Virtus Multi-Sector Short Term Bond Fund
4Q 2016 COMMENTARY
MARKET — The surprise outcome of the U.S. presidential election spurred a U.S. Treasury selloff in the fourth quarter on expectations of faster growth and rising inflation. As expected, the Federal Reserve raised its target rate 25 basis points at its last meeting of 2016.
PERFORMANCE — The Fund’s underweight to U.S. Treasuries added value in a period in which most spread sectors outperformed government securities. Allocations to corporate high yield and high yield bank loans contributed positively to returns in the rising rate environment.
OUTLOOK — With strong demand by investors and a supportive environment for fixed income, spread sectors continue to offer attractive 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: The unexpected victory of Donald Trump in the U.S. presidential election was a pivotal event in markets as well as geopolitics. Expectations of faster growth and rising inflation through infrastructure spending, tax cuts, and a loosening of regulations sent U.S. Treasury yields surging in the fourth quarter. The U.S. dollar rose in their wake. Politically, the Trump win was the U.S. equivalent of Brexit and another stake in the ground for global anti-establishment movements.
Treasuries: The yield on the U.S. 10-year Treasury accelerated in the immediate aftermath of the November 8 election. The benchmark yield ended the quarter at 2.45%, up from 1.60% at the end of the third quarter. The bond selloff went beyond the U.S., with rising yields reducing the outstanding amount of global negative-yielding debt from a high of $12.9 trillion in July 2016 to $8.6 trillion in early January 2017, according to J.P. Morgan. U.S. bonds remain attractive relative to their counterparts in Japan and Europe as the latter continue to rely on easy monetary policies and bond purchase programs to tackle chronic slow growth and low inflation. Key elections across Europe in 2017 raise fresh concerns about the Continent’s growth prospects. As a precursor, a “no” vote on the December 4 Italian referendum to change the constitution gave that country’s populist party an opportunity to advance its agenda.
Federal Reserve: At its last meeting of the year, the FOMC raised the benchmark federal funds rate by 0.25% to a range of 0.5% to 0.75%. The decision to hike, the first since liftoff in December 2015, reflected improvements in labor market conditions and a considerable increase in market-based inflation expectations. The revised dot plot shows the policymaking body now expects three hikes in 2017, a more hawkish stance than the market had anticipated. While the December decision was widely expected, investor focus now turns to the potential impact of Trump’s policies on future Fed actions.
U.S. Economy: By most measures, the new president will inherit a relatively sound U.S. economy. The labor market has shown solid jobs growth, with unemployment at 4.6% at year-end. Inflation expectations have increased since the election – a continuation of the longer-term trend, but also reflecting the inflationary impact of Trump’s yet-unspecified spending plans. Core PCE (personal consumption expenditures ex food and energy), at 1.7%, is trending higher and slowly approaching the Fed’s 2% goal. Consumer confidence and the housing sector both are supportive. Gross domestic product (GDP) grew at an annual rate of 3.5% in the third quarter, a sharp acceleration from sluggish growth in the first half of the year.
U.S. Dollar: As bond yields surged, the U.S. dollar followed suit as overseas investors sought to benefit from expectations of further Fed tightening and expansionary fiscal policy. The Bloomberg Dollar Index, a basket of 10 leading currencies against the U.S. dollar, closed the year at 1267.38, after touching a low of 1156.29 on May 2 and trading in a narrow and subdued range for much of the second and third quarters. The euro slid against the dollar during the fourth quarter, ending at 1.0517 and suggesting that the euro will reach parity with the greenback in 2017.
Oil: In another unanticipated outcome after months of false starts, Saudi Arabia-led OPEC and non-member major oil producers (notably Russia) reached a milestone agreement on November 30, 2016 to curb output and reverse the global supply glut. Brent Crude, the international benchmark, ended the year at $55.89 per barrel after trading between $45 and $50 for much of the second and third quarters and reaching a low of $26.39 in January. Compliance with the agreement, which took effect on January 1, 2017, is a primary challenge to its success. An increase in U.S. shale production or slippage in demand as a result of a strengthening U.S. dollar could offset the impact of the curbs.
China: Relative calm persisted in China during the quarter amid some encouraging economic data. But storm clouds may be on the horizon. While the economy appears on track to maintain the government’s annual growth target of 6.5% to 7.0%, the stimulus measures to support that growth may be unsustainable. Destabilizing factors include China’s estimated debt load of 250% of GDP, as well as the potential for Trump’s threat of a trade war to come to fruition. Further, China’s currency began to slide following Trump’s election, setting off a surge of capital outflows and a drain on foreign currency reserves to stem the losses.
GLOBAL FIXED INCOME PERFORMANCE SUMMARY
The broader fixed income market as represented by the Bloomberg Barclays U.S. Aggregate Bond Index returned -3.0% for the fourth quarter. U.S. Treasuries tumbled with the backup in rates. Most spread sectors outperformed the benchmark as spreads tightened. The global demand for yield continued to boost returns.
High yield corporates was the quarter’s best performing sector, offsetting the negative impact of rising rates with improving fundamentals and a positive economic outlook that led to spread compression. With the exception of healthcare, all of the industries within high yield had positive results for the quarter. Metals & mining and energy were the top performers for the three-month period and the full year. On a quality basis, CCC-rated securities ably outperformed higher-rated credit tiers for the quarter and year.
Bank loans also generated strong performance, benefiting from a pickup in investor demand. Bank loans offer a hedge in a rising rate environment because loan coupons get reset as rates go up. While investment grade corporates outperformed Treasuries, their greater sensitivity to interest rate movements generated a negative return.
The poor performance of emerging markets in the quarter revealed their vulnerability to rising U.S. rates and a stronger U.S. dollar. Trump’s espoused protectionist policies and their potential impact on trade and other economic lifelines were an additional factor driving the cautious sentiment toward these markets. The fourth quarter saw a surge in retail fund flows away from emerging markets.
HOW THE FUND PERFORMED
- U.S. Treasuries and Agency Mortgage-Backed Securities (MBS): Our underweight position benefited performance as most spread sectors outperformed the government sector.
- Corporate High Yield: The sector performed well due to its shorter duration in the rising rate environment and spread tightening during the period. Global accommodative central bank policy, sound fundamentals, a supply shortfall, and fair-to-good valuations provided a positive backdrop.
- Bank Loans: Loans benefited from strong technicals, the backup in rates, and tighter spreads. Also contributing to the sector’s performance were a robust collateralized loan obligation (CLO) market, positive retail fund flows, a lack of net new supply, expectations of continued central bank accommodation, and the global demand for yield. Fundamentals within the sector remain positive.
- Asset-Backed Securities (ABS): Fundamentals in the sector remain positive with low unemployment supporting our consumer focus. Technicals are strong as supply is running flat to last year’s level, and rising rate expectations enhance the demand for short, stable average life spread product.
- Non-U.S. Dollar: Though the Fund has a small allocation to the sector, the combination of higher inflation expectations and rising U.S. interest rates caused the U.S. dollar to strengthen and, as a result, led non-U.S. dollar securities to underperform.
- Emerging Markets High Yield: The sector slightly detracted from performance during the quarter. Though fundamentals have shown signs of bottoming, recent geopolitical events have reintroduced downside risk. Technical factors are neutral, with retail flows turning negative in the fourth quarter. Issuance is expected to decline from the high levels in 2016, but overall will be manageable. Emerging markets sovereign valuations are generally fair, even after strong year-to-date gains. Credit selection remains critical for the sector.
- Higher Quality Bias: Though exposure to the corporate high yield sector contributed to the overall performance of the Fund, our higher quality bias detracted from returns during a period in which lower quality outperformed.
CURRENT FUND STRATEGY
Reduced Exposures: We have reduced our weightings to U.S. Treasuries and commercial mortgage-backed securities (CMBS). We redeployed the sale proceeds primarily to corporate high quality and residential mortgage-backed securities (RMBS).
Foreign Exposure: We maintained the Fund’s overall foreign exposure over the quarter. With regard to emerging markets, valuations in specific countries are attractive and fundamentals seem to be turning; Brazil and Russia are driving expected improvement in 2017. Exposures could receive a boost from greater U.S. growth, but higher U.S. rates and a stronger dollar are risks. Commodity prices are supportive, and the political election calendar is relatively light. We favor sovereigns in larger capital structures. Total foreign exposure remains relatively low compared to historical averages, but our emerging markets country exposure is close to the five-year average for the Fund.
Higher Quality Focus: In addition to sector allocation changes, our relative value focus often leads to repositioning within sectors. Credit spreads in sectors such as corporate high yield and corporate investment grade continued to widen during the first half of the first quarter of 2016 to what we considered to be near-recessionary levels, and likely pricing in a high degree of negative news. We responded by adding incremental credit risk to the Fund, increasing our positions in U.S. high yield, emerging market credits, non-U.S. dollar bonds, and investment grade corporates. Although we have added to credit, we have continued to hold higher quality companies, generally avoiding very low-rated credits.
Energy: From an industry perspective, we have added energy-related credits. We have sought to add investment grade energy companies that trade wide and are either expected to maintain their investment grade ratings or already are fallen angels. Our focus has been less on trying to predict a quick recovery in oil and more on investing in companies that we believe can survive any type of market for oil, particularly those that can withstand two to three years of low prices in the $35 to $45 per barrel area. We have also added some higher risk/higher beta energy credits that have significant upside potential if oil rises above $55 over the next few years. In terms of supply and demand, the oil market is becoming more balanced and is expected to continue to improve, barring a big drop in global growth.
Overweights: We continue to overweight corporate high yield, high yield bank loans, RMBS, and ABS (specifically out-of-index/non-traditional ABS).
Securitized Product: Our allocation to the securitized product 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 more sensitive to global macroeconomic concerns. These securities also offer diversification to the corporate credit allocation within the Fund.
- Commercial mortgage-backed securities (CMBS) 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 (RMBS) have benefited from the continuing improvement in the housing market and demand for mortgage credit.
We are entering 2017 with a fair amount of uncertainty, much of it related to whether and how the newly elected president’s campaign rhetoric will materialize into well-defined policies. Other challenges from 2016 remain as the new year begins. These include the ramifications of divergent global monetary policy; the extent to which the U.S. dollar will appreciate as the Fed tightens; the path of commodity prices; Chinese economic activity and policy; and the ever present but unknown geopolitical risks. Politics has become a heightened dimension of uncertainty as important elections in Europe in 2017 will test the strength of political gains made by anti-establishment individuals and parties.
We also enter the new year with renewed optimism for U.S. economic growth, modestly improving credit fundamentals, and evidence of continued albeit slowly improving emerging markets fundamentals. All of these factors should be positive for spread sectors. Trump’s proposed policies are growth-oriented, which implies rising inflation and interest rates. We believe, however, that the Fed will stay the course and let economic data drive monetary policy. While the exact pace and magnitude of future rate hikes is unknown, there is significant evidence to support a gradual rise in rates. This also creates a positive situation for spread sectors.
As always, we believe it is important to stay diversified, have granular positions, and emphasize liquid investments. We will 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-sound fundamentals, strong technicals, accommodative central banks, and attractive valuations in certain areas of the fixed income markets.
With strong demand for fixed income by investors and a supportive environment, spread sectors continue to offer attractive opportunities to investors searching for total return and yield. Some of the specific sectors where we see value are: out-of-index/off-the-run ABS, non-agency RMBS, corporate high yield, high yield bank loans, and select emerging market bonds.
The Fund maintains its higher quality focus and short duration to limit both spread and interest rate volatility.
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.
Foreign & Emerging Markets: Investing internationally, especially in emerging markets, involves additional risks such as currency, political, accounting, economic, and market risk.
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.
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.
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.
Prospectus: For additional information on risks, please see the fund's prospectus.
The Morningstar RatingTM for funds, or "star rating", is calculated for managed products (including mutual funds, variable annuity and variable life subaccounts, exchange-traded funds, closed-end funds, and separate accounts) with at least a three-year history. Exchange-traded funds and open-ended mutual funds are considered a single population for comparative purposes. It is calculated based on a Morningstar Risk-Adjusted Return measure that accounts for variation in a managed product's monthly excess performance, placing more emphasis on downward variations and rewarding consistent performance. The top 10% of products in each product category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars, and the bottom 10% receive 1 star. The Overall Morningstar Rating for a managed product is derived from a weighted average of the performance figures associated with its three-, five-, and 10-year (if applicable) Morningstar Rating metrics. The weights are: 100% three-year rating for 36-59 months of total returns, 60% five-year rating/40% three-year rating for 60-119 months of total returns, and 50% 10-year rating/30% five-year rating/20% three-year rating for 120 or more months of total returns. While the 10-year overall star rating formula seems to give the most weight to the 10-year period, the most recent three-year period actually has the greatest impact because it is included in all three rating periods.
© 2017 Morningstar, Inc. All rights reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete, or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Strong ratings are not indicative of positive fund performance. Past performance is no guarantee of future results.
The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS, and CMBS.
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.
Please carefully consider a Fund’s investment objectives, risks, charges, and expenses before investing. For this and other information about any Virtus mutual fund, contact your financial representative, call 1-800-243-4361, or visit Virtus.com for a prospectus or summary prospectus. Read it carefully before investing.