Virtus Strategic Income Fund
2Q 2016 COMMENTARY
MARKET — The UK’s decision to leave the European Union dominated second quarter events. Though relative calm returned to the markets after a volatile reaction to the vote, “Brexit” introduces new uncertainties to the global outlook.
PERFORMANCE —The Fund’s underweight to U.S. Treasuries added value during a period in which most spread sectors outperformed government securities. Exposure to the top-performing corporate high yield and emerging markets high yield sectors benefited performance, as did exposure to yankee high quality.
OUTLOOK —With strong demand by investors and a supportive environment for fixed income, spread sectors continue to offer attractive investment opportunities to investors searching for total return and yield. Our emphasis continues to be on diversification, higher quality, and liquidity.
IMPORTANT DEVELOPMENTS THIS QUARTER
Overview: On June 23, the United Kingdom voted to end its 43-year membership in the European Union (EU), a historic event that shook markets around the globe. The “Brexit” outcome took markets by surprise as the “remain” campaign appeared to have the edge in the days leading up to the vote. In the immediate aftermath, the British pound plummeted to its lowest level versus the U.S. dollar in 30 years, stock markets tumbled, gold surged, and government bond yields dropped to record low levels. The Japanese yen and U.S. dollar rose as investors flocked to safe havens. Oil prices fell on fears of a global recession.
But as the quarter came to a close, relative calm returned to the markets. Most equity market indices retraced their losses, the dollar retreated, and oil recovered. The VIX measure of volatility, which spiked on June 24 (closing at 25.76), returned to its second-quarter range in the mid-teens, not quite reaching the sustained highs it hit during the tumultuous first weeks of 2016.
UK: The UK ended June in a state of political and economic malaise. Leadership in both major parties disintegrated. Rating agencies Standard & Poor’s and Fitch downgraded UK credit, both citing the deterioration in outlook and the possibility of future downgrades. The pound continued to slump, with expectations that the Bank of England will cut rates over the summer to avert recession. The pound-to-dollar exchange rate fell from the year’s high of nearly 1.50 on June 23 to end the quarter at 1.33.
Federal Reserve: Besides Brexit, investors dwelled on further tightening by the Federal Reserve. In mid-May, signs of strength in the U.S. economy prompted Chair Janet Yellen to state that a rate hike was “appropriate” in the coming months, increasing the probability for June or July. A weak non-farm payroll report on June 3, however, dashed those prospects and clouded the outlook. To no surprise, the June FOMC meeting left rates steady, with the looming Brexit vote an additional deterrent. Though the 2016 median dot plot at the June meeting called for two rate increases this year (from an expectation in December 2015 of four), rate hikes are less likely for the rest of the year in the aftermath of Brexit.
U.S. Economy: The U.S. economy continues to be resilient against global headwinds, including the UK’s vote. Consumer spending data remain strong, as does the housing sector. Gross Domestic Product (GDP) grew at an annual rate of 1.1% in the first quarter, below the 1.4% growth recorded in the fourth quarter of 2015. Inflation remains below target but has accelerated modestly over the past 12 months. Core PCE (personal consumption expenditures ex food and energy) is 1.6% versus the Fed’s 2% goal. Future job growth, however, is key to reinforcing U.S. economic strength.
Treasuries: The yield on the benchmark U.S. 10-year Treasury ended the quarter at 1.47%, down from 1.77% at the end of March and 2.27% at year-end 2015. Foreign buyers have had a huge impact on the U.S. Treasury market as investors have sought not just safe havens but also yield in a global negative rate environment. In the wake of the UK referendum, Fitch Ratings reported that the global total of sovereign debt with negative yields rose to $11.7 trillion as of June 27.
U.S. Dollar: The U.S. dollar zigged and zagged throughout the quarter (Bloomberg Dollar Spot Index), ending at a level close to where it started, but roughly 5% below the January high. The greenback has been on a downward path in 2016, though it spiked in mid-May on anticipation of higher rates and in June on the Brexit outcome.
China: Fears of a sharp slowdown in China have faded but have not gone away. Recent economic data have been soft (e.g., fixed asset investment), and the International Monetary Fund (IMF) has warned that the country’s massive corporate debt burden is a “key fault line” in the economy. The People’s Bank of China intervened to devalue the renminbi against the surging U.S. dollar following Brexit. Though it was not to the extent expected, it did raise the specter of the sudden and disruptive devaluation in August 2015.
Oil: Oil prices continued their upward trend. Brent Crude, the international benchmark, topped $50 per barrel in early June before ending the quarter at $48.21. Supply disruptions in Canada (wildfires) and Nigeria (militant activity on oil infrastructure) helped to boost prices, as did a decline in inventories and U.S. shale production.
GLOBAL FIXED INCOME PERFORMANCE SUMMARY
The broader U.S. bond market, as represented by the Barclays U.S. Aggregate Bond Index, returned 2.21% for the second quarter. Despite the volatility and uncertainty surrounding the Brexit vote, spread sectors outperformed U.S. Treasuries as spreads tightened.
High yield corporates was the best performing sector, posting its fifth consecutive month of positive returns since the sharp selloff in the early part of 2016. All of the industries within high yield ended the quarter with positive results, led once again by energy and metals & mining, which posted double-digit returns. On a quality basis, CCC-rated securities continued to be the best performers. Overall, the sector benefited from the rally in commodity prices, a more dovish Fed, major central bank easing, and favorable technicals.
The emerging markets sector also performed well. Emerging markets were relatively stable following the Brexit vote, suggesting that the event was less systemic to global financial markets than previous events in recent history. Though greater fallout may yet occur, the emerging markets stand to benefit from a continuation of low U.S. interest rates, easing on the part of major central banks, and their potential to generate income in a yield-starved environment.
Outperformance of longer duration assets contributed to the gains in investment grade corporates.
HOW THE FUND PERFORMED
U.S. Treasuries and Agency Mortgage-Backed Securities: Our underweight position benefited performance as most spread sectors outperformed the government sector.
Yankee High Quality Securities: Fading concerns over China, a more dovish Fed, major central bank easing, higher commodity prices, and the overall demand for yield in the market all contributed to drive improving global risk sentiment during the quarter.
Emerging Markets High Yield: Continued improvement in the global appetite for risk, a weaker U.S. dollar, and a perceived stabilization in fundamentals helped drive outperformance.
Corporate High Yield: The Fund’s exposure to the quarter’s strongest-performing fixed income sector benefited performance.
CURRENT FUND STRATEGY
Reduced exposures: We have reduced our weightings in the structured finance sectors. We repositioned our bet within high yield by adding more exposure to the cash market, but balanced that gross exposure with an increased hedge utilizing the high yield CDX derivative instrument. We continue to hold zero notional exposure to the option overlay strategy at quarter end. We also initiated a currency short of the British pound via the forwards market.
Increased exposures: Given the continued injections of liquidity by the world’s central banks, we decided to allocate more capital to foreign issuers via our yankee high quality and emerging markets high yield sectors. We also added some exposure to the taxable municipal market when the muni ratio screened as providing value or displaying its relative cheapness.
Higher quality focus: Although we have added to credit sectors, we continue to emphasize higher quality companies, generally avoiding very low-rated credits.
Energy: From an industry perspective, we have added energy-related credits to get closer to a neutral position. Our focus in the energy industry has been on investment grade energy companies that trade wide and are either expected to maintain their investment grade ratings or already are fallen angels. We are focused on companies that we believe can make it through the cycle even if oil prices stay in the $35 to $45 per barrel area for two to three years. We have also added slightly to some higher risk/higher beta energy credits that have significant upside potential if oil rises above $55 over the next few years.
Overweights: We continue to overweight corporate high yield, high yield bank loans, commercial mortgage-backed securities, residential mortgage-backed securities, emerging markets high yield, and asset-backed securities (specifically out-of-index/non-traditional asset-backed).
Structured Finance: Our allocation to the structured finance sectors continues to play an important role in the Fund. Valuations remain attractive in the areas in which we invest, and this segment of the market offers diversification to sectors that are more sensitive to global macroeconomic concerns. They also offer diversification to the corporate credit allocation within the Fund.
Commercial mortgage-backed securities have benefited from the strengthening U.S. economy and demand for U.S. real estate. Underlying commercial real estate fundamentals have softened but remain solid and, for the most part, are not hurt by low oil prices.
Our consumer focus within the asset-backed sector has been helpful to performance as a result of the continuing ability of the U.S. consumer to lift the domestic economy.
Non-agency residential mortgage-backed securities have benefited from the steady improvement in the housing market and demand for mortgage credit.
The UK’s decision to leave the EU introduces new uncertainties to the global outlook with broad social, economic, and political implications that will take years to materialize. The UK has two years to extricate itself from the bloc. Until now, no country has left the EU since its origins in the late 1950s, and there are no guidelines for the process. A worst-case scenario is that the UK’s action inspires other exit referendums.
Although challenges remain in the global environment, a number of positive developments continued to help the credit markets perform well as the second quarter came to a close. These included:
a more dovish Fed that has taken global macro risks into greater consideration,
global central bank easing,
yields in the U.S. that are attractive compared to yields in other parts of the world,
continued weakening of the U.S. dollar,
a continued rally in oil, and
evidence that growth in China is not weakening dramatically.
Technical conditions in the credit markets also have improved. Against the more positive global backdrop, better economic data in the U.S. have alleviated fears of an impending recession.
Our approach to investing in the global credit markets nonetheless requires caution as a number of these positive developments are still fluid situations:
negative surprises and further currency devaluations are possible in China,
oil likely will remain volatile, and
the U.S. dollar could resume its ascent.
All eyes will continue to be on the Fed. Though global concerns are a driving factor in its accommodating posture, the central bank has to weigh a host of external concerns against a resilient U.S. economy. We enter the third quarter guided by a modest improvement in the global environment, but also aware of newer risks such as the uncertainty associated with the UK’s vote and a divisive U.S. presidential election.
In this unsettled environment, we believe it is especially important to stay diversified, have granular positions, and emphasize liquid investments. We continue to look for opportunities in all sectors of the bond market, striving to uncover any out-of-favor or undervalued sectors and securities. We are constructive on spread sectors based on still solid fundamentals and attractive valuations. We continue to generally focus on higher quality credits within our below-investment-grade allocation, and are willing to give up some yield in order to avoid potential credit issues as we navigate the credit cycle.
With strong demand by investors and a supportive environment for fixed income, spread sectors continue to offer attractive investment opportunities to investors searching for total return and yield.
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.
Foreign & Emerging Markets: Investing internationally, especially in emerging markets, involves additional risks such as currency, political, accounting, economic, and market risk.
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.
ABS/MBS: Changes in interest rates can cause both extension and prepayment risks for asset- and mortgage-backed securities. These securities are also subject to risks associated with the repayment of underlying collateral.
Derivatives: Investments in derivatives such as futures, options, forwards, and swaps may increase volatility or cause a loss greater than the principal investment.
Call/Put Spreads: Buying and selling call and put option spreads on the SPX Index risks the loss of the premium when buying, can limit upside participation and increase downside losses.
Prospectus: For additional information on risks, please see the fund's prospectus.