Market Sector Update

• The third quarter saw a continued strong recovery in risk assets due to improving macroeconomic data and continued monetary policy support resulting in domestic equities rallying almost 9%.
• Despite the upswing in risk assets, U.S. Treasury yields only rose slightly as the Federal Reserve (Fed) announced it would adopt an average 2% inflation policy, which served to anchor U.S. Treasuries as rates are likely to remain near zero for years. The yield on the 10-year U.S. Treasury rose 2 basis points (bps) to 0.68%, while the yield on the 2-year U.S. Treasury fell 2 bps to 0.13%. 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 5 bps to 55 bps.
• The Fed significantly dialed back its corporate bond purchases during the quarter, ending the period at a pace of just over $100 million per week, down from roughly $300 million per week at the start of the quarter. Despite this, the improving macro backdrop caused the spread on the Fund’s benchmark, the Bloomberg Barclays U.S. Corporate Index to fall modestly from 150 bps to 136 bps. High yield gained 4.6% as the spread on the Bloomberg Barclays U.S. Corporate High Yield fell from 626 bps to 517 bps, while leveraged loans gained 4.1%.
• Investment-grade issuance continued to be highly elevated relative to historical norms as companies continued to shore up liquidity and refinance. Third quarter issuance increased to $460 billion, up 19% over last year. Year-to-date issuance of $1.84 trillion is substantially above the $1.3 trillion issued during the entirety of last year. In the quarter, high-yield issuance nearly doubled over last year to $122 billion and year-to-date issuance is higher than all but two of the prior 20 full-year periods.
• Ratings actions improved slightly but continued to be negative in the third quarter with Standard & Poor’s upgradeto- downgrade ratio in investment grade at 0.38 versus 0.30 in the second quarter and 1.12 in 2019. The same ratio in high yield showed a more positive trend with the upgrade-to-downgrade ratio rising to 0.75 in the third quarter from 0.14 in the second quarter. Fallen angel activity declined from $38 billion in the second quarter to roughly $20 billion in the third quarter.

Portfolio Strategy

• The Fund had a positive return and outperformed the benchmark.
• The Fund’s duration rose slightly during the period and remains moderately under the benchmark’s duration of 8.68 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 securities, while decreasing its exposure to BB rated securities.
• The largest changes in sector positioning were increases in the communications and technology sectors and decreases in the industrial and financial sectors.

Outlook

• After an extremely volatile year, the investment-grade market stabilized in the quarter with index spreads trading in a relatively narrow 24 bps range. We believe the Fed’s actions have suppressed volatility and provided material support for risk assets. This support for risk is unlikely to go away anytime soon, however one must balance it with the risks and fundamentals. The future continues to have numerous material risks that will likely impact markets going forward. We are in a pandemic, have a weak economy, and the upcoming U.S. Presidential election presents risks to the markets broadly as well as individual sectors. We’ve already started to see substantial hedging across asset classes ahead of the U.S. election cycle, the impact of which is considerably larger than the normal election hedging.
• 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 136 basis points for investment grade, well below their 20-year average of 145 bps. The reason for this disconnect 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 historically high investment-grade supply was offset by fund inflows and substantial foreign demand. However, towards the end of the quarter we saw a weakening of fund inflows, which remained positive. 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 coupled with low levels of mergers and acquisitions, suggests low issuance in the fourth quarter and beyond.
• Like investment grade, high yield spreads of 517 bps are below the 20-year average of 548 bps. Fundamentals are also poor with default rates at 5.8% versus the long-term average of 3.4%. It is also concerning that recovery rates sit at historic lows, hitting just over 15% in the prior 12 months, lower than any year in the past 30 years and below the 25- year average of 40% and the trend began before the pandemic. While we think there are and will continue to be interesting opportunities in high yield, we favor investment grade. We maintain a very selective in our high yield exposure going forward given the default and recovery rate dynamics, valuations and the fact that much of the higher rated parts of high yield trade above their call prices.
• Going forward, we believe record leverage and near-record duration, along with the myriad of risk factors in the future, is likely to lead to more frequent periods of volatility and prevent spreads from rallying materially in the coming quarter and beyond. While the technical picture remains favorable, it is fleeting while the weak fundamentals are likely to persist for years. Our current conservative positioning is designed to allow us to opportunistically take incremental risk into these periods to capitalize on the volatility as it presents itself.
• We believe that credit selection continues to be paramount and we continue to find ample mispriced credit situations to take advantage of as the pandemic continues to drive vastly different results from companies across the corporate credit universe. As always, our team is continually focused on assessing the rapidly changing landscape to ensure our positioning optimizes the risk and reward for our investors.

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 Sept. 30, 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.