Market Sector Update

• The first quarter saw a dramatic sell-off in risk assets due to the COVID-19 pandemic, which caused domestic equities to decline by nearly 20%.
• The evolving COVID-19 pandemic has been met with unprecedented fiscal and monetary stimulus. During the quarter, the government responded with several stimulus measures including the $2.2 trillion CARES Act, similar to the stimulus passed during the 2008-2009 crisis. In addition to cutting rates 150 basis points (bps), the Federal Reserve (Fed) also launched QE4, which was subsequently termed “unlimited” in size. It will purchase both U.S. Treasuries and agency mortgage-backed securities for however long and in whatever quantity is necessary. It is going to be purchasing investment-grade corporate bonds with maturities of four years and less in the primary (new issue) market, while it has a separate program to purchase investment grade corporate bonds with maturities of five years and less in the secondary market. Additionally, it will also begin buying highly rated commercial paper. The launch of the investmentgrade corporate bond purchase program by the Fed has thus far marked the high point investment-grade spreads, which rapidly compressed in the days subsequent to the program’s announcement.
• U.S. Treasuries rallied sharply in the quarter with the yield on the 10-year U.S. Treasury falling 125 bps from 1.92% to 0.67%. The yield on the 2-year U.S. Treasury fell 132 bps from 1.57% to 0.25% as the Fed cut rates twice, by 50 bps in early-March then again by 100bps in mid-March, ending the quarter with a target range of 0%-0.25%.
• During the quarter, the yield curve steepened slightly as the difference between the 10-year U.S. Treasury and the 2-year U.S. Treasury rose 8 bps to 42 bps.
• The spread on the Fund’s benchmark, the Bloomberg Barclays U.S. Credit Index, widened massively from 90 bps to 255 bps, a level not seen since the 2008-2009 financial crisis and above the prior recession level in 2002. Intraquarter, the index reached 341 bps before rallying into the end of the quarter. High yield lost 12.68% as the spread on the high yield index rose from 336 bps to 880 bps, while leveraged loans fared even worse, losing 13.19%.
• Despite the substantial increase in volatility in the quarter, investment-grade bond supply increased dramatically in the days after the Fed announced it would begin purchases. During the period, investment-grade bond issuance totaled $480 billion, up 49% from the $321 billion issued in the first quarter of 2019. The month of March accounted for $262 billion of issuance by itself, up 129% year over year. This surpassed the prior monthly issuance record of $178 billion in May 2016. Given the spread widening, issuance was dominated by higher quality issuers. For the quarter, AA, A and BBB rated issuance increased 193%, 89% and 4% year over year, respectively. The duration of issuance during the quarter rose with average time to maturity at 13.3 years, above the 11.7 years average for new issuance over the past four years.
• Ratings action this quarter had a severe negative trend with the two-week rolling net ratings change hitting -$673 billion in March, the highest in at least 20 years. The market saw a large uptick in fallen angels, those issuers downgraded from investment grade into the high-yield market. The first quarter had $149 billion of fallen angels, and we believe more will come as $243 billion of BBB rated investment-grade bonds have spreads wider than the BB index. This compares with the approximately $60 billion of fallen angels in the first quarter of 2016 during the energy crisis, $80 billion in the second quarter of 2009, and less than $20 billion through all of 2019.

Portfolio Strategy

• The Fund had a negative return, but outperformed its benchmark, mainly driven by the Fund’s conservative positioning relative to the benchmark. The Fund’s return was primarily driven by a fall in interest rates and coupon income, more than offset by the widening of the benchmark spread by 165 bps.
• The Fund’s duration fell slightly during the quarter and remains modestly under the benchmark’s duration of 7.65 years. Higher duration means higher price volatility for a given change in spreads as well as interest rates.
• The Fund increased its allocation to BBB and BB rated credits, at the expense of the Fund’s exposure primarily to A rated credits. The largest changes in sector positioning were increases in the financial and consumer cyclical sectors and decreases in the industrial and energy sectors.

Outlook

• The markets have been derailed by the COVID-19 pandemic. We believe markets will find difficulty pricing in the vast uncertainty and the impact on macroeconomic variables and asset classes. A year ago it would have been impossible to predict the events of 2020 thus far, but what was seemingly predictable was that eventually a negative economic shock would occur and expose the excesses built in the corporate credit markets, a process now unfolding.
• While we have long been cautious on the corporate credit market due to our view that excesses had built up, we now believe the combination of the valuations and stimulus programs, most principally the program to purchase investment-grade bonds by the Fed, has created an attractive environment to take risk in the asset class and are positioning the portfolio accordingly.
• For the last 20 years, spreads in the investment-grade market have averaged 146 bps, and now stand at 255 bps. The yield on the 10-year U.S. Treasury has averaged 335 bps over the same 20-year period and ended the quarter at 67 bps. The ratio of investment-grade spreads to the 10-yr Treasury yield currently sits at 3.81-times versus the average of around 0.5-times over the last 20 years – this exceeds the prior peak of approximately 2.5-times during the 2008- 2009 recession. Coupled with the $10.5 trillion of negative-yield debt instruments globally, we believe there is a powerful technical supporting the investment-grade market.
• While we believe the high point in spreads has been reached for this cycle, the path will be bumpy given the unprecedented scenario that occurred in the first quarter. We believe the various investment-grade issuers will see a wide dispersion in returns as various businesses are impacted in dramatically different ways by the COVID-19 pandemic. We believe this year will have the largest number of fallen angels ever with greater than $500 billion of investment grade issuers falling in 2020. This amount is roughly 50% of the entire high-yield market, which we believe will be difficult to absorb. We think the dispersion and fallen angel activity we expect this year favors an active approach to investing in this market, so we will be selective in adding risk and will continue to seek attractive riskreward investments.

The opinions expressed are those of the Fund's managers and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through March 31, 2020, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon. Past performance is not a guarantee of future results.

The impact of COVID-19, and other infectious illness outbreaks that may arise in the future, could adversely affect the economies of many nations or the entire global economy, individual issuers and capital markets in ways that cannot necessarily be foreseen. In addition, the impact of infectious illnesses in emerging market countries may be greater due to generally less established healthcare systems. Public health crises caused by the COVID-19 outbreak may exacerbate other pre-existing political, social and economic risks in certain countries or globally. The duration of the COVID-19 outbreak and its effects cannot be determined with certainty.

The Bloomberg Barclays U.S. Credit Index measures the investment grade, U.S. dollar-denominated, fixed-rate, taxable corporate and government-related bond markets, including a non-corporate component of non- U.S. agencies, sovereigns, supranationals and local authorities. It is not possible to invest directly in an index.

Risk factors: The value of the Fund's shares will change, and you could lose money on your investment. An investment in the Fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Fixed income securities are subject to interest rate risk and, as such, the net asset value of the fund may fall as interest rates rise. Investing in below investment grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. These and other risks are more fully described in the Portfolio's prospectus. Not all funds or fund classes may be offered at all broker/ dealers.