Global fixed income sectors generated positive returns in the second quarter. Political tensions were a focal point, with U.S.-China disputes reigniting, a wave of protests engulfing the United States, and Brexit uncertainty increasing in the United Kingdom. Sovereign bond yields remained broadly range-bound near record lows across most developed markets, supported by central bank purchase programs. Fixed income credit spreads tightened as countries began to gradually emerge from pandemic lockdowns. Vaccine developments progressed, and asset purchases by the U.S. Federal Reserve Board (Fed) commenced through its credit facilities. The U.S. dollar weakened against most currencies.
The quarter reinforced two of the portfolio manager’s core investment beliefs. First, patience is often rewarded when managing a fundamentally driven, thematic portfolio in which many of the allocations are determined by structural growth factors. While the COVID-19 pandemic has created short-term economic uncertainty, we believe that, over the longer term, the economy could accelerate many of the secular tailwinds that underpin the portfolio’s core allocations. With a combination of strong recoveries in our highest-conviction strategic-sector positions (inflation-linked bonds, cyclical high-yield, emerging-markets debt) and the rising dispersion of returns across currencies, sectors and securities, the fund realized performance from each component of the portfolio. The subadvisor’s highest-conviction long-term strategic sector positions contributed a total return of 5.2% during the period. These positions focused on assets that benefit most from aggressive fiscal and monetary policy globally (e.g. global inflation-linked bonds, U.S. agency MBS, and U.S. municipal bonds); declining inflation in emerging-market countries and a weak U.S. dollar policy by the Fed (e.g. emerging-market external and local debt); and relatively stronger resilience in the U.S. consumer (e.g. U.S. residential mortgage-backed securities and asset-backed securities).
Secondly, the fund’s deep liquidity profile and ability to be nimble can be beneficial when market dislocations occur. As the COVID-19 crisis has impacted countries, sectors and industries quite differently, there has been a significant dispersion of returns across fixed-income by currencies, sectors and issuers. As result, the Fund’s market-neutral and tactical strategies generated returns through more dynamic positioning over the quarter: generating 1.0% and 0.6%, respectively.
Early in the quarter, as fixed income markets began to re-open, the Fund generated significant returns by capturing unprecedented new issue concessions across investment-grade corporate bond markets. At the same time, as U.S. Agency MBS offered an historical level of yield premium over similar-duration U.S. Treasuries, the portfolio manager meaningfully increased exposure to this asset class on a tactical basis. These decisions early in the crisis generated positive returns in the portfolio.
As the quarter progressed and markets began to price in diverging expectations for the cycle across U.S. and Europe, the portfolio manager implemented relative-value positions that featured overweights to U.S. High-Yield versus European Financial and High-Yield issuers. Finally, rotational currency strategies that featured an underweight to the U.S. dollar versus a diversified set of developed- and emerging- market currencies also contributed strongly as markets began to price-in the collapse of the U.S. term structure relative to the world and the significant expansion of U.S. monetary and fiscal policy.
- The portfolio manager aims to position the portfolio to take advantage of the current structural and cyclical economic environment. Past recessions have been catalysts for new key thematic ideas in the portfolio, and the Coronavirus Recession of 2020 will be no exception. As such, the portfolio manager has introduced several new themes in the portfolio and expanded the scope of others to increase exposure to sectors they expect to lead in the next business cycle:
- The “Activist Governments” theme is now more relevant than ever, as open-ended fiscal policy, backstopped by central banks, could lead to higher inflation expectations and lower real yields globally. Global inflation-linked bonds will continue to be a main allocation, but the portfolio manager is also including other sectors within U.S. fixed income that should directly benefit from the Fed’s effort to ease financial conditions at the zero-bound.
- Introduced the “Term Asset-Backed Securities Loan Facility (TALF) Trickle-Down theme,” on the expectation that the most attractive returns in the structured-credit universe may come from non-TALF- eligible assets as the Fed has driven eligible asset valuations to levels that are less compelling for investors with unlevered mandates.
- The four R’s driving unique opportunities in credit markets in the post-COVID-19 economy are: Recession, Ratings constrained owners, Redemptions and Restructurings. The portfolio manager’s approach is to take advantage of these opportunities embedded in a new theme called “Credit Dislocation Strategies.” The approach targets idiosyncratic ideas in three different categories: (1) industry leaders and critical infrastructure companies in COVID-directly impacted sectors; (2) resilient businesses that can still generate positive earnings and continue to de-lever despite economic headwinds; and finally (3) cyclical/industrial companies with pristine investment-quality balance sheets and low levels of net debt relative to enterprise value.
- With yields collapsing to near zero, core government bonds will no longer offer the same degree of protection to investment portfolios as they have in the past. The portfolio manager has addressed this by introducing the “Core Challenges” theme, which seeks exposure to global sovereign bonds of countries that have more sustainable fiscal trajectories and high domestic savings to avoid monetary financing of deficits.