Market Sector Update

• Following the rally in December 2019, spreads on high-yield bonds continued to tighten during the first few weeks of January amid a backdrop of consistently positive macroeconomic data, a signed Phase One U.S.-China trade agreement, and a relatively strong start to fourth quarter earnings. Notably, like late last year, lower quality rating tiers started the month by outperforming higher quality. However, the outbreak of COVID-19 towards the end of January reversed this trend and put the reinvigorated global growth story on hold as investors grappled with the potential implications.
• Subsequently, the first few weeks of February saw investors shrug off concerns of a material economic impact caused by the outbreak. However, the global spread of the virus towards the end of the month increased fears of a global pandemic, leading to a market selloff and bringing 10-year U.S. Treasury yields to record lows.
• The selloff continued in March as high-yield markets experienced unparalleled declines. The pace of spread widening has been historic, faster than any other period on record, and spreads are trading at levels not seen since the 2008- 2009 Global Financial Crisis. Spread levels on the inde are now roughly 500 basis points (bps) wider relative to levels at the end of January.
• Markets continue to grapple with the unsettling effects of the novel coronavirus outbreak, with worries extending from the risks to human health to the potential flow-on effects on economies and social systems. As a result of the outbreak, governments across the globe imposed extreme containment measures and shut down non-essential functions. Although COVID-19 may prove transient, the impact from fear-based actions on fundamentals can be severe and this particular fear has caused a market panic.
• Central banks have begun taking dramatic steps to combat the economic shocks caused by the outbreak, with government-sponsored fiscal stimulus on its heels. The Federal Reserve (Fed) reduced rates 150 bps via two rate cuts in March, bringing the federal funds target range to 0-0.25%, and rolled out additional initiatives to guarantee liquidity to the primary and secondary investment grade credit markets. On top of the actions already taken, the Fed stated it “will continue to use its full range of tools to support the flow of credit to households and businesses.” Fiscal stimulus measures have also moved forward, with the U.S. passing a $2.2 trillion relief package, believed to be the largest in U.S. history.
• The 5- and 10-year Treasury rates traded 131 bps and 125 bps lower during the quarter, respectively. The optionadjusted spread on the Bloomberg Barclays U.S. High Yield Index traded 544 bps wider during the quarter to end at 880 bps, with spreads reaching levels as wide as 1,100 bps during March. High-yield mutual funds and exchange-trade funds reported outflows of $16.7 billion in the first quarter, with March outflows of $13.0 billion notching the second largest monthly outflow on record. Gross new issue activity totaled $72.7 billion during the quarter – it was strong to start the quarter, but with yields hitting a decade high, only five bonds priced for $4.2 billion during March. Additionally, net issuance has been low so far this year as only $18.7 billion has priced ex-refinancing.

Portfolio Strategy

• Across high yield from a rating standpoint, BB rated bonds returned -10.15%, while single-B rated bonds returned - 12.97% and CCC rated bonds returned -20.55%.
• The Fund had a low double-digit negative return, but outperformed the Bloomberg Barclays U.S. Corporate High- Yield Index. Sector selection was a major contributor to performance during the quarter, with security selection detracting to a smaller degree.
• From a sector selection standpoint, an underweight allocation to the energy sector and the cash position were the largest contributors to performance, more than offsetting detractions from an underweight allocation to the consumer non-cyclical sector and an overweight allocation to real estate investment trusts (REITs). From a security selection standpoint, holdings in the technology and energy sectors were the largest detractors, while holdings among REITs, communications and capital goods names contributed.
• We remain relatively defensively positioned and underweight energy. Valuations are inexpensive in scenarios excluding a deep and prolonged recession. Against this backdrop, we are looking for opportunities to add to our risk exposure from our existing cash positions. As has been the case in prior cycles, we expect high-yield bonds to benefit from a longer spread duration profile relative to other fixed income alternatives.
• From a maturity standpoint, we have been underweight the front-end of the yield curve (1-4 year maturities and not including our cash holdings), instead maintaining a preference for the belly of the yield curve (4-9 year maturities) where we believe our credit selection expertise can drive outperformance as we are able to identify securities that stand to benefit from spread compression as prices rally off of low levels. In terms of sector weights, we are overweight REITs, electric utilities, finance companies and technology sectors. Overweights generally result from an aggregation of where we are finding the largest number of attractively priced securities. We remain most underweight energy and consumer cyclicals as these segments are expected to face negative credit trends in the coming quarters.

Outlook

• While COVID-19 may prove transient, the ultimate severity of the human and economic toll remain as large unknowns. Policy support has begun, and we expect much more will be forthcoming, yet markets will also need to see signs that the outbreak is under control in the U.S. From the top-level portfolio perspective, we anticipate heightened volatility to persist for the next few weeks, if not months.
• Outflows have been relatively orderly and while spreads have widened, we are still early in the U.S. and Europe COVID-19 impacts, in our opinion. At present, it looks likely that the U.S. and Europe will have a brief but sharp economic contraction followed by a gradual recovery rather than a sharp upturn. Default outcomes will depend upon the duration of the contraction, as well as the time it takes to see a meaningful upturn. Given the sector mix and leverage characteristics of the market, our base case is a roughly 8% default rate in 2020 based on par-amount.
• Overall, we believe more patient positioning is prudent, although recent spread widening has made belowinvestment- grade segments look attractive. The rate cuts and additional quantative easing actions are a signal the Fed stands ready to help, but we do not believe monetary policy alone will solve issues related to the economic impacts of social distancing. The market continues to look for two key areas of policy responses – one in the form of fighting the virus and the other in the form of financial support. We have seen progress on both initiatives. Our view is that the virus is causing a valuation reset in credit and creating very attractive opportunities in the high-yield asset class. Even credits that are not impacted or stand to benefit from the current environment are trading at wide levels. We expect that COVID-19’s overall negative effect on the economy will fade by the second half of 2020, resulting in materially better 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 March 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 Bloomberg Barclays U.S. Corporate High-Yield Index measures the U.S. dollar-denominated, high-yield, fixed-rate corporate bond market. It is not possible to invest directly in an index.

All information is based on Class I shares.

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. In addition, the impact of infectious illnesses in emerging market countries may be greater due to generally less established healthcare systems. Public health crises caused by the COVID-19 outbreak may exacerbate other pre-existing political, social and economic risks in certain countries or globally. The duration of the COVID-19 outbreak and its effects cannot be determined with certainty.

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. International investing involves additional risks including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. 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.