Market Sector Update

• The fourth quarter saw a continued recovery in risk assets due to positive vaccine news, further stimulus measures, as well as the passing of certain risk events like the U.S. election and Brexit, resulting in domestic equities rallying over 12%.
• The positive news drove U.S. Treasury yields meaningfully higher in the period. The yield on the 10-year U.S. Treasury rose 23 basis points (bps) to 0.91%, while the yield on the 2-year U.S. Treasury fell 1 bps to 0.12%. During the quarter, the yield curve steepened moderately as the difference between the 10-year U.S. Treasury and the 2-year U.S. Treasury rose 24 bps to 79 bps.
• While the Federal Reserve (Fed) continued buying corporate bonds at a pace similar to where it ended the third quarter, the facility created by the Fed and the U.S. Treasury, was terminated in the quarter as the U.S. Treasury requested its funding back and determined that legally the facility expired 12/31/20. This facility drove the recovery in credit markets this year. The markets took the change in stride and focused instead on the positive vaccine and stimulus news. This caused the spread on the Fund’s benchmark, the Bloomberg Barclays U.S. Corporate Index, to fall materially from 136 bps to 96 bps. High yield gained 6.45% as the spread on the Bloomberg Barclays U.S. Corporate High Yield Index fell from 517 bps to 360 bps, while leveraged loans gained 3.6%.
• Investment-grade issuance fell from the blistering pace of the first three quarters of 2020 as most funding and refinancing desires were met prior in the year. Fourth quarter issuance of $267 billion was well below third quarter, but still up 15% over last year. Full-year issuance was $2.1 trillion, substantially above the $1.3 trillion issued during the entirety of 2019, and 43% higher than the prior record year of 2017. Issuance net of maturities has been even more dramatic with net issuance of $1.07 trillion year to date versus just $356 billion of net issuance for all of 2019.
• In the quarter, high-yield issuance was $94 billion, which was down from a strong third quarter, but still well above the $68 billion issued in the third quarter of 2019. For the full year 2020 issuance in high yield was $418 billion, which like the investment-grade market, was a record for the asset class.
• Ratings actions marginally weakened in the fourth quarter with Standard & Poor’s upgrade-to-downgrade ratio in investment grade at 0.33 versus 0.39 in the third quarter and 1.12 in 2019. In high yield, the ratio stayed relatively flat from the third quarter at 0.77. Fallen angel activity increased slightly to $23 billion in the fourth quarter from roughly $20 billion in the prior period.

Portfolio Strategy

• The Fund had a positive return and outperformed the benchmark.
• The Fund’s duration fell slightly during the period and remains moderately under the benchmark’s duration of 8.84 years. Higher duration means higher price volatility for a given change in spreads as well as interest rates.
• The Fund increased its allocation primarily to A and BB rated securities, while decreasing its exposure primarily to BBB rated securities. The largest changes in sector positioning were increases in the consumer cyclical and communications sectors and decreases in the technology and industrial.

Outlook

• After one of the most volatile years in credit market history, the year ended close to where it started with a path no one could have predicted. The immense response from fiscal and monetary authorities will continue to impact markets going forward and cannot be ignored. Nor can one ignore the fundamentals, which we have often talked about, and which remain incredibly weak for corporate credit markets.
• We believe the future has numerous material risks that will likely impact markets going forward. We remain in a pandemic, a situation that has been de-risked with the arrival of the vaccines, but plenty of uncertainty still remains on the timing, uptake and efficacy on variants of the virus. We have a weak but strengthening economy, and significant policy uncertainty remains after the recent elections. Regarding fixed income markets, the recent rounds of stimulus lead to a greater degree of duration supply that the market may struggle to absorb, particularly given the already upward pressure on rates from resurging inflation expectations.
• We believe there is significant excess risk taking in the marketplace, a situation that in the past has brought meaningful volatility without the need for material macro deterioration. It is during these times of euphoria that credit markets become impacted by increases in financial engineering and mergers and acquisitions (M&A). While such activity impacts specific credits, it also has macro implications for the market by creating an increased risk premium for re-leveraging conditions, as well worsening the supply and demand technicals.
• Investment-grade fundamentals continue to be extremely weak with leverage remaining at record highs and duration in the market being near a record high. However, credit spreads sit at 92 bps for investment grade, well below their 20-year average of 145 bps. Similarly, high yield spreads of 360 bps versus their long-term average of 543 bps do not seem congruent with a default rate of 6.17%, which was up from 5.8% in the third quarter and above the long-term average of 3.5%. Layer on the fact that recovery rates after default sit at near-record lows and that upside is constrained by most of the high-yield market trading above its call price. The reason for the disconnects between the fundamentals and valuations is the favorable technical picture and the search for yield driven by the Fed’s actions.
• The technical backdrop continued to be favorable as supply in the quarter fell from the record pace of the prior two quarters and fund flows and foreign demand largely continued to be strong. Market forecasters largely believe that supply going forward is likely to be supportive. In aggregate, companies issued more than enough debt to shore up liquidity in the pandemic and subsequently refinanced a great deal of debt which suggests low issuance in the coming year.
• Going forward, we believe there are likely to be more frequent periods of volatility that prevent spreads from rallying materially in the coming year. Our conservative positioning is designed to allow us to opportunistically take incremental risk to capitalize on the volatility as it presents itself. In environments like these the cost of being defensive is very low. For instance, the breakeven spread on the investment-grade market, which means the amount of spread widening that will wipe away a year’s worth of spread carry, is roughly 11 bps. Calendar year 2020 saw the index widen by 11 bps or more in a single day nine times. We believe the best offense is a good defense to achieve sustained and attractive relative performance with current valuations.

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, 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. The duration of the COVID-19 outbreak and its effects cannot be determined with certainty.

The Bloomberg Barclays U.S. Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market and includes USD-denominated securities publicly issued by U.S. and non-U.S. industrial, utility and financial issuers. It is not possible to invest directly in an index.

All information is based on Class I shares.

Bloomberg Barclays U.S. Corporate High-Yield Index measures the USD-denominated, high-yield, fixed-rate corporate bond market. 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. Fixed income securities in which the Fund may invest are subject to credit risk, such that an issuer may not make payments when due or default or that the risk that an issuer could suffer adverse changes in its financial condition that could lower the credit quality of a security that could affect the Fund’s performance. A rise in interest rates may cause a decline in the value of the Fund’s securities, especially securities with longer maturities. Investing in below investment grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. Investing in foreign securities involves a number of economic, financial, legal, and political considerations that are not associated with the U.S. markets and that could affect the Fund’s performance unfavorably, depending upon the prevailing conditions at any given time. Mortgage-backed and asset-backed securities in which the Fund may invest are subject to prepayment risk and extension risk. The Fund typically holds a limited number of fixed income securities (generally 40 to 70). As a result, the appreciation or depreciation of any one security held by the Fund may have a greater impact on the Fund’s NAV than it would if the Fund invested in a larger number of securities. Fund performance is primarily dependent on the management company’s skill in evaluating and managing the Fund’s portfolio. There can be no guarantee that its decisions will produce the desired results. These and other risks are more fully described in the Fund’s prospectus. Not all funds or fund classes may be offered at all broker/dealers.