Market Sector Update

• The third quarter saw a continuation of the risk-on environment from the second quarter, but experienced a moderate sell-off in risk assets in August as trade tensions resurfaced.
• Despite the risk-on environment, U.S. Treasuries continued to rally. This was due to the anticipation of the Federal Reserve (Fed) cutting its benchmark interest rate, as well as falling interest rates across the globe. At the end of the second quarter, the federal funds rate was 2.25-2.50% with the market pricing in a greater than 50% chance of the rate ending the year at (or below) 1.50-1.75%. By the end of the third quarter, odds increased to more than 70% that it would end the year below 1.50-1.75%.
• Macroeconomic data and expectations of easing by the Fed caused the 2-year U.S. Treasury yield to decline 13 basis points (bps) to 1.62% and the 10-year U.S. Treasury yield to decline 34 bps to 1.66%. The spread between the 10-year U.S. Treasury note and the 3-month U.S. Treasury bill remains inverted after turning negative for the first time since 2007. Historically, an inverted yield curve has implied a forthcoming recession, but the time lag can be significant. Another yield curve measure, the spread between the 10-year U.S. Treasury note and the 2-year U.S. Treasury note, flattened from 25 bps to 4 bps during the quarter. However, it did invert in August due to concerns that trade tensions would affect growth.
• After rising nearly 10% in the first half of the 2019, high yield rose 1.3% in the quarter mainly due to falling rates and coupon income. Spread tightening contributed slightly with the spread on the Bloomberg Barclays U.S. Corporate Bond Index falling from 377 bps to 373 bps. Similar to last quarter, higher quality segments of the high yield market outperformed with BB, B and CCC returning 2.03%, 1.65% and -1.76%, respectively. Leveraged loans returned 92 bps, continuing to trail high yield.
• Fundamentals for the investment grade universe continued to weaken, as revenue and earnings before interest, tax, depreciation and amortization (EBITDA) growth decelerated. In the second quarter, revenue and EBITDA (excluding commodity sectors) were up 2.4% and 1.3%, respectively. This was down from 3.2% and 2.6% in the first quarter of 2019. Sequentially, leverage for the investment grade universe was flat at 3.1-times, while the percentage of the universe greater than four-times leveraged was up 2% to 28%.
• In high yield, median leverage was flat sequentially at 3.9-times for the second quarter. Leverage increased 0.1-times to 7.7-times for the most levered quartile of the high yield universe. Positive ratings actions continued in the quarter with downgrade-to-upgrade ratios of 0.67 and 0.23 at Moody’s and Standard & Poor’s, respectively.
• Investment grade issuance was $385.5 billion in the quarter, up more than 40% year over year, with September being the third highest month on record. Issuance, net of maturities, was up nearly 28% year over year in the quarter and year-to-date net issuance is down less than 3%. BBB-rated issuance is 42% of year-to-date supply, down slightly from 43% of full-year supply in 2018. Overall maturity of issuance has increased with 59% of year-to-date issuance longer than six-years-to-maturity versus 54% for calendar year 2018. The high yield market had $64.9 billion in issuance, up more than 50% year over year, but was flat year over year net of redemptions.

Portfolio Strategy

• The Fund had a positive return, but slightly underperformed its benchmark. The return was primarily driven by falling rates and coupon income, while the spread for the index was flat at 115 bps.
• The Fund’s duration was unchanged versus the benchmark in the quarter. It remains lower than benchmark duration, which rose 0.2 years to 7.8 years at quarter-end. Higher duration means higher price volatility for a given change in spreads.
• We increased the Fund’s BBB exposure and reduced BB and A rated exposure. The largest changes in sector positioning were increases in the consumer non-cyclical and industrial sectors and decreases in the technology and financial sectors.

Outlook

• We believe the fourth quarter will likely be driven by the two principal concerns that have been the focus of investors this year – Fed policy and trade policy. U.S.-China trade tensions escalated with President Donald Trump announcing an additional 15% tariff starting on Sept. 1, as well as other tariffs targeted for October and December. Many believe a truce may develop in October with the remaining tariffs put on hold, but incremental damage to growth has already occurred and trade remains unpredictable.
• We believe the Fed is likely to cut in October. We think macroeconomic data may continue to soften and likely fall short of expectations in the fourth quarter due to trade policy uncertainty, Brexit and geopolitical concerns.
• We believe credit spreads may widen in the fourth quarter due to a few factors. First, macroeconomic data points are likely to underwhelm relative to consensus. Secondly, fundamentals in investment grade remain stretched with corporate balance sheets at their most levered levels post-crisis. Lastly, duration in the investment grade marketplace continues to rise.
• Outside of investment grade, cracks are forming in certain areas of credit, most notably high yield and leveraged loans. CCC-rated debt has lagged high yield returning 5.6% year to date versus 11.4% for the overall market. Additionally, the ratio of bonds trading below 70% of face value, a so-called distressed ratio, is at higher levels than during the fourth quarter of 2018 when risk assets sold off materially. We believe this portends an increase in the default rate.
• While lower-rated tiers of high yield have lagged, we believe BB returns may be negatively impacted going forward. Approximately 80% of BB debt is trading to call, meaning the price of the bond exceeds the price for which it can be redeemed in the future. This may limit further price appreciation and could result in negative asymmetry from changes in spread. Right now, we see better relative value in the BBB space.
• The technical backdrop for spreads remains relatively positive. We expect net supply to be materially lower than last year due to smaller merger and acquisition volume and tax changes. However, we expect a higher amount of total fixed income issuance due to U.S. deficit funding. On the demand side, trends are modestly supportive of spreads. We believe robust mutual fund flow is likely to continue in the near future, but yield compression may reduce demand.
• Given our expectation for modest widening of spreads in 2019, 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 Sept. 30, 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. 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.

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.