Q3 2018 Portfolio Manager Review
Fixed income investors faced substantially similar market themes during the third quarter as in the prior two quarters of 2018. Market participants continued to wrestle with periods of volatility caused by geopolitical developments, trade rhetoric, mixed global economic signals, and the evolution of quantitative easing programs that began in the aftermath of the now decade-old Financial Crisis. During the quarter, oil prices continued their ascent driven by the outlook for supply/demand dynamics. U.S. economic data stayed on a positive trend, which contrasted with other global economies. Primary inflation readings remained in check, but pressure in key components (i.e., wages) has started to build.
As expected, the Federal Open Market Committee (FOMC) increased its target rate at the September meeting to a range of 2.00-2.25%. The pace of the Federal Reserve’s (Fed) balance sheet adjustment remains as originally deployed. The European Central Bank remains on track to end its monthly bond purchases at the end of 2018 while reinvesting proceeds from maturities and maintaining key policy rates well into 2019 and beyond if deemed necessary by incoming economic data. The Bank of Japan made some minor adjustments to its purchase program during the quarter but no substantial changes are expected for the next 12-18 months.
During the quarter, yields were higher across the curve though slightly more pronounced at the front end. Overall, the curve flattened.
Most spread sectors outperformed during the quarter led by high yield corporates and bank loans, both demonstrating their resilience in a rising rate environment. Across other spread sectors, tightening spreads offset price declines from rising rates to a greater degree for longer duration assets relative to their shorter duration counterparts. Additionally, lower credit ratings outperformed higher quality on a total return basis. Non-U.S. dollar was the largest underperformer during the period.
- The Fund’s underweight to U.S. Treasuries benefited performance.
- Exposure to the corporate high yield sector contributed positively. The sector was among the top performers during the quarter.Solid earnings, lack of supply, and inflows into the sector in the past couple of months have been beneficial.
- 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.
- Allocation to the non-agency residential mortgage-backed security (RMBS) sector versus agency mortgages helped performance as did issue selection. 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.
- Allocation to the bank loan sector contributed positively. One of the quarter’s best performing sectors, loans continue to provide a compelling investment due to the strong fundamental backdrop, protection against rising rates, and attractive income carry profile.
- Issue selection within the corporate high quality sector had a positive impact on performance.
- There were no significant detractors to performers during the quarter.
CURRENT FUND STRATEGY
Sector Changes: We reduced our exposure to asset backed securities and non-agency commercial mortgage-backed securities and we increased our exposure to corporate high quality and U.S. Treasury securities.
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 markets. They also offer diversification to the corporate credit allocation within the portfolio. Our consumer focus within the ABS sector has been beneficial as the U.S. consumer continues to show the ability to lift the U.S. economy. RMBS benefits from the continuing strength 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 opportunity in spread sectors. Benign consumer, housing, and corporate fundamentals as well as the global demand for yield continue to underpin our strategy. Recognizing that valuations are fair to rich given that spreads are inside long term averages in most areas of the fixed income market, selection and positioning within sectors is critical. Some of the specific sectors where we see opportunity are out-of-index/off-the-run ABS, RMBS, investment grade corporates (BBB rated and financials), and leveraged finance (bank loans and corporate high yield), with the allocation mix driven by each fund’s risk tolerance.
Newfleet Asset Management
Portfolio Manager of MINC