The Fed shifts on inflation – What does it mean?
The Fed unveiled a revision to its monetary policy, allowing for higher inflation to help support the labor market. We believe this action could keep interest rates low for years.
The Fund outperformed the benchmark during second quarter. To what do you attribute this performance, especially in this turbulent market?
Tom Houghton: We believe it is important to trust your strategic allocation, especially in a market environment like we currently are experiencing. We see value in spreads and expect this to continue through the cycle, particularly with range-bound rates. We continue to focus on business models that are likely to sustain in a post-pandemic environment while avoiding those that will not, which is where we believe we are limiting our risk exposure.
Our strategy is underpinned by fundamental research. While benchmark-aware, we consider the broader universe of securities, and typically find ideas in the less-followed areas of the market. As larger capitalization structures and bench weight names have been supported by the Federal Reserve (Fed), we have moved more into those names in this market.
We continue to be mindful of downside risks in this market. We haven’t followed our peers in loading up on high-yield securities due to our bias around valuations, choosing to participate in the investment-grade space. Certainly, there are pockets of trauma in high yield where pain is going to be felt, many of these companies are unlikely to strengthen in this market. In fitting with our position to more core holdings in portfolios, we currently are underweight to high yield. While we recognize the level of market uncertainty that appears to lie ahead, we believe the portfolio is positioned for opportunities in the back half of this year.
Tell us how the Fund’s high-yield exposure works for and against you?
Daniel Henken: We decreased our high-yield weighting in 2018 and continued throughout 2019, as our analysis showed the risks outweighed the potential rewards. We started 2020 with a somewhat defensive positioning. Our relative performance early on was strong, then trailed as the market liquidity evaporated. As the market turned positive toward the end of March into April, we made the conscious choice at that time to increase our corporate exposure.
Our reasoning was to take advantage of the dislocation, though it’s difficult for us to get comfortable with the risk/reward equation as we move further down the credit spectrum. From our standpoint, we believe this to be an imprudent risk to take at this point in the cycle. That said, we regained ground in second quarter and still have some beta in the portfolio but are not willing to put our foot all the way down on the gas pedal.
We believe it’s important to acknowledge the Fed’s actions regarding the purchase of some high yield ETFs. However, as we’ve stated, we are focused on securities built for a post-pandemic world. To that end, we are avoiding gaming and leisure holdings where revenues are down 30% or more and it remains unclear what these will look like going forward.
How do you make a case for core fixed income in an environment where we have negative real rates due to levels of inflation that are well north of nominal rates?
Tom: Inflation is currently higher than treasury yields. Longer-term, we want to make the case for core fixed income as a ballast in time of volatility, regardless of the rate environment, and for the Fund given the yield advantage relative to the benchmark.
Do Treasuries have a role in a core-fixed income portfolio?
Lena Harhaj: Treasuries absolutely have a role in the portfolio. These are zero-bound at the low end, and in the absence of runaway inflation expectations, we believe the longer end is anchored. We do think rates will stay lower for longer. We also do not see a big upward push in yield. Lower rates have encouraged investors to take on greater risk in their portfolios. In periods of stress, Treasuries are often the only show in town. The yield advantage globally still exists today relative to the international/developed world. The Fed’s medicine comes with a price tag where absolute yield is discounted. Our allocation to Treasuries ranges from 10-20% throughout a cycle. Today we are around 13%, using this as a source of liquidity to make tactical moves and to adjust duration.
What opportunities do you see for the Fund?
Dan: We’ve been active in the new issue market and have also added on the residential side. This may sound counterintuitive given headlines about mortgage delinquencies and easy-to-obtain forbearance. However, we see that rent collections on single-family rentals with dual-income or high-income families have remained at pre-crisis levels.
We remain cognizant of the differences in borrower profiles between sub-prime auto, student loans and single-family rentals. Spreads are still wider than before the COVID-19 outbreak, though we feel strongly the consumer is in a much better position, which makes these assets attractive investments.
We reduced exposure to commercial-mortgage backed securities as we believe the corporate office environment may look very different in a post-pandemic environment, which puts pressure on the space.
Past performance is no guarantee of future results.The views are current through Aug. 19, 2020 and are subject to change at any time based on market or other conditions.
This information is not meant as investment advice or to predict or project the future performance of any investment product. The opinions are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This informa¬tion 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.
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 in¬sured 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. Mortgage-backed and asset-backed securities are subject to prepayment risk and extension risk. 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.
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.