Market Sector Update

• Positive economic indicators including robust corporate earnings, consumer confidence at decade-high levels, and a substantial sell-off in the Treasury market prolonged the risk-on environment throughout the third quarter. Second quarter gross domestic product (GDP) was revised upwardly in July and the 10-year note is now holding steady above 3%.
• As widely anticipated, the Federal Reserve (Fed) raised rates by a 0.25-percentage point in September. Despite it being the eighth rate hike in the current cycle, inflationary pressures remain on longer dated credit and the flattened yield curve persists.
• The risk-on environment continues to favor high-yield bonds for the year and the quarter. Citing the ICE BofAML US High Yield Index as a reference, high-yield bonds returned 2.4% for the quarter. Leveraged loans posted an impressive gain of 2.0%, the strongest performance within a quarter since Q4 2016.
• Yields on the asset class decreased slightly to 6.3% while the credit spread narrowed to a decade low in September. Across the credit spectrum, lower rated bonds continued to outperform relative to higher rated bonds outside a slight reversal in August. For the quarter, CCC credits returned 2.9%, while B and BB rated investments were both up 2.4%. The top industry performers year-to-date (YTD) are retail (+5.02%) and telecom (+5.68%), whereas the largest underperformers are autos (-4.05%) and housing (-0.46%).
• High-yield mutual fund outflows continued over Q3 but were more muted than previous quarters, equating to a loss of approximately $1.0 billion. YTD outflows total -$25.5 billion for the asset class versus -$10.9 billion during the same timeframe in 2017.
• New issue activity decelerated in the quarter, with new volume totaling around $42.1 billion. This marked the lowest level of activity for a quarter since the end of 2011. Leverage loan issuance totaled $94.6 billion.
• At the end of the quarter, the U.S. loan market is now roughly the same size as the U.S. high-yield market at $1.1 trillion. Five years ago the U.S. high-yield market was also $1.1 trillion while the U.S. loan market was $683 billion.

Portfolio Strategy

• The portfolio composition between bonds and loans remains relatively unchanged versus last quarter. Our exposure to leveraged loans relative to our peer group remains elevated at 19.51%. Higher London Interbank Offered Rates (LIBOR) have been favorable to loan yields and with the Fed indicating it plans to continue down the path of gradual rate increases (for now), our exposure to loans will continue. Loans have been one of the best performing fixed income asset classes YTD returning 4.83%.
• With regard to portfolio distribution by credit ratings, our work indicates that there has become less differentiation between credit rating categories. In addition, the compensation (spread) given for taking on more leverage/risk has continued to decline. As a result, we have reduced our exposure to CCC-rated bonds from 37.2% at the end of the first quarter of 2018 to 31.1% at the end of the third quarter, as measured by Standard & Poor’s ratings.
• Sectors that contributed to performance for the quarter were basic industry, retail and financials, specifically the insurance sub-sector and gains within specific credits therein.
• The portfolio’s approximate 4% exposure to equities detracted from performance.
• The largest detractors were the portfolio’s fairly substantial underweight to health care and energy sectors. The ICE BofAML US High Yield Index had an average allocation of 15.88% to energy while the portfolio had roughly half that weighting for the quarter. Similarly, the health care exposure within the portfolio was less than half the index’s 10.66% weighting.
• Although the lower duration due to the overweight exposure to loans has been favorable to the portfolio in the current rising rate environment, this has been a result of individual security selection rather than a macro call.

Outlook

• Although many firms on the street recommended a decrease from an allocation standpoint to high yield at the beginning of 2018, the asset class has been a top performer across fixed income. With lower credit quality bonds continuing to outperform higher credit quality bonds, the risk-on environment continues especially within noninvestment grade. YTD, CCC credits are up 6.06% versus BB credits up 0.76%.
• Despite the instability experienced within a variety of asset classes as of late, high-yield credit spreads narrowed four basis points throughout the quarter. High-yield spreads remained near the lower end of their long-term range, which is consistent with the low risk premium currently observed across other asset classes.
• Although investors welcomed higher yields at quarter-end, they were flirting with decade lows in April. Net supply of new high-yield bonds has been declining recently, creating a positive technical backdrop in the market place. Technicals, however, do not replace fundamentals in our decision making process. Managing the amount of risk we are willing to take for moderate returns in this setting is becoming increasingly important.
• Even though high yield is more correlated to equities than other credit strategies, it historically has offered more downside protection than stocks in volatile times. It continues to be our view that the tailwinds from corporate and individual tax reform, along with deregulation and the resulting boost in consumer and business confidence will outweigh global trade worries and headwinds for now. The downward trend of default activity for the quarter also remains constructive for the asset class.
• It is our view that finding value in the high-yield market has become increasingly more difficult and considerable caution is warranted in making new investments. As such, we believe our continued process of bottom-up, in-depth fundamental research and analysis will guide us to those investments where the risk/reward is in our favor.

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 Sept. 30, 2018, 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.