the US, easing inflation pressures should allow the Fed to halt the rapid rate rise, but we do not expect rate cuts until labor markets rebalance. The cumulative effects of central bank tightening, disruption in the energy supply and the fading impact of Covid stimulus will push global growth below potential and threaten recession in several key economies — particularly in the Eurozone. While the probability of a US recession is high, we do not anticipate that economic growth will drop suddenly. This is in part because we do not see significant imbalances in either the corporate or consumer segments. Corporate balance sheets are merely cooling from their very strong positions, and consumer spending is still supported by excess savings left over from various Covid stimulus packages.

If a recession happens, it will be a painful experience for many people. But from an economic perspective, it will be a necessary medicine to ensure the healthy functioning of an economy. A side effect will be higher unemployment, driven by the decrease in demand for labor. But on the flip side, companies have been struggling to recruit skilled talent, which could cause many of them to hold onto workers in a downturn. The persistent shortfall in the labor supply should keep the unemployment rate from going too high, too quickly.

That said, the speed of interest rate hikes has been swift and unrelenting, increasing the strain on the markets. Housing has fallen, crypto is in crisis, and the September rout in the UK government bond market forced many UK pension plans to offload assets.