Market Sector Update

• The fourth quarter saw strong returns across risk asset classes as trade tensions eased significantly between the U.S. and China, Brexit appeared headed toward a benign outcome and macro data strengthened. The equity market had an impressive high-single-digit return in the quarter.
• Given the reduction in macro and geopolitical risks, U.S. Treasuries sold off during the quarter with the yield on the 10-year U.S. Treasury climbing 26 basis points (bps) from 1.66% to 1.92%. The yield on the 2-year U.S. Treasury fell 5 bps from 1.62% to 1.57% as the Federal Reserve (Fed) cut rates by 25 bps in the quarter to a target range of 1.50-1.75%. The market has priced in more than 60% odds of one additional rate cut in 2020.
• The yield curve steepened in the quarter with the difference between the 10-year U.S. Treasury note and the 2-year U.S. Treasury note rising 30 bps to 34 bps, generally a sign the bond market is pricing in more robust future economic growth.
• The spread on the Fund’s benchmark, the Bloomberg Barclays U.S. Credit Index, tightened from 109 bps to 90 bps, marking the tightest level for the index since early 2018. High yield continued to deliver solid gains in the quarter returning 2.62% with the spread on the high yield index tightening from 373 bps to 336 bps. The full-year return for the asset class was 14.32%.
• After CCC-rated credits lagged returns of BB and B in previous quarters, they outperformed in the fourth quarter returning 3.73% versus 2.45% and 2.61% for BB and B, respectively. We believe this is a sign of a more broad-based risk-on environment compared to the prior three quarters. Leveraged loans underperformed high yield as they have done all year with the index returning 1.68%, with a full-year return of 8.17%.
• Debt growth in the investment grade universe, excluding the volatile commodity sectors, slowed to 4.3% in the third quarter of 2019 compared to last year, its slowest pace since 2011. The same universe saw a slowdown in EBITDA growth to 2%, resulting in leverage of 3.1-times, flat sequentially, and up 0.1-time year over year.
• Despite concerns over the BBB space recently, BBB leverage has declined 0.1-time year over year to 3.6-times, while A-rated company leverage increased 0.3-time year over year to 2.5-times. This is consistent with the trend in the earnings payout ratio (the proportion of EBITDA used for dividends and share repurchases) where BBB-rated issuers payout ratio declined 4% year over year to 30%, while the payout ratio for A-rated issuers rose 3% to approximately 55%. Thus, while credit trends were roughly stable at extremely weak levels, the trend worsened for A-rated space and BBB saw modest improvement.
• Investment-grade issuance was $231.6 billion in the quarter, up 14% year over year. This is an underwhelming increase given the low issuance in fourth quarter 2018 as the market sold off during that period. Issuance, net of maturities, was up 50% year over year but remained small at $22 billion in the fourth quarter, typically a light period for net issuance. For the year, gross issuance was nearly $1.3 trillion, an increase of 7% year over year, while net issuance was $356 billion up 5% year over year. BBB-rated issuance was 43% of gross issuance in 2019, in line with 2018 levels. Longduration issuance increased during the year with 58% of issuance longer than 6 years, relative to 54% in 2018 as low rates encourage longer duration issuance.

Portfolio Strategy

• The Fund had a positive return, but underperformed its benchmark, mainly driven by the Fund’s conservative positioning relative to the benchmark. Return was primarily driven by benchmark spreads tightening 19 bps and coupon income, which was partially offset by rising interest rates.
• The Fund’s duration remained constant in the quarter and modestly under the benchmark’s duration of 7.6 years. Higher duration means higher price volatility for a given change in spreads as well as interest rates.
• The Fund increased its allocation to A rated credits, at the expense of the Fund’s exposure to BBB, AA and BB rated credits.
• The largest changes in sector positioning were increases in the consumer non-cyclical, energy and utilities sectors and decreases in the technology and financial sectors.

Outlook

• The principal risk of 2019 was trade policy, and given the likelihood of a trade deal in January 2020, this risk has abated. Replacing this risk is the 2020 U.S. presidential election, as the two political parties have starkly different candidates and policies that could dramatically impact risk assets.
• We believe the Fed is less likely to be a material driver of risk assets in either direction in 2020 since expectations are either for one rate cut, or none. While we expect the Fed to remain “on hold” for 2020, rate cuts are possible if the macro picture worsens.
• The fourth quarter saw a notable change in high yield as CCC credits began to outperform higher rated high yield in December. While this bodes well for staving off a larger uptick in the default rate, we believe some of these companies and capital structures are broken and will need restructuring. We think an increase in the default rate is likely in 2020, although we don’t expect recession-level defaults.
• The technical backdrop for spreads remains very positive. We expect net supply of investment-grade issuance in 2020 to be materially lower than 2019 due to smaller merger and acquisition volume, lessening leveraging trends and higher maturities in 2020. However, we expect a higher amount of total fixed income issuance principally from U.S. deficit funding. On the demand side, trends are modestly supportive of spreads. Mutual fund flows remain robust and are likely to continue, but demand may be reduced due to yield compression. Additionally, foreign demand is likely to remain strong given the yield gap between U.S. investment grade yields and those found in foreign countries.
• We believe spreads will widen in 2020 as valuations are near historically tight levels, particularly when adjusting for declining credit fundamentals and increasing duration. One potential catalyst would be if rating agency action turns more negative. The agencies have been very lenient with companies pushing the envelope on leverage or failing to hit deleveraging targets. While the timing of such a change is hard to anticipate, this leniency is appearing in financial media and the political realm, which may catalyze rating action. As it stands, 2019 saw a deterioration in the upgradeto- downgrade ratio in investment grade, which was 1.46 in 2018 for Moody’s (meaning 1.46 upgrades per downgrade), dropping to 1.25 for 2019, and 1.07 in fourth quarter 2019.
• Given our expectation for modest widening of spreads in 2020, we believe our conservative positioning relative to the benchmark is appropriate.

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 Dec. 31, 2019, 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 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.