Virtus Senior Floating Rate Fund
4Q 2016 COMMENTARY
FUNDAMENTALS — Broad market fundamentals modestly improved and remain acceptable. The S&P/LSTA Leveraged Loan Index default rate by number declined modestly during the quarter.
TECHNICALS — Loan market technicals continued to strengthen as the pace of retail fund flows and collateralized loan obligation (CLO) issuance accelerated while net new issuance remained relatively muted.
VALUATIONS — Valuations remain attractive, even after the recent recovery, and are well positioned to produce solid risk-adjusted returns in a rising rate environment.
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 tacklechronic 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.
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.
The loan market, as measured by the S&P/LSTA Leveraged Loan Index (S&P/LSTA Index), posted a strong return of 2.26% for the fourth quarter, bringing full-year 2016 returns to 10.16%. This was the best year for loan performance since 2009.
- On a quarterly basis, fourth quarter returns improved substantially year-over-year from a loss of 2.1% in the fourth quarter of 2015, but lagged the strong third quarter 2016 return of 3.08%.
- The loan market rebound that began in March 2016 continued into the fourth quarter based on strong loan market technical factors against the backdrop of a favorable environment for risk assets.
- Performance has been led by lower quality paper and the commodity industries as prices of loans in these sectors recovered after being heavily beaten down during last year’s sell-off. CCC-rated, second lien and defaulted paper were up 8.81%, 5.41% and 8.52%, respectively, in the fourth quarter of 2016.
- Higher quality credit underperformed, with BB-rated paper lagging but up a still-solid 1.35% in the fourth quarter. On an industry basis, energy and metals & mining led the rally, posting returns of 14.2% and 12.5%, respectively. Only about seven of the 33 industry groups in the S&P/LSTA Index outperformed the overall index return during the quarter.
- To put loan market performance into context, loans outperformed high yield (1.88%), investment grade corporate bonds (-2.88%) and the 10-year Treasury (-6.81%) as Treasury yields rose during the quarter.
Loan market technicals continued to strengthen in the fourth quarter as the pace of retail fund flows and collateralized loan obligation (CLO) issuance accelerated while net new issuance remained relatively muted.
- For the quarter, net supply as measured by loan index outstandings increased by roughly $6 billion versus a quarterly average increase of $6.8 billion over the last two years, while visible demand rose to roughly $39 billion. This resulted in a supply deficit of about $33 billion.
- Fourth quarter gross loan issuance totaled $102 billion, a decrease of 5% from the third quarter but a still-elevated level, as capital markets were wide open throughout the quarter. A large portion of the issuance was opportunistic volume such as refinancings that did not add much net new supply to the market.
- With a large portion of the market trading above par on strong technicals, repricing activity picked up to roughly $85 billion during the fourth quarter, an increase of 44% over the prior quarter and the most since the first quarter of 2014. Repayments from mergers and acquisitions (M&A) and bond-for-loan take-outs continued at an elevated level, which limited net supply.
- Gross M&A new issuance volume has remained fairly muted and range-bound. We have observed a distinct trend of more aggressive issuance given the excess demand, and more limited pricing differentiation between credits. Negative trends include higher levels of adjustments to cash flow and higher leverage on new issuance. These developments may result in poor performance down the road for the current vintage of issuance in terms of defaults and recoveries.
- Retail loan fund flows improved substantially in the fourth quarter and accelerated on a monthly basis, culminating in a $5.7 billion inflow in December. This was the largest level since August of 2013. Flows have accelerated due to a combination of factors including changes in expectations regarding growth and inflation post the Trump election, rising Treasury yields and anticipation of further Fed rate hikes in 2017.
- CLO issuance picked up during the fourth quarter to $25.7 billion, versus $19.9 billion in the third quarter, as issuers looked to tap the markets before the new risk retention rules went into effect in late December 2016. Issuance was also supported by improved pricing on both senior and mezzanine CLO liabilities. For the full year 2016, CLO issuance declined about 26% largely due to the dislocation in liabilities in the first quarter of the year. The outlook for issuance is constructive for the first quarter of 2017, although a slow start is likely as managers finalize their risk retention strategies. Scarcity of collateral with limited new issuance and increased repricings may also constrain CLO issuance in the first quarter.
- The improving macro backdrop and technicals led to an increase of $2.87 points in the average price of the loan index, to $98.08 at quarter-end. Fully $1.55 points of the increase was due to the exit of the Texas Competitive Electric Holdings debt facilities following its emergence from bankruptcy.
Broad market fundamentals modestly improved and remain acceptable as the S&P/LSTA Index default rate by number declined modestly to 2.06% at December 31, 2016 from 2.23% at the previous quarter-end.
- Quarterly defaults remained relatively quiet as just three small defaults occurred in the fourth quarter, compared with only two in the third quarter. The declining level of defaults is due to rising commodity prices and wide open capital markets. Defaults remain below the long term average of 2.8%, and are concentrated in the troubled energy and metals & mining sectors.
- It does not appear that default activity is spreading to other sectors, although stress seems to be increasing in the retail sector due to changing consumer preferences, and to some extent in healthcare. Supportive fundamentals include adequate third quarter earnings, strong but slightly deteriorating cash flow coverage of interest, a diminished maturity wall, and expected positive growth in U.S. gross domestic product (GDP) over the next few quarters.
- The positive performance of the overall bank loan market contributed to the Fund’s gains.
HOW THE FUND PERFORMED
The Virtus Senior Floating Rate Fund (Class A NAV) returned 2.05% for the quarter ending December 31, 2016, compared with the S&P/LSTA Leveraged Loan Index, which returned 2.26%.
- Solid credit selection in the energy and utilities industries contributed positively to returns.
- An underweight to the retail industry was additive to performance.
- Remaining fully invested with the modest use of leverage contributed positively.
- Our high yield allocation added value.
- Detractors from performance included selection and, to a lesser extent, allocation across the metals & mining, information technology, healthcare and automotive industries.
- A more modest overweight to quality and a slight underweight to higher beta credit relative to earlier in the year still detracted from performance as risk continued to rally in the fourth quarter.
CURRENT FUND STRATEGY
At quarter-end, 90% of the Fund was invested in senior secured first lien bank loans, 3.2% in non-first lien bank loans, and the majority of the remaining exposure in high yield bonds consistent with our liquidity strategy.
We continued to add some risk at the margin during the fourth quarter as a result of the improvement in the commodity markets as well as continued healing in the capital markets.
- The net result for the quarter was an increase by roughly 185 bps in the Fund’s exposure to the lower quality credit tiers and, to a much lesser extent, high yield. The increase in exposure to single B credit contributed to the solid performance of the Fund in the fourth quarter.
- We continue to scrutinize existing holdings to ensure that our fundamental thesis is intact, and for relative value opportunities given the large rally since February 2016 and the current wave of repricings. We also continue to review the secondary market for discounted/total return opportunities and have added several discounted loans to improve the convexity of the Fund.
- We have also become more comfortable with oil supply/demand dynamics and certain energy credits in favorable basins with favorable cost structures. As a result, we are now slightly overweight to the energy industry through the addition of some energy credits.
- In the new issue market, underwriting standards progressively weakened throughout the latter half of 2016 and into early 2017. We have noted an increase in leverage, large adjustments to cash flow in marketing transactions, and several non-traditional agents bringing deals to get around the Fed’s leverage guidelines. We see this vintage of new loan transactions as aggressive, and are passing on a substantial number of new deals.
- During the quarter, we increased our industry weightings to the information technology, energy and retail industries while decreasing our exposure to the cable, healthcare and food & drug industries. Some of the largest industry overweights in the Fund are to the housing, chemicals and cable industries. The largest industry underweights in the Fund are to the diversified media, service and information technology industries.
We added risk over the past year as markets recovered and it became more clear that the default cycle had been likely pushed farther into the future. However, we continue to have an underweight to the single B and below credit tiers in the aggregate, given more compressed valuations as the market approaches par and until we have more clarity on the impact of the new administration’s fiscal and regulatory policies on the economy.
We are comfortable with our liquidity position, and we cautiously monitor it and consider it daily in managing the Fund.
The outlook for leveraged loans remains constructive given a combination of:
- still-attractive valuations even after the recent recovery, with spreads still inside the long-term average,
- stabilizing fundamentals, and
- the recent increase in Treasury rates along with the expectations for addition monetary tightening by the Fed.
Valuations remain attractive relative to our forecast for below long-term average defaults over the next year. Loans also offer floating rates and much lower return volatility relative to high yield, which sets up the asset class to outperform in either a too hot or too cold economy.
Going forward, returns are more likely to come from coupon clipping with more modest total return potential given the limited upside with the average dollar price for the loan index at $98.08 as of the end of the year. The average price of the index remains somewhat deceiving as evidenced by the average index prices by credit tier:
- BBs are at $100.37,
- Bs at $98.47, and
- CCCs at $83.58.
Further, with approximately 70% of the market trading above par, the market will likely see some coupon erosion from repricings. This could be more than offset by rising LIBOR, depending on the Fed. In fact, three-month LIBOR has pierced 100 bps. With the average LIBOR floor set at 100 bps, investors should begin to benefit from additional income and from a rate hedge perspective as loans get reset into a rising rate environment.
Fundamentals are likely to stabilize and remain acceptable as we move past the commodity default cycle. They should also benefit from the forecast for positive GDP growth, solid cash flow coverage and still-positive corporate earnings. In fact, the next default cycle has likely been pushed farther into the future as refinancings have extended maturities and the markets anticipate fiscal stimulus in the form of lower taxes and infrastructure spending.
The technical picture continues to improve with a slight increase in CLO issuance, a return to positive retail fund flows, modest net new issuance and a muted forward calendar. The main risk in the short term is a reversal of technical trends.
We enter 2017 fully invested to take advantage of continued strong technicals in the loan market, and with incrementally more credit risk than we had in the beginning of 2016. However, we still generally position ourselves with an overall up-in-quality bias until we have more clarity on the impact of the new administration’s fiscal and regulatory policies on the economy, inflation and interest rates.
The fund class gross expense ratio is 1.08%. The net expense ratio is 1.02%, which reflects a contractual expense reimbursement in effect through 1/31/2018. 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 1.01%.
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 2.75%. 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 S&P/LSTA Leveraged Loan Index is a daily total return index that uses LSTA/LPC Mark-to-Market Pricing to calculate market value change. On a real-time basis, the Index tracks the current outstanding balance and spread over LIBOR for fully funded term loans. The facilities included in the Index represent a broad cross section of leveraged loans syndicated in the United States, including dollar-denominated loans to overseas issuers. The index is unmanaged, its returns do not reflect any fees, expenses, or sales charges, and is not available for direct investment.
Duration represents the interest rate sensitivity of a fixed income fund. For example, if a fund’s duration is five years, a 1% increase in interest rates would result in a 5% decline in the fund’s price. Similarly, a 1% decline in interest rates would result in a 5% gain in the fund’s price.
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.