During the second quarter of 2019, the Thornburg Strategic Income Fund returned 2.04% (Class I shares), underperforming both the 3.11% gain in the Bloomberg Barclays U.S. Universal Bond Index and the 3.34% gain of the blended benchmark. While we certainly don’t dismiss the quarterly underperformance of the Fund, we maintain our focus on delivering strong risk-adjusted returns over longer periods.
We remain skeptical about the U.S. Federal Reserve’s actions and motives. It seems policy decisions are no longer driven by economic fundamentals, but instead by market movements. In many instances, asset prices are widely disconnected from their fundamentals. What has gone from a tacit inference that the Fed will prop up swooning financial markets—the Greenspan, Bernanke and Yellen “puts”—has become more explicit under current Fed Chairman Jerome Powell, as he speaks increasingly openly about financial conditions and stability as part of the Fed’s decision- making process. A financial asset’s price should reflect more of its individual fundamentals and less of the tidal effect of Fed policy.
It now appears highly likely that market sentiment hinges on a 25-basis-point cut in the Fed’s key policy rate this month, not on the overall condition of the U.S. economy, which is in decent shape despite bearish headlines on trade and global growth. It is hard to imagine a quarter-point reduction in the Federal funds rate either helps or hurts the broader U.S. economy. It is, however, easier to imagine a century-old institution undercutting its credibility by seemingly allowing itself to be bullied by markets.
To be sure, some economic data have been weakening in the U.S. and abroad. The global PMI is down a record 14 months in a row and has recently moved into contractionary territory. The U.S itself is also sitting on the precipice on some leading indicators. The most recent ISM New Orders Index came in at 50.0, the exact number that defines the difference between contraction and expansion. Yet strong U.S. labor force growth and a supportive capex cycle are driving productivity gains. And while wage growth has leveled off lately, consumer sentiment and balance sheets remain relatively healthy.
It’s important to note that slowing global growth has prompted many central banks, not just the Federal Reserve, to move toward monetary accommodation. A number of central banks have already cut their key rates or provided guidance suggesting an easing bias. Some countries are pushing macro- prudential measures or fiscal stimulus. The European Central Bank recently extended forward guidance, as did the Bank of Japan, suggesting their respective policy rates will remain exceedingly low for quite some time. Others, such as the Reserve Bank of Australia, lowered rates due to concerns about slowing growth.
While the economic backdrop is important for fixed income investors, it’s also crucial to look at both corporate and consumer health as leading indicators for the economy. Corporate fundamentals slipped a bit in the first quarter of 2019, as growth in revenue and earnings before interest, taxes, depreciation and amortization were roughly flat, with the trend continuing in the second quarter. One important area of concern in the corporate market is leverage and interest coverage. While we are at or near all-time highs in terms of leverage, it is in a very different market than we experienced a decade ago. What we find disconcerting is not the sheer amount of leverage in the system but how stretched the fundamentals become when one factors in a slowing growth environment. This will surely cause problems for those who have thrown caution to the wind and indiscriminately bought credit at current levels.
For example, U.S. High Yield bonds continued their stellar performance in the second quarter and ended the first half 2019 up 9.85%. High yield continues to benefit from the Fed’s dovish pivot and market expectations for an insurance-related cut of 25 basis points. With yields and spreads continually compressed, investors should consider taking some risk off the table as historic measures continue to indicate complacency amongst investors.
Along with a decline in corporate fundamentals, consumer fundamentals have deteriorated, albeit much more modestly. The consumer is seeing increasing debt-to-income ratios as credit card rates are at a decade high. As expected, there has also been an uptick in delinquencies and losses. Despite these metrics, we continue to believe the consumer is on solid footing, bolstered by the tight labor market.
The strength of the consumer has led us to opportunities in the consumer loan ABS sector. Often issued by online credit providers, with proceeds used by credit-worthy borrowers for credit card refinancing or home improvement loans, the structures offer several attractive features. The credit profile of the bonds improves dramatically every six months through an amortization process. The bonds offer an attractive spread to other shorter-duration bonds that quickly deleverage. Lastly, the shorter history for online lending allows for pricing inefficiencies, providing us the opportunity to purchase issues that create a wide margin for error.
And margin for error is all the more important given the backdrop of interest rates. For much of the second quarter, rates have been in a free fall as the two-year U.S. Treasury has dropped from 2.41% in mid-April to 1.75% by the end of June. While the decrease in rates has generated a boon in fixed income prices, the lower yields have created a less appealing environment for the marginal dollar being invested. More importantly, total return has been driven by price appreciation despite all that has been said about the decline in fundamentals. Factoring in credit spreads, which have fallen precipitously throughout much of the year, the margin of safety is narrow by all measures.
In light of tight spreads, weakening corporate and consumer fundamentals, and a slowing global economic environment, we remain defensively positioned. We continue to reduce corporate risk and move into short, senior tranches of ABS and RMBS, where spreads have widened and offer a larger margin of safety. Given our skeptical view on the Fed and its motives, the duration of the portfolio has remained constant through much of the second quarter as we have focused more on diversifying the portfolio to weather many economic outcomes.
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.
Thank you for investing in the Thornburg Strategic Income Fund.