Like much of the first half of 2019, major market movements in the third quarter were dominated by the U.S.-China trade dispute and monetary policy. The Thornburg Strategic Income Fund (I shares) returned 1.28%, underperforming both the 2.12% gain in the longer duration Bloomberg Barclays U.S. Universal Index and the 1.94% gain of the heavier- risk rated blended benchmark. While we certainly don’t dismiss the quarterly underperformance of the portfolio, we maintain our focus on delivering superior returns over longer periods. Over the last decade, the fund has returned 6.32% on an annualized basis versus 4.14% and 4.94% for the benchmarks, respectively.
The U.S. Federal Reserve reduced its key rate by 25 basis points (bps) in both July and September in what U.S. Fed Chairman Jerome Powell deemed a “mid-cycle adjustment” in the first case and an “insurance” cut in the second. The July reduction was accompanied by an earlier-than-expected end to the Fed’s balance sheet contraction. The press conference following the July meeting proved particularly eventful as Powell initially seemed to suggest the cut was “one and done,” but then clarified that it was neither that nor a long series of coming cuts, causing markets to gyrate. The September drop in the Fed funds rate and press conference went more smoothly, with asset prices neither jumping nor falling in response.
However, both rate decisions were met with a couple of dissents and the July meeting minutes further suggest the case for lower rates was not crystal clear. Also, the September Summary of Economic Projections (dot plot) median Fed funds projection suggests no further cuts for 2019. We believe another cut or two is likely by year end and futures markets are also pricing in at least one more Fed funds rate reduction in 2019.
The Fed’s actions are interesting for multiple reasons. First, Powell explained the cuts were made to counter low inflation and risks to the economy, largely from the trade war. Yet both conditions were present during the June meeting, when no action was taken. Low inflation, in fact, has been a persistent thorn in the side of policymakers for some time. To many observers, this explanation rings hollow and gives credence to the argument that perhaps the markets are leading the Fed rather than the other way around.
Investors around the globe are ultimately left to ponder what “financial conditions” as a term actually means. When conditions are said to be tight, does that imply the S&P 500 Index is too low? If the Fed fund futures market is pricing in a cut with increasing confidence, does it become a self-fulfilling prophecy because the Fed is loathe to disappoint, even when the merits of a reduction are debatable? Whatever the case, U.S. output does seem to be slowing along with the rest of the global economy amid the trade conflict and falling fixed investment, and with few signs of inflation breaking out, perhaps more easing might be helpful. However, a risk that policy makers must consider is the potential lack of firepower should the economy fall into recession and a prolonged easing cycle becomes necessary.
Two other significant developments in the realm of rates took place during the quarter. The two-year/10-year U.S. Treasury yield curve briefly inverted. This is traditionally viewed as a harbinger of future recession, but with “long and variable lags” as recessions haven’t typically materialized for another 12–24 months. Only time will tell. Moreover, the bond buying programs of the Fed and other major central banks may have disrupted the predictive power of the yield curve. Recent non-economic bond demand has driven term premiums negative in the U.S. and significantly so elsewhere. With a more normal term premium, the curve would not likely have inverted and thus no recession signal would have surfaced. That said, we don’t appear to live in “normal” times.
Take, for example, the recent turmoil in short-term funding markets. In mid-September, overnight repurchase (repo) market rates spiked, dominating headlines around the globe. The immediate cause seemed to be an abnormally large U.S. Treasury settlement coinciding with a U.S. tax payment day, as U.S. firms (and probably to a lesser extent, individuals) pulled cash from money market funds. The resultant large supply/ demand mismatch caused rates to spike, leading to questions surrounding the health of liquidity markets. The Fed stepped in with a special overnight repo operation and an additional 14-day repo program, calming markets. While some have called this “quantitative easing” (QE), we disagree. The action was designed to fix a temporary market supply/ demand imbalance, whereas QE was aimed at stimulating the economy. Policy makers are starting to acknowledge that bank demand for reserves is higher than originally thought. The Fed can solve this shortfall by allowing its balance sheet to grow along with the natural rate of the economy, just as it had in the past (see Chart 1).
Credit & Portfolio
Given the Strategic Income Fund’s ability to invest across the credit/sector/ geographic spectrum, one might expect our portfolio to be quite volatile in both allocations and returns. However, part and parcel of our success since launching the strategy in 2007 has been striking a balance between attractive risks and solid “blocking and tackling” investments. Over the past few months, we’ve fielded many questions from investors on the risks related to high yield, emerging markets and other riskier areas of the credit markets. We advise investors to avoid positioning their portfolios in a way that depends upon a single economic outcome in order to be successful. That’s easier said than done, of course.
Timing turns in the credit cycle is an inherently complex and uncertain exercise, often rife with random events, their mutual interactions and other unforeseen second-order effects. Many market participants attempting to time shifts in credit often end up frustrated. Yet, focused, fundamental investors can employ useful measures, qualitative attributes and previous experience to gain a better understanding of where we are in the current credit cycle. Ultimately, our goal when assessing the cycle is to effectively identify unsustainable trends in their late stages of development and position the portfolio to balance identified risks with a spectrum of attractive opportunities, such that the portfolio can be more than the sum of its parts, both before and after the cycle turns— however long that may take.
Within corporate credit, growth trends persist, but we keep a watchful eye. Investment-grade (IG) leverage continues to remain high and aggregate growth in debt necessitates a closer look. Since 2009, U.S. non-financial corporations have added $4.3 trillion in new debt, for a 66% increase. After a short pause during the market dislocation in the fourth quarter of 2018, growth in debt has resumed. A dearth of yield globally has kept demand for IG corporate paper generally strong. For example, despite being the fourth-largest month of issuance ever at roughly $160 billion, September saw spreads tighten five bps. Unfortunately, we may see leverage move somewhat higher from here as total debt continues to grow while EBITDA (earnings before interest, taxes, depreciation and amortization) growth slows, along with the broader global economy. Spreads, while off recent lows, are still tight by historical standards, making all-in yields not particularly attractive. However, the market continues to provide select opportunities within corporates that have less-cyclical underlying cash flows.
Surprisingly enough, while investment grade credit, private debt and broadly syndicated loan markets have all grown over the past three years, high yield has actually declined over the past three years (see Chart 2).
While, growth, spread and yield suggest a healthy high-yield marketplace, the truth is much more complicated. Higher- quality high yield (BB rated) is currently held extremely dear by investors while CCC credits are broadly unloved. In an earlier stage credit cycle, or true risk-on environment, the lowest quality and riskiest credits tend to outperform, but that has not been the case in 2019. This suggests that things are not as rosy as they appear. A strong bid for BB credit has created a wide universe of names trading near call prices, suggesting extremely limited upside pricing potential for recent investors. So, the downside potential of high yield bonds creates a poor convexity profile.
Energy continues to be a hot topic of conversation when discussing high yield securities. The oil patch was one of the most sickly sectors in HY during 2015- 2016. Many producers claimed that oil at $50-60 per barrel was the right price for sustainable financial health. Yet that’s been the price range this year, and the malaise in the space has spread. The new-found focus on financial discipline over production growth has come too late for quite a few oil producers, and their investors. We maintain de minimis exposure to the sector at the present time but will continue to hunt for select opportunities as they present themselves.
Another top-of-mind issue for high yield/loan investors is loose debt covenants and their potential pitfalls at the end-stages of the cycle. Lax covenants carry high potential risks, as poor investor protections go far beyond the general maintenance tests that originally brought us “cov-lite” deals. Today’s version of bonds with weak covenants have transitioned to new frontiers such as EBITDA add-backs, poorly structured asset liens, and low controls over additional debt issuance. Add-backs, for the uninitiated in mergers and acquisitions numbers, is an expense that is added back to the profits (most often earnings before interest, taxes, depreciation and amortization, or EBITDA) of a business for the express purpose of improving the profit situation of the company. Moody’s classifies EBITDA adjustments generally into four categories: minimal, conservative, aggressive and very aggressive. The rating agency has found that none of the deals priced so far this year fit into the minimal or conservative definitions, while two-thirds classified as aggressive and one-third as very aggressive. True financial health in the area may be masked.
Consumers, on the other hand, remain financially healthy with relatively strong balance sheets. Jobs are still plentiful and incomes continue to rise. Total debt is rising, as are loan delinquencies, but consumer credit quality underlying ABS (asset-backed securities) and MBS (mortgage-backed securities) remains solid. We believe credit underwriting and structure within these spaces are still favorable and especially so for our portfolios as we stay focused on the top of the capital stack. Spreads have recently tightened but remain absolutely and relatively attractive. Overall, we remain defensive across portfolio sectors, maintaining lower credit duration with a focus on defensive businesses. Currently we prefer consumer ABS and MBS over corporates, consistent with our preference for superior balance sheets.
Risks remain elevated and the U.S.- China trade spat will likely continue to reverberate through global economies, increasing volatility and depressing fixed investment. Growth around the world is indeed slowing as evidenced by weak PMI numbers abroad and challenged ISM data domestically. Additionally, the International Monetary Fund (IMF) recently trimmed developed world economic growth in 2019 to 1.9% and emerging market growth to 4.1%, with global growth estimated at 3.2%, all down from 2.2%, 4.5% and 3.6% in 2018, respectively. And while the IMF expects better growth in 2020, it describes its forecast as “precarious.”
Looking forward, investors have to contend with BREXIT, the Hong Kong protests, talk around a potential U.S. presidential impeachment, and bouts of geopolitical turmoil, particularly in the Middle East. Not a backdrop most would find appealing, yet risk asset prices remain near all-time highs. Investors would do well to remember that uncertainty often breeds opportunity for astute investors with a long-term, balanced focus.
We continue to believe caution in the corporate sector, both within investment grade and high yield, is warranted. At this stage of the credit cycle, individual security selection across industries, credit quality, maturities and region are likely to be key drivers of future returns. We believe our unique approach and structure offers our investors an edge in this strange and tumultuous environment. Over time, we rely on our results to bear this out. On a three-year rolling basis over the life of the fund we’ve managed to outperform both the Morningstar Multisector Bond category and Non-Traditional Bond Category 100% of the time, a period that included several different market episodes, both risk on and risk off (see Charts 3 and 4).
Thank you for investing alongside us in Thornburg Strategic Income Fund.
Performance data shown represents past performance and is no guarantee of future results. Investment return and principal value will fluctuate so shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than quoted. For performance current to the most recent month end, see the mutual funds performance page or call 877-215-1330. The maximum sales charge for the Fund’s A shares is 4.50%.