Market Sector Update

• The high-yield sector posted a modest quarterly gain of 2.88% and ended with a full-year return of 14.08%, as measured by JPMorgan. Meanwhile, leveraged loans returned 1.85% and 8.64% for the quarter and full year, respectively. Overall in 2019, B-rated returned 15.69% and outperformed BB-rated and CCC-rated bonds, which returned 15.61% and 11.25%, respectively.
• Default activity in bonds and loans decreased to $1.2 billion in December, the lowest level since January 2019. This is compared to an average monthly default rate of $4.9 billion, $3.6 billion and $3.1 billion in 2019, 2018 and 2017, respectively. Sectors contributing to this year’s default activity were energy (44%), healthcare (9%) and retail (9%). The full-year U.S. default rate was 2.86%.
• Bond yields declined sharply in December as completion of phase-one of the U.S.-China trade deal came into focus. Yields and spreads decreased 44 basis points (bps) and 46 bps in December to 5.91% and 424 bps, respectively. Yields on the high-yield index ended the year below 6% for the first time since January 2018.
• In December, after underperforming for seven consecutive months, lower rated CCC bonds returned 5.08% and meaningfully outperformed B and BB bonds, which returned 2.36% and 1.37%, respectively. Energy was the largest outperformer in December at 5.79%, but lagged the broader index for the year.
• High-yield fund flows were mixed throughout the quarter with a net inflow of $3.6 billion.
• The high-yield universe had strong new issuance in the quarter with $78 billion of new bonds. Refinancing continues to lead among the use of proceeds for 35 straight months. In terms of full-year new issuance by ratings, split BBB or BB accounted for the highest volume at 47% of total volume; CCC or non-rated was the lowest volume at 10%.
• Leveraged loans ended the year with December posting the strongest gains since January. In terms of quality, CCC and B loans returned 5.04% and 1.99%, respectively, sharply outperforming the BB loans return of 0.85%.
• For the full year, leveraged loans returned 8.64%, but underperformed the high yield sector and investment grade sectors which returned 14.08% and 14.10%, respectively.
• Leveraged loans ended the quarter with $7 billion of outflows. Loan funds reported their 15th consecutive outflow in December, albeit it was one of the lowest outflows of the year at approximately $1 billion. The last four quarters rank among the eight largest quarterly outflows on record.
• The new issue activity picked up considerably in the fourth quarter with $141.3 billion priced versus $93 billion, $91 billion and $67 billion in the third, second and first quarters, respectively. Similar to bonds, refinancing was the main use of proceeds.

Portfolio Strategy

• The Portfolio had a positive return, but underperformed its benchmark. Compared to the Portfolio’s all-bond benchmark, as well as our peer group, we are underweight high-yield bonds. This detracted from our performance as bank loans underperformed high yield in 2019. The allocation to loans has been the largest detractor from performance. Additionally, credit selection inside our loan portfolio in the mining, oil & gas and retail sectors detracted from relative performance. Conversely, the selection effect of our bond portfolio outperformed the index in 2019.
• The Portfolio’s allocation across asset classes remained steady, ending the year with 67.4% bonds, 25.0% loans, 4.4% other and 3.2% cash. The Portfolio’s weighting by rating category is 11.0% BB, 48.4% B, and 29.4% CCC, as measured by Standard & Poor’s. The breakdown of our loan portfolio is 17% first lien and 6% second lien.
• Leveraged loans continue to offer attractive yields relative to their seniority in the capital structure. First-lien loans are the largest loan category and one of the most senior parts of the capital structure. In times of stress and volatility, loans offer the potential for more stability and outperformance as compared to high-yield debt and equity.
• As we assess the market uncertainty around tariffs and trade, we have become more cautious about the risks we are taking. The outperformance of BB-rated bonds in 2019 has mostly been rate driven as the 10-year U.S. Treasury yield moved from 2.68% at the beginning of the year to 1.92% at the end of the year. We continue to view our loan portfolio as a replacement for our exposure in the BB category. The yield pick-up in loans relative to expensive BBrated paper reinforces our allocation to leveraged loans.

Outlook

• The Federal Reserve’s (Fed) early-year dovish approach to interest rate policy had an effect on high-yield bonds as the bonds became the preferred way to lock in cheaper borrowing rates. As economic indicators stabilized toward the end of 2019 and clarity around phase-one of a U.S.-China trade pact became clear, there was a late-year increase in issuance and a better-bid in the secondary market.
• As the market becomes more comfortable that the Fed is done cutting rates, we believe outflows from the loan asset class should cease which would reverse the large technical that the loan market experienced in 2019.
• Still looming over the market in 2020 are the presidential impeachment proceedings, the 2020 U.S. presidential election, unrest in the Middle East and questions around the trajectory of global growth.
• On the flip side, the strong labor market continues to help consumer confidence, the Fed and global central banks are easing and providing stimulus, which in turn has continued to help sectors such as housing and building materials.
• Replicating the returns experienced in 2019 may be extremely difficult as spreads sit close to 400 bps versus 570 bps when 2019 started. Market predictions for high yield’s performance in 2020 indicates expectations for single-digit returns, while S&P Global Ratings expect the corporate default rate to rise to 3.9% by the end of 3Q 2020, driven by more energy sector defaults.
• As always, our focus when evaluating investments is a company’s business model and competitive advantages in order to weather a recession and perform throughout the cycle.

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, 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.

Diversification is an investment strategy that attempts to manage risk within your portfolio but it does not guarantee profits or protect against loss in declining markets.

The ICE BofAML US High Yield Index tracks the performance of U.S. dollar denominated below investment grade corporate debt publicly issued in the U.S. domestic 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 Portfolio 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. Loans (including loan assignments, loan participations and other loan instruments) carry other risks, including the risk of insolvency of the lending bank or other intermediary. Loans may be unsecured or not fully collateralized may be subject to restrictions on resale and sometimes trade infrequently on the secondary market. 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.