“It is easy to toss out a bunch of negative prefixes. Unprecedented, dislocated, and non-functional pretty much describes the market for fixed income securities at this point in time.” Those were our words that began our commentary for the third quarter of 2008, and over the quarter found history once again repeating. The first quarter of 2020 began with strong returns for risk assets, only to end in the quickest meltdown experienced in our lifetimes. Global policy making bodies continue to make unprecedented moves, announcing a host of steps to combat the spread of COVID-19 and minimize, as much as possible, the economic fallout. The last few weeks have been a period of enormous volatility and limited visibility. In many ways, this is (yet another) 100-year storm for financial markets but, unlike in the past, there is not one focal point in the financial markets or economy. It is not banks; it is not S&Ls; it is not dot-com or energy or another Long-Term Capital Management. In that sense, what investors are currently experiencing is a very different form of market stress in that traditional bunkers in which to hide from risk are scarce.
Current markets are volatile and fast. The outlook is uncertain and unpleasant. As portfolio managers we seek to balance the needs for capital preservation, liquidity, positioning portfolios to avoid future landmines, and being able to take advantage of liquidation-driven opportunities in order to add alpha to our portfolios. Over the course of the turmoil, we believe we have achieved these goals. Albeit with some volatility.
First-Quarter 2020 Performance Highlights
- During the first quarter, the Thornburg Strategic Income Fund (I shares) returned negative 5.57%, underperforming the longer duration Bloomberg Barclays U.S. Universal Bond Index, which returned 1.30%. We have a high level of confidence in our thoughtful, opportunistic process during times of market stress; if the last several bouts of market volatility are any guide, our strategy should be well suited to provide investors attractive returns for balanced-risk investors on a go-forward basis.
- Heading into “coronacrisis,” our portfolios were defensively positioned from both a duration and credit standpoint. Why? A key tenet of our philosophy: take risk only when compensated appropriately. Prior to the sell-off, spreads were tight and yields were low. Overall market leverage was building, especially in corporates. Similar to our other portfolios, we spent most of 2018 and 2019 in risk-off mode, waiting for better buying opportunities. These opportunities have certainly arrived, and while we expect some volatility across our recent purchases in corporate credit (both investment grade and high yield) and securitized holdings, we are quite confident in our ability to navigate choppy waters.
- Over the quarter, many participants were forced to be price-takers. The need for liquidity came at a steep cost to investors managing redemptions and other claims on capital. Our prudent management of capital allowed us to take advantage of these opportunities, providing ‘liquidity bids’ to the marketplace. In all markets, we have been a provider of liquidity, at very attractive terms, to over-extended investors. We began the quarter with an enviable 15% in cash and opportunistically deployed half of that amount amid the market rout.
Current Positioning and Outlook
Our opportunity set is broad, spanning corporate credit (investment grade and high yield loans and bonds), municipal credit, structured credit, securitized products (agency and non-agency RMBS and CMBS, consumer and other forms of ABS) and of course “risk-free” assets such as Treasuries. Through our process we seek to assess fundamental opportunities relative to compensation and for most of the last 18 months, compensation was subdued at best. This quickly changed as the economic realities from the spread of the COVID-19 virus and secondary effects (e.g. oil market collapsing) reverberated through markets.
Despite the media attention on the trouble in the corporate bond market, it was ABS and non-agency MBS that inflicted the most pain on investors. Why? Short durations within the securitized arena attracted forced sellers who believed that any price declines from spread widening would be minimal. Unfortunately, they were mistaken. Also, investors had flocked to this area for a pickup in yield relative to corporate bonds as ABS and non-agency MBS securities were “cheap for the rating”, which, please note, happens to be one of the most dangerous sayings in our business. But as the perception of credit risk increased, investors rushed for the exits at once, creating further liquidity issues. As this ensued, we were able to be a liquidity provider in the marketplace and pick up attractive securities at discounted prices across the securitized landscape.
Of course, the corporate bond market was not spared. In fact, the degree of spread widening across the markets was both significant and more rapid than in prior bear markets. We began the quarter with ~47% in corporate bonds. By the end of March we had opportunistically increased that exposure to ~55%. Heading into coronacrisis, 22% of the portfolio was rated below investment grade, with 1% rated CCC. Quite a defensive position relative to the history of the portfolio. As the quarter came to an end, we had opportunistically moved the portfolio to 33% high yield, while avoiding some of the most COVID-19-exposed business models and lower quality credits. Our exposure to CCC rated debt remained near 1% for example. Nimble managers succeed in fast-moving markets.
Credit markets have come a long way since the Fed expanded its asset purchases to include corporate bonds and these programs provide an important capital lifeline, but only to the right credits. No support is currently offered to high yield issuers of loans and bonds. Meanwhile, rating agencies are downgrading investment grade credits to the high yield universe at a record pace, thereby counteracting the Fed’s efforts. The good news is that market prices usually incorporate the downgrades before they occur. A downgrade cycle happens in response to an external shock. Market valuations also respond to that shock, incorporating the expectations of impending downgrades. For Strategic Income this creates both current opportunities, and potential future opportunities as the market attempts to assess risk.
We continue to believe we’ll see additional volatility in markets as we’ve only just begun to see negative economic data. A plethora of governmental actions within the market will certainly dampen negative effects, but we continue to sail in uncharted waters. There are many challenges ahead as policymakers and markets address bridging the gap in economic activity for an unknown period of time. However, we continue to believe that market stress and volatility brings opportunities to those investors who have ‘dry powder’ and have the flexibility to invest across a wide range of opportunities.
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%.