Q2 2018 Portfolio Manager Review
During the second quarter, investors faced multiple challenges and bouts of elevated volatility that carried over from the first quarter. Investors continued to grapple with the potential market implications of the emerging risks of a trade war among major economic powers, geopolitical tensions, the political climate in Washington, and the ongoing evolution of the quantitative easing (QE) programs initiated by the key global central banks in the aftermath of the Financial Crisis. Oil prices moved higher during the three-month period, U.S. economic data modestly improved, the U.S. dollar climbed, and interest rate volatility remained elevated.
As expected, the Federal Reserve (Fed) increased its target rate during the quarter to a range of 1.75% - 2.0% at the June Federal Open Market Committee (FOMC) meeting. The European Central Bank and Bank of Japan are expected to continue QE until late 2018 and early 2019, respectively.
During the quarter, yields were higher across the curve although more pronounced at the front end. Overall, the curve flattened.
Most spread sectors underperformed for the quarter, with emerging market high yield bonds the largest underperformer. Long duration assets across sectors underperformed on a total return basis as interest rates rose.
- Within the asset-backed security (ABS) sector, both allocation and issue selection positively impacted performance during the quarter. The sector generally offers lower volatility, a diversified collateral base, and attractive valuations relative to many other areas of the fixed income market. Expectations are for range-bound spreads with modest room for tightening.
- Issue selection within the non-agency residential mortgage-backed securities (RMBS) sector versus the benchmark benefited performance.Similar to ABS, RMBS generally offers lower volatility and a diversified collateral base. In addition, the sector typically is less sensitive to global macro volatility.
- Issue selection within the corporate high quality sector had a positive impact on performance.
- The Fund’s underweight to U.S. Treasuries was a detractor.
CURRENT FUND STRATEGY
Sector Changes: We reduced our exposure to corporate high quality securities, agency mortgage backed securities and U.S. Treasury securities. We redeployed the sale proceeds primarily into RMBS.
Non-U.S. Exposure: Over the quarter, we reduced the overall non-U.S. and emerging market debt exposure within the Fund based on our concerns of continued macro headwinds for the sectors. Valuations in specific countries are attractive, and we expect fundamentals to remain positive. Fundamentals, however, have peaked and are becoming a bit mixed near term. The Fund’s non-U.S. exposure could receive uplift from improving global growth, stronger-than-anticipated Chinese growth, a weaker U.S. dollar, supportive commodity prices, and accommodative monetary policy from major global central banks. In this space, we favor sovereigns in larger capital structures.
Securitized Product: Our allocation to the securitized product sectors (RMBS and ABS) continues to play an important role. These sectors of the market offer a diversified collateral base and attractive valuations relative to many other areas of the fixed income market. They also offer diversification to the portfolio’s corporate credit allocation. Our consumer focus within the ABS sector benefits from the U.S. consumer’s continued ability to drive the U.S. economy. RMBS benefits from the continuing improvement in the housing market and investor demand for mortgage credit.
The Fund maintains its higher quality focus and short duration to limit both spread and interest rate volatility.
We continue to see value in spread sectors and expect them to benefit from the projected improvement in global growth this year. As favorable conditions for borrowers remains in place, the positive outlook for corporate and consumer fundamentals is on solid footing and the global demand for yield continues to support fixed income market technicals.
Valuations are fair to rich, given that yields and spreads are inside long-term averages in most areas of the fixed income market. Selection and positioning within sectors thus is critical. Some of the specific sectors where we see value are out-of-index/off-the-run ABS, RMBS, investment grade corporates (BBB rated and financials), and bank loans. As always, we believe it is important to stay diversified, have granular positions, and emphasize liquid investments.
Newfleet Asset Management
Portfolio Manager of MINC