Virtus Credit Opportunities Fund
4Q 2016 COMMENTARY
MARKETS — Over the last calendar year, financial markets rallied strongly while major shifts in fiscal, monetary, regulatory, and trade policies began to brew. The net result of those shifts is a potential end, or at least pause, of the tailwind that fixed income investors have enjoyed from failing interest rates over the last 35 years.
PORTFOLIO — As a result, we continue to avoid long duration securities and expect that an actively managed domestic credit portfolio will offer an attractive source of risk-adjusted return going forward.
OUTLOOK — In addition, we believe that the combination of improved economic conditions domestically, potential interest rate increases, and foreign policy uncertainty will result in greater volatility in credit and fixed income markets. We are prepared to invest a substantial portion of the Fund when that happens.
HOW THE FUND PERFORMED
The Fund posted a total return of 6.33% during 2016, compared with 13.45% for its benchmark composite index (50% Bloomberg Barclays High Yield/50% Credit Suisse Leveraged Loan), and relevant market indices: 17.49% (BofA Merrill Lynch U.S. High Yield Master II Constrained Index) and 19.72% (HFRX Event Driven: Distressed Restructuring Index). Since inception (6/5/15) through December 31, 2016, the Fund’s 2.52% return (Class A NAV) trailed the benchmark and relevant indices by a much smaller margin: 4.21%* (composite index), 5.31% (BofA ML U.S. HY Master II Constrained Index), and 2.61% (HFRX ED: Distressed Restructuring Index).
On an absolute basis, the Fund underperformed its benchmarks. However, importantly, on a risk-adjusted basis, in our view the Fund’s performance met or exceeded that of its benchmarks, because we believe the Fund was invested in higher quality, lower risk assets than the benchmark and relevant market indices, as demonstrated by:
- The Fund held a significant cash position throughout the quarter
- The Fund maintained a substantially lower duration than the benchmarks
- The Fund was less correlated to equity markets than the benchmarks
- The Fund was extremely liquid
- More than a third of the securities held by the Fund were secured and typically higher in capital structures
MARKET CONDITIONS AND THEIR IMPACT ON THE FUND
At the beginning of 2016, financial markets were showing signs of serious stress. Spreads on high yield bonds increased to the highest levels since the global financial crisis, and equity markets began to tumble. Since February, financial asset prices have recovered and maintained an almost one-way trajectory on the backs of a rebound in oil prices and stimulus by central banks. Meanwhile, global growth remains muted and populism has started spreading throughout the developed world.
Although fundamentals have not changed much, investor expectations have improved dramatically to bullish levels. Markets have started pricing in faster economic growth and higher inflation driven by deregulation, greater fiscal spending, and tax cuts while ignoring the risk of protectionist policies such as trade barriers and tariffs. While we do not know how foreign and economic policy will play out over the next 12 to 18 month, we remain vigilant, opportunistic, and focused on our long-term goal of investing in great businesses with a compelling margin of safety.
Many financial pundits and celebrity portfolio managers have recently called an end to the 35-year bond bull market. While their call is certainly possible and consistent with near-term inflation trends, we do not try to predict interest rates. More importantly, accurate interest rate predictions are not necessary for the Fund to perform well. Instead, we monitor economic data as they develop and construct a portfolio of securities for the Fund that considers a range of risks, of which interest rates is just one.
That said, it is important to note that the 35-year decline in interest rates has been a significant tailwind for investors, particularly for long duration assets such as bonds, equities, and real estate. And with the 10-year Treasury yielding 2.5%, we believe a diversified fixed income portfolio based on fundamentally researched credits is superior to a fixed income portfolio based largely on interest rate duration. The section below discusses the three-decade long decline in interest rates.
“The Decline”—Three Decades of Falling Interest Rates
In September of 1981, interest rates in the U.S. reached multi-generational highs. The yield on the 10-year Treasury note was almost 16%. Rates have been steadily declining ever since, reaching all-time lows in the summer of 2016 (below 1.4% for U.S. 10-year Treasury notes). The Decline has not been simply a domestic phenomenon. Real long-term interest rates—that is, interest rates adjusted for inflation—have decreased since the early 1980s by almost 5% in both developed and emerging economies. Put simply, the Decline has been a persistent, long-lasting tailwind to economic performance and the valuation of most financial assets.
For example, the Decline has consistently lowered corporate and consumer borrowing costs, allowing businesses to pursue marginal projects and consumers to pull forward additional future consumption. On a macro level, the cumulative effect of that behavior is a series of transitory boosts in economic production.
The implications for fixed income securities are obvious and oft-repeated: a decline in interest rates means that existing fixed income securities yield above current market rates, and therefore their prices should rise (hence the “35-year bond bull market”). The implications for other financial assets may be masked by short term economic cycles and are therefore somewhat less obvious. But viewed over a longer period, valuations for most financial asset classes including stocks, real estate, and private equity, have unquestionably benefited from the Decline.
Although the effects of the Decline may be readily apparent, its causes are much less clear and also much more important. The culprit that is cited most often is central bank intervention. Short-term correlations certainly support that explanation. Therefore, it may appear that the Decline is simply the aggregate result of many decisions by omnipotent central bankers.
But central bank intervention as the sole cause of the Decline has its shortcomings. First, the Decline—a worldwide phenomenon—would require 35 years of supranational central bank coordination on a level that seems quite unlikely. Second, while central banks certainly have the practical ability to lower interest rates in the short term, that ability is not unchecked by market forces. If central banks maintain target interest rates below the rates required by fundamental market forces—i.e., “neutral interest rates,” then inflation rates will necessarily rise.
And yet the Decline has been coupled with moderate, stable inflation, particularly since the global financial crisis. And short-term interest rates have remained near and even below zero for almost a decade. Thus, either recent monetary excesses will eventually lead to significant inflation, which would require countervailing increases in interest rates, or neutral interest rates have shifted downward as a result of fundamental secular changes in the global economy, which would allow interest rates to remain low without increased inflation.
Without going into detail, those secular trends could include:
- Demographic changes in developed countries, such as baby boomers leaving the workforce and consuming less, without sufficient replacement from native younger generations or immigrants
- Increased income and wealth inequality reducing consumer consumption demand and economic growth
- Rapid technological changes altering the demand for labor and capital
- Decreased growth in global productivity
- Increased global indebtedness
While we do not know whether this is the end of the 35-year bond bull market, several near-term catalysts could alter these secular changes, even temporarily, resulting in major risks and opportunities for fixed income investors. These catalysts could include increased trade protections and tariffs, greater fiscal spending and deficits, decreased immigration into developed countries, and breakdowns in global cooperation. The net result of any of those catalysts could be a rise in inflation that necessitates higher interest rates. With interest rates still near generational lows and the tailwind from lower rates uncertain, we believe that spread products such as credit and event-driven situations such as distressed debt will offer better risk-adjusted returns than long duration assets.
2017 OUTLOOK AND OPPORTUNITIES
The domestic economy is reasonably strong. Unemployment and wage rates continue to improve, while inflation has slowly climbed to more appropriate levels. The domestic economy could strengthen further if President Trump is able to fulfill his domestic policy campaign promises of increased fiscal spending, corporate tax cuts, and deregulation. Given that, the likelihood of a recession or abrupt end to the current credit cycle seems low.
However, the global economy may be more fragile, particularly if President Trump is able to fulfill his foreign policy campaign promises of increased tariffs and protectionist treaty revisions. The worst outcome on this front, which is more than remote, is a breakdown in trade between the U.S. and China. In addition, Europe remains on the verge of political instability with near-term elections that have existential implications for the European Union and the eurozone.
Over the short term, we believe the result will likely be increased inflation, with less monetary stimulus from central banks and rising interest rates. Thus, interest rate duration, which has been a significant source of return in fixed income portfolios for decades, could quickly become a significant drag. That is not, however, a recommendation to short duration, as the long-term secular trends mentioned above could eventually dominate shorter term fiscal or regulatory policy decisions.
Instead, we believe that focusing on domestic credit is a more appropriate means of earning total return in a fixed income portfolio. As the domestic economy continues to improve and inflation increases, many industries and individual borrowers will thrive, while others suffer, making industry allocation and security selection paramount. Rising interest rates could also force borrowers with unstainable capital structures to restructure, creating additional opportunities for investors who can invest in stressed and distressed debt.
*Benchmark since inception performance is reported from 6/30/2015.
Benchmark since inception performance is reported from 6/30/2015.
The fund class gross expense ratio is 1.71%. The net expense ratio is 1.45%, which reflects a contractual expense reimbursement in effect through 3/1/2017. This ratio reflects the direct and indirect expenses paid by the Fund.
The net expense ratio minus the indirect expenses incurred by the underlying funds in which the Fund invests is 1.35%.
Average annual total returns reflect the change in share price and the reinvestment of all dividends and capital gains. Net Asset Value (NAV) returns do not reflect the deduction of any sales charges. POP (Public Offering Price) performance reflects the deduction of the maximum sales charge of 3.75%. A contingent deferred sales charge of 0.50% may be imposed on certain redemptions within 18 months on purchases on which a finder’s fee has been paid.
Performance data quoted represents past results. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown. Investment return and principal value will fluctuate so your shares, when redeemed, may be worth more or less than their original cost. Please visit Virtus.com for performance data current to the most recent month-end.
Index: The composite index consists of 50% Bloomberg Barclays U.S. High-Yield Bond Index (an index that measures fixed rate noninvestment grade debt securities of U.S. and non-U.S. corporations, calculated on a total return basis) and 50% Credit Suisse Leveraged Loan Index (an index designed to mirror the investable universe of the U.S. dollar denominated leveraged loan market, calculated on a total return basis). The composite index is unmanaged, its returns do not reflect any fees, expenses, or sales charges, and is not available for direct investment.
BofA Merrill Lynch U.S. High Yield Master II Constrained Index is a capitalization-weighted index which measures the performance of below-investment grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market. Total index allocation to an individual issuer is limited to 2%. HFRX Event Driven: Distressed Restructuring Index: Distressed restructuring strategies employ an investment process focused on corporate fixed income instruments, primarily corporate credit instruments of companies trading at significant discounts to their value at issuance or obliged (par value) at maturity as a result of either formal bankruptcy proceeding or financial market perception of near term proceedings.
The commentary is the opinion of the subadviser. This material has been prepared using sources of information generally believed to be reliable; however, its accuracy is not guaranteed. Opinions represented are subject to change and should not be considered investment advice or an offer of securities.
Credit & Interest: Debt securities are subject to various risks, the most prominent of which are credit and interest rate risk. The issuer of a debt security may fail to make interest and/or principal payments. Values of debt securities may rise or fall in response to changes in interest rates, and this risk may be enhanced with longer-term maturities.
High Yield-High Risk Fixed Income Securities: There is a greater level of credit risk and price volatility involved with high yield securities than investment grade securities.
Bank Loans: Loans may be unsecured or not fully collateralized, may be subject to restrictions on resale and/or trade infrequently on the secondary market. Loans can carry significant credit and call risk, can be difficult to value and have longer settlement times than other investments, which can make loans relatively illiquid at times.
Derivatives: Investments in derivatives such as futures, options, forwards, and swaps may increase volatility or cause a loss greater than the principal investment.
Non-Diversified: The fund is non-diversified and may be more susceptible to factors negatively impacting its holdings to the extent that each security represents a larger portion of the fund's assets.
Equity Securities: The market price of equity securities may be adversely affected by financial market, industry, or issuer-specific events. Focus on a particular style or on small or medium-sized companies may enhance that risk.
Prospectus: For additional information on risks, please see the fund's prospectus.