Virtus Strategic Income Fund
4Q 2016 COMMENTARY
MARKET — Another quarter with little to no volatility made investors more willing to add incremental risk in search of yield. The best performers during the quarter were the riskier sectors of the bond market and those typically less correlated with rising rates, including bank loans and corporate high yield.
PERFORMANCE — The Fund's underweight to U.S. Treasuries and agencies added value during a period in which most spread sectors outperformed government securities. Exposure to the top-performing corporate high yield and bank loan sectors benefited performance.
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 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.
GLOBAL FIXED INCOME PERFORMANCE
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: 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.
- Corporate High Quality: In the face of rising interest rates, the sector underperformed for the quarter. The Fund’s considerable weighting of close to 20% in the sector accounted for a large percentage of the overall negative performance for the three-month period.
- Emerging Markets High Yield and Yankee High Quality: The sectors slightly detracted from performance during the quarter. Though fundamentals have shown signs of bottoming, recent geopolitical events have reintroduced downside risk. Technicals are neutral, with retail flows turning negative in the fourth quarter.
- 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. In addition, the Fund’s large short exposure to the Markit North American High Yield CDX Index detracted from performance as high yield continued to defy the odds and perform very well in the face of rising rates.
CURRENT FUND STRATEGY
Reduced Exposures: We have reduced our weightings in corporate high yield and corporate investment grade. We continue to hedge our exposure to the corporate high yield market with a healthy short position in the High Yield CDX Index. In addition, we continued to hold zero notional exposure to the option overlay strategy at quarter-end. This is due mostly to the pricing of option contracts that we feel would leave the Fund exposed should we get a short-term pickup in volatility. With the minimal volatility currently residing in the markets, the options do not have much leeway should the stock market take a leap in either direction. Lastly, we closed out our currency short of the British pound via the forwards market. We are not long or short any currencies at the moment.
Increased Exposures: We added exposure to asset-backed securities, bank loans, residential mortgage-backed securities, and emerging markets high yield. We also are building a cash position in order to be well positioned to take advantage of trading opportunities in the event of increased volatility as we enter 2017, especially as it may relate to the new and somewhat controversial presidential administration.
Foreign Exposure: Overall foreign exposure is slightly lower over the quarter, as we realized gains in select names that appeared rich. With regard to emerging markets, valuations in specific countries are attractive and fundamentals seem to be turning. In particular, 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 in the Fund is slightly below historical averages.
Higher Quality Focus: Although we have added to our credit exposures, we generally have continued to hold higher quality companies within our below investment grade allocation and avoid very low-rated credits.
Energy: From an industry perspective, we have added energy-related credits. 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.
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. We have been looking to reduce our CMBS exposure by letting it run off as principal prepayments accelerate, and have been reluctant to add back exposure at current valuations.
- Our consumer focus within the asset-backed sector (ABS_ 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 asset-backed securities, non-agency residential mortgage-backed securities, corporate high yield, high yield bank loans, corporate investment grade, and emerging markets.
The Fund maintains its higher quality focus, based on current valuations across most sectors, and shorter duration to limit both spread and interest rate volatility. The Fund will continue to invest in pockets of longer duration assets, but the yield for those particular issues must compensate for the risk of extending farther out on the maturity curve.
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.