Market Sector Update

• In stark contrast to the third quarter, which saw a risk-on environment and the equity markets gaining high singledigits, the fourth quarter marked an abrupt downturn in the performance of risk assets. Equity markets dropped more than 10% in the quarter. Despite an OPEC production cut, the oil market sold off dramatically in the fourth quarter with West Texas Intermediate declining almost 40% from $73.25 to $45.33.
• Given the risk-off environment, Treasury yields fell with the 2-year yield falling 30 basis points (bps) from 2.82% to 2.52% and the 10-year yield falling 34 bps from 3.06% to 2.72%. The Federal Reserve (Fed) raised the federal funds rate from 2.00-2.25% to 2.25-2.50%. The market implied probability of at least one additional hike by the end of 2019 dropped from 77% to 16%.
• The spread of the Bloomberg Barclays U.S. Corporate Bond Index rose from 106 bps to 152 bps, more than offsetting the benefit of lower Treasury yields.
• After having outperformed investment grade for much of the year, the high yield market fell in the fourth quarter with the Bloomberg Barclays U.S. Corporate High-Yield Index returning negative 4.53% for a yearly loss of 2.08%. The spread for the high yield market increased from 316 bps to 522 bps. Leveraged loans, which had outperformed substantially all year, also dropped sharply in the quarter with a loss of 3.08%, but still ended the year up 1.14%.
• Fundamentals for the investment grade universe were slightly better relative to last quarter. Revenues and EBITDA (excluding commodity sectors) were each up 4.8% year over year. Sequentially, leverage for the investment grade universe was flat, while the percentage of the investment grade universe that is greater than four-times leveraged declined. Overall fundamentals for the investment grade marketplace remain weak relative to history, especially when considering the expansion is entering its eleventh year. Of particular note in the quarter was the high-profile downgrade of large investment grade issuers from the A to BBB. The quarter saw the highest level of A to BBB downgrades since fourth quarter 2015.
• Investment grade issuance for the quarter was $187 billion versus $277 billion last quarter. December saw $8 billion of investment grade issued, compared to an average of $40 billion the past four years in December. Calendar year 2018 saw 25% of investment grade issuance used for acquisitions, higher than the prior two years (22% for 2016 and 17% for 2017). The year ended with the pipeline of mergers and acquisitions (M&A) deals at the lowest point in the last few years indicating M&A-related issuance may be materially lower in 2019. In the high yield market, the quarter saw just over $18 billion in gross issuance down from almost $68 billion in fourth quarter 2017 with not a single high yield issue pricing in December 2018.

Portfolio Strategy

• During the quarter the Fund’s benchmark, the Bloomberg Barclays U.S. Corporate Bond Index, returned negative 18 bps, bringing the year-to-date loss to 2.51%.
• The Fund’s duration was reduced to roughly half-a-year lower than benchmark duration.
• The overall risk of the Fund, as measured by its spread relative to the benchmark, increased slightly in the quarter. The Fund’s spread remains above the benchmark due to its exposure to the high yield market, which is not a material component of the benchmark.
• The Fund continued trimming cyclical exposure in consumer cyclical and industrial, while increasing exposure to technology and consumer non-cyclical sectors.
• The Fund reduced its high yield exposure by approximately one-third, while reallocating to BBB.
• We remain comfortable with our positioning to the investment grade and high yield as well as the Fund’s overall duration, spread and sector exposure.

Outlook

• Looking forward, we expect continued softening of economic data due to the lagged effect of interest rate increases, tariff impact, Brexit, and the recent impact of risk asset correction on the wealth effect and confidence.
• Last quarter we wrote that we believed the Fed would pause in 2019 and we now believe that probable number of hikes in 2019 is zero. As noted above, the market expectation has moved in this direction.
• We believe credit spreads in investment grade and high yield will modestly widen in 2019 as the slowdown in economic growth we foresee is priced in. Fundamentals in investment grade remain stretched with corporate balance sheets remaining at the most levered they have been post-crisis.
• Net supply should be materially lower than last year owing to wider spreads, lower M&A volume and the tax change reducing the incentive to issue debt. However, we expect a higher amount of total fixed income issuance principally from U.S. deficit funding. Additionally, the global shift towards quantitative tightening should offset at least in part the positive supply technical within the credit markets. On the demand side we expect more muted demand from foreign buyers due to currency hedging costs and demand from the fund community as flows tend to follow returns which have been negative this year.
• Given our expectation for modest widening of spreads in 2019, we will be opportunistic about our credit selection and overall positioning to take advantage of the opportunities and dislocations as they present themselves.

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, 2018, 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. 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.

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 30 to 50). 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.