Market Sector Update

• The fourth quarter saw a continued recovery in risk assets due to positive vaccine news, further stimulus measures, as well as the passing of certain risk events like the U.S. election and Brexit, resulting in domestic equities rallying over 12%.
• The positive news drove U.S. Treasury yields meaningfully higher in the period. The yield on the 10-year U.S. Treasury rose 23 basis points (bps) to 0.91%, while the yield on the 2-year U.S. Treasury fell 1 bps to 0.12%. During the quarter, the yield curve steepened moderately as the difference between the 10-year U.S. Treasury and the 2-year U.S. Treasury rose 24 bps to 79 bps.
• While the Federal Reserve (Fed) continued buying corporate bonds at a pace similar to where it ended the third quarter, the facility created by the Fed and the U.S. Treasury, was terminated in the quarter as the U.S. Treasury requested its funding back and determined that legally the facility expired 12/31/20. This facility drove the recovery in credit markets this year. The markets took the change in stride and focused instead on the positive vaccine and stimulus news. This led to the spread on the Portfolio’s benchmark, the Bloomberg Barclays U.S. Credit Index, to fall materially from 128 bps to 92 bps. High yield gained 6.45% as the spread on the Bloomberg Barclays U.S. Corporate High Yield Index fell from 517 bps to 360 bps, while leveraged loans gained 3.6%.
• Investment-grade issuance fell from the blistering pace of the first three quarters of 2020 as most funding and refinancing desires were met prior in the year. Fourth quarter issuance of $267 billion was well below third quarter, but still up 15% over last year. Full-year issuance was $2.1 trillion, substantially above the $1.3 trillion issued during the entirety of 2019, and 43% higher than the prior record year of 2017. Issuance net of maturities has been even more dramatic with net issuance of $1.07 trillion year to date versus just $356 billion of net issuance for all of 2019.
• Ratings actions marginally weakened in the fourth quarter with Standard & Poor’s upgrade-to-downgrade ratio in investment grade at 0.33 versus 0.39 in the third quarter and 1.12 in 2019. Fallen angel activity increased slightly to $23 billion in the fourth quarter from roughly $20 billion in the prior period.

Portfolio Strategy

• The Portfolio had a positive return, however underperformed its benchmark.
• The Portfolio’s duration fell slightly during the period and remains modestly under the benchmark’s duration of 8.55 years. Higher duration means higher price volatility for a given change in spreads as well as interest rates.
• The Portfolio increased its allocation to BB and BBB rated securities, while decreasing its exposure to AA and A rated securities. The largest changes in sector positioning were increases in the communications and utility sectors and decreases in the industrial and basic materials sectors.

Outlook

• As odd as it was, after one of the most volatile years in credit market history, the year ended very close to where it started with a path no one could have predicted. The immense response from fiscal and monetary authorities will continue to impact markets going forward and cannot be ignored. Nor can one ignore the fundamentals, which we have often talked about, and which remain incredibly weak for corporate credit markets. Particularly after the Fed backstop of the credit markets was eliminated during the quarter.
• We believe the future has numerous material risks that will likely impact markets going forward. We remain in a pandemic, a situation that has been de-risked with the arrival of the vaccines, but plenty of uncertainty still remains on the timing, uptake and efficacy on variants of the virus.
• We have a weak but strengthening economy, and significant policy uncertainty remains after the recent elections. Regarding fixed income markets, the recent stimulus and additional future stimulus are not as positive as they are for equities. The stimulus leads to a greater degree of duration supply that the market may struggle to absorb, particularly given the already upward pressure on rates from resurging inflation expectations.
• We believe there is significant excess risk taking in the marketplace, a situation that in the past has brought meaningful volatility without the need for material macro deterioration. It is during these times of euphoria that credit markets become impacted by increases in financial engineering and mergers and acquisitions (M&A). Lagging equities likely feel obliged either under their own volition or under pressure of activists to borrow at 2% for a 10-year bond to repurchase stock, pay dividends or embark on M&A. While such activity impacts specific credits, it also has macro implications for the market by creating an increased risk premium for re-leveraging conditions, as well worsening the supply and demand technicals.
• 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 92 bps 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 supply in the quarter fell from the record pace of the prior two quarters and fund flows and foreign demand largely continued to be strong. Market forecasters largely believe that 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 suggests low issuance in the coming year. However, the wildcard remains the activity we mentioned above, M&A and re-leveraging, which we believe may surprise to the upside resulting in supply which is likely to exceed expectations.
• Going forward, we believe there are likely to be more frequent periods of volatility that prevent spreads from rallying materially in the coming year. Our conservative positioning is designed to allow us to opportunistically take incremental risk to capitalize on the volatility as it presents itself. In environments like these the cost of being defensive is very low. For instance, the breakeven spread on the investment-grade market, which means the amount of spread widening that will wipe away a year’s worth of spread carry, is roughly 11 bps. Calendar year 2020 saw the index widen by 11 bps or more in a single day nine times. While 2021 is unlikely to be quite as volatile as 2020, we believe there will be plenty of volatility. We believe the best offense is a good defense to achieve sustained and attractive relative performance with current valuations.

The opinions expressed are those of the Portfolio’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, 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. 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.

The Bloomberg Barclays U.S. Credit Index measures the investment grade, U.S. dollar-denominated, fixed-rate, taxable corporate and government-related bond markets, including a non-corporate component of non- U.S. agencies, sovereigns, supranationals and local authorities. It is not possible to invest directly in an index.

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 Portfolio's shares will change, and you could lose money on your investment. An investment in the Portfolio 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. These and other risks are more fully described in the Portfolio's prospectus. Not all funds or fund classes may be offered at all broker/ dealers.

Annuities are long-term financial products designed for retirement purposes. Annuity and life insurance guarantees are based on the financial strength and claims-paying ability of the issuing insurance company. The guarantees have no bearing on the performance of a variable investment option. Variable investment options are subject to market risk, including loss of principal. There are charges and expenses associated with annuities and variable life insurance products, including mortality and expense risk charges, management fees, administrative fees, expenses for optional riders and deferred sales charges for early withdrawals. Withdrawals before age 59 1/2 may be subject to a 10% IRS tax penalty and surrender charges may apply.