Seeking Long‑term Value in a Gradually Healing Economy

Q: How would you describe markets today?

Ivascyn: Broadly speaking, markets and market functioning have stabilized significantly since the March sell-off. Markets are reacting not only to the current easing of both the health crisis and the economic lockdown, but also to the massive policy response. However, we must emphasize the fragility of this recovery. There are clear downside risk scenarios: Equities could perform poorly, and credit markets could face further liquidity deterioration, despite central bank support.

Another important point is that in very high quality segments of the fixed income market, yields are extremely low, and in some areas, they’re not even keeping up with diminished inflation expectations. We expect yields in general will remain relatively range-bound over the coming year, and this poses a challenge for finding yield in government bonds.

On a more positive note, we’re seeing a very high volume of issuance in areas like corporate credit alongside continuing pricing dislocations in some segments of global markets. These are giving rise to interesting pockets of opportunity. In some areas, we believe yields look quite attractive relative to the last few years.

Q: Before we delve into the portfolio ideas in the Income Strategy today, could you please remind us of the strategy’s high-level objectives?

Ivascyn: The primary goal of the Income Strategy is to generate a responsible and consistent dividend stream. We also aim for long-term capital appreciation as a secondary goal. We look across the global opportunity set in an effort to construct a robust and income-oriented portfolio.

In today’s environment, consistent with our top-down macro outlook, we’re focusing on finding long-term value. We’re willing to accept a certain amount of volatility in investments where we see potential for longer-term resilience or capital appreciation. And we seek to avoid areas of the market with higher potential for permanent capital impairment, even when it means sacrificing some yield. We call this a “bend-but-not-break” approach to generating income.

This philosophy should help investors participate in the ongoing healing of the global economy, offering potential for attractive yield and price appreciation. And even under more negative macro scenarios (which aren’t our base case but are clear risks), this philosophy is still designed to generate a consistent yield.

Q: Turning to the Income Strategy portfolio, what is the investment stance on interest rates?

Ivascyn: High quality bond markets today aren’t paying investors very much for taking on interest rate risk. Ten-year sovereign yields in many developed markets are close to or even below zero. From that perspective, we continue to be fairly defensive on interest rate exposure.

That said, because we believe high quality bonds exhibit defensive characteristics and provide diversification, they still have a role in the Income Strategy. We continue to prefer sourcing most of the strategy’s duration from the U.S., where rates remain higher than in many developed markets. To hedge the portfolio’s interest rate risk, we remain underweight interest rates in certain negative-yielding sovereigns, namely Japan.

Q: One sector the Income Strategy has favored for some time is agency mortgage-backed securities (MBS). What is our latest view on these markets?

Ivascyn: As background, agency MBS are very high credit quality assets with either a direct guarantee from the U.S. government or a strong indirect guarantee from agencies of the U.S. government. We like this sector because it’s high quality and very liquid provided one invests in mortgage pass-throughs (where we – and the Fed – typically focus).

Because the Fed has actively supported this market, valuations of agency MBS have richened since mid-March. We look at valuation from a long-term perspective, and today agency MBS appear historically closer to average or fair. That said, given the disruption in the economy, we also expect prepayment rates to be more subdued over the next few months – meaning agency MBS remain attractive as defensive income-producing assets. In the past couple of months we have been gradually reducing our exposure to agency MBS, but they still represent a significant portion of the portfolio.

Q: The Income portfolio also has exposure to the non-agency MBS sector. What is our view and positioning in this market?

Ivascyn: First, let’s briefly review the differences between agency and non-agency MBS. Because agency MBS have either direct or indirect guarantees from the U.S government or government agencies, from an investor’s perspective, they tend to be very high quality assets where the main risk is prepayment risk. Non-agency MBS, by contrast, are backed by non-government-guaranteed mortgage loans, so the main risk for these positions is credit risk.

Coming into this period, U.S. housing market fundamentals were strong overall, in our view, with stable valuations. And due to regulations enacted after the global financial crisis, we haven’t seen many excesses in housing.

Beyond the starting fundamentals of the housing market, it’s important to emphasize that the vast majority of the Income Strategy’s exposure to non-agency MBS is in seasoned investments that participated in that longer-term stabilization in the housing market: that is, assets or pools of loans that originated prior to 2008. Most borrowers in these pools have been in their properties across a decade of economic growth, and many have built considerable equity in their homes. We believe our non-agency MBS exposure is therefore likely to be fundamentally resilient over the long term.

There are other segments of the non-agency MBS market that are more exposed to credit risk and volatility, particularly some of the more subordinate structures. We have very limited exposures in these higher-risk areas, even though valuations are beginning to look more interesting.

Q: Corporate credit markets saw spread widening in March and some retracing since, though trends haven’t been homogeneous across all sectors. What are our views on corporate credit in the Income Strategy?

Ivascyn: Prior to the pandemic, the Income Strategy was quite light on broad credit exposures. Today, we are cautiously optimistic on certain segments of corporate credit. We’re not diving into this space, but we have been adding some corporate credit risk to the Income portfolio on a bond-by-bond basis, always with a focus on bend-but-not-break opportunities. We are most overweight the financials sector, which saw significant volatility recently but now shows signs of healing in Europe and the U.S. The Income portfolio has very limited exposures to riskier areas of corporate credit, such as energy and hospitality. Whenever we move into more stressed areas of corporate credit, as we are doing very gradually and selectively, we seek only the exposures that we believe offer attractive compensation for taking that risk.

Another approach we utilize selectively in corporate credit markets is adjusting where we take risk on the maturity curve. In some cases, it has made sense to take advantage of the potential for longer-term spread tightening.

A broader observation is that corporate credit is undergoing a notable shift from a pre-pandemic market that generally favored borrowers – we were seeing weakened covenants and fewer protections for investors – to one that increasingly favors lenders. We’re seeing many originations in higher-yielding corporates that offer improved investor protections, better documentation, stronger covenants, or backing by hard assets.

That said, we don’t want to strike an overly optimistic note on credit markets. Even if the economy recovers relatively quickly off today’s lows, many companies will not avoid bankruptcy or restructurings. As investors, we need to be very thoughtful about managing credit risks when evaluating the wide range of opportunities in corporate credit.

Q: What are our views and portfolio positions in emerging markets?

Ivascyn: There are significant risks in these economies as they face this global health crisis; they don’t have the policy capacity and capabilities we see in developed economies. But despite these shorter-term risks, we see attractive opportunities over the long term. Overall, we hold a fairly neutral view on emerging markets in the Income Strategy, and don’t anticipate making major changes. Within emerging markets we focus on defensive, relatively stable holdings in higher-quality sovereigns and quasi-sovereigns.

Q: Putting it all together, what is the overall outlook for the Income Strategy?

Ivascyn: Uncertainty and volatility may have challenged the Income portfolio earlier this year, but we believe the strategy is resilient, well-diversified, flexible, and poised to target opportunities arising across the global opportunity set today. There is clearly room for price appreciation in many segments of the Income portfolio as the economy begins to recover – for example, we expect to see more stabilization in the corporate credit markets, where we’ve been trading quite actively, as well as in mortgage-related markets.

We actively manage the Income Strategy with the goal of creating a consistent dividend. Our aim is for investors to participate in the ongoing normalization and healing in the global economy, but without too much exposure to the risk of a more negative outcome.

DISCLOSURES

Past performance is not a guarantee or a reliable indicator of future results.

All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Corporate debt securities are subject to the risk of the issuer’s inability to meet principal and interest payments on the obligation and may also be subject to price volatility due to factors such as interest rate sensitivity, market perception of the creditworthiness of the issuer and general market liquidity. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market’s perception of issuer creditworthiness; while generally supported by some form of government or private guarantee, there is no assurance that private guarantors will meet their obligations. U.S. agency mortgage-backed securities issued by Ginnie Mae (GNMA) are backed by the full faith and credit of the United States government. Securities issued by Freddie Mac (FHLMC) and Fannie Mae (FNMA) provide an agency guarantee of timely repayment of principal and interest but are not backed by the full faith and credit of the U.S. government. Sovereign securities are generally backed by the issuing government. Obligations of U.S. government agencies and authorities are supported by varying degrees, but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Diversification does not ensure against loss.

The credit quality of a particular security or group of securities does not ensure the stability or safety of the overall portfolio. Although the strategy may seek to maintain stable distributions, the distribution rates may be affected by numerous factors, including but not limited to changes in realized and projected market returns, fluctuations in market interest rates, portfolio performance, and other factors. There can be no assurance that a change in market conditions or other factors will not result in a change in the Income Strategy’s distribution rate or that the rate will be sustainable in the future.

For instance, during periods of low or declining interest rates, the distributable income and dividend levels may decline for many reasons. For example, the portfolio may have to deploy uninvested assets (whether from purchases of shares, proceeds from matured, traded or called debt obligations or other sources) in new, lower yielding instruments. Additionally, payments from certain instruments that may be held by the portfolio (such as variable and floating rate securities) may be negatively impacted by declining interest rates, which may also lead to a decline in the distributable income and dividend levels.

The continued long term impact of COVID-19 on credit markets and global economic activity remains uncertain as events such as development of treatments, government actions, and other economic factors evolve. The views expressed are as of the date recorded, and may not reflect recent market developments.

Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. There is no guarantee that the desired results will be achieved.

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