Virtus Newfleet Multi-Sector Intermediate Bond Fund

1Q23

Market Review

2023 looks to be a year of transition. Global central banks are expected to transition from tightening monetary policy to pausing and assessing the tightening already in the system. China is well on its way to transitioning from its strict zero-COVID policy toward a return to normalcy. The global economy looks to transition towards a slower growth trajectory, while some major economies may transition to a mild recession. We hope to see a peaceful transition in Eastern Europe as well. During most of the first quarter, financial markets behaved as though most of these transitions would be orderly, and, perhaps, even avoided in some cases. March proved to disrupt that narrative as the rapid failures of three regional banks in the U.S. and distressed combination of Credit Suisse and UBS caused an increase in volatility and left confidence shaken. Policymakers responded forcefully and rapidly, but we do not yet know the economic impact. Tighter financial conditions may lead to slower growth and lower inflation. It’s certainly possible that the impact alters the expected course of monetary policy this year.

This backdrop provides challenges for the central bankers who are still tasked with returning inflation to target while maintaining financial stability. To date, policymakers have continued to tighten monetary policy with both the Federal Reserve (Fed) and European Central Bank (ECB) raising interest rates in the quarter. Both Fed and ECB members have sought to separate the inflation fight from issues affecting stability through their rhetoric, and by introducing new programs to counter banking sector concerns while using the interest rate tool to combat inflation. We expect these efforts to be successful. We are also keeping an eye on Washington for progress on the looming debt ceiling issue.

Despite all the volatility during the quarter, financial market performance has been very resilient, with most risk assets posting positive total returns during the period. The U.S. Treasury curve shifted lower on maturities longer than six months as traders adjusted views around the monetary policy path and banking sector concerns created a flight to quality: the 1-year Treasury yield decreased 8 basis points (bps), the 5-year Treasury yield fell by 32 bps, the 10-year Treasury yield decreased by 27 bps, and the 30-year Treasury yield moved 19 bps lower. These moves resulted in a slightly flatter curve to close out the quarter.

We continue to see value being restored across most of the fixed income sectors in which we invest. We expect the banking sector concerns will abate, and the Fed will successfully return inflation to acceptable levels. We continue to watch the economic data to inform our views on the possibility of recession. While our base case is still that any contraction would be mild, recession risks have risen. As the markets digest global developments, we continue to believe active sector and issuer selection is critical to take advantage of market volatility as it arises. Our approach to fixed income – the approach we have implemented for over three decades – enables us to scan the bond market for the most attractive investment opportunities and is ideally suited for the current environment.

How The Fund Performed

The Fund (Class I, Accumulating) returned 2.91% in the first quarter versus the U.S. Bloomberg Aggregate Bond Index return of 2.96%.

Allocation to high yield bank loans had a positive impact on performance. Loans outperformed most spread sectors during the period amid risk asset volatility, benefiting from a constructive technical and attractive valuations. Allocation to non-agency residential mortgage-backed securities (RMBS) over agency mortgage-backed securities (MBS) and positioning within the RMBS sector had a positive impact on performance. RMBS outperformed due to strong mortgage credit performance and the yield advantage over MBS. Allocation to the corporate high yield sector had a positive impact on performance during the period.  Despite the volatility seen during the quarter, the corporate high yield sector outperformed most spread sectors. Issue selection within investment grade corporates had a positive impact on performance. The Fund’s overweight to BBBs and general positioning within that sector contributed to the outperformance relative to the sector’s index. Issue selection within asset-backed securities (ABS) also had a positive impact on performance during the quarter.

The Fund’s shorter duration relative to the benchmark had a negative impact on performance during the period due to the outperformance on the longer end of the U.S. Treasury curve. For similar reasons, the Fund’s shorter duration curve positioning within U.S. Treasuries also detracted from performance as the rally in rates impacted maturities further out the curve. Allocation to emerging markets (EM) high yield also had a negative impact on performance. The drivers were still very much macro in nature and centered around the Fed’s inflation-fighting path, China’s reopening, and stress in the banking system. Selection, however, had a positive impact for the period.

Current Fund Strategy and Positioning

Reduced exposure to non-agency RMBS and investment grade corporate securities. Increased exposure to asset backed securities, corporate high yield, and commercial mortgage-backed securities. In addition to changes to the Fund’s sector allocation during the quarter, we continue to optimize positioning within sectors based on our view of the best relative value.

EM Debt and Non-U.S. Exposure: The first quarter saw an uptick in volatility across markets both due to factors seen last year, such as inflation and China’s re-opening, as well as the shakeup in confidence in banking in March, which supported a bid for U.S. Treasuries. Our exposure was marginally lower throughout the quarter. We have used both the new issue and secondary markets to add positions that offer relative value in this environment. Exposure to EM has remained near historically low levels, and we continue to avoid non-USD exposure in the Fund. Investment Grade Corporates: Investment grade spreads were tighter YTD through early March when Silicon Valley's abrupt failure triggered a sharp selloff from +120 to +160 in a matter of days. We are set to end the quarter at +138 − 8 bps wider YTD. Rates have moved lower during this selloff, so while excess returns are slightly negative, total returns are positive by 3.5%. Industrials outperformed financials handily in the first quarter − wider by 9 basis points versus 43 bps of widening for financials. Regional banks were hit particularly hard, with spreads over 100 bps wider. We view this weakness as a potential opportunity and are seeking to gradually lean into this trade at these wider levels. We remain overweight to the BBB segment of the market as overall fundamentals remain strong, ratings trajectory is positive, and fallen angel risk is low. Corporate High Yield: High yield started the year with credit spreads tightening over 80 bps into early February. Total returns were hurt later in February by rising Treasury rates, but the real volatility started in March when the regional banking crisis weighed on the market and drove credit spreads to a year-to-date high of +518 bps on March 24. The technical picture remains weak as outflows have increased, reaching over $17 billion by quarter-end. Unsurprisingly, new issuance has been below average, with multiple weeks of zero issuance. Though fourth quarter results were generally positive, there were notable pockets of weakness and increasing dispersion in certain industries such as wirelines, media, and REITS. Though we increased our allocation during March given the wider credit spreads, overall, we remain below long-term average allocations.  Over the quarter, we further de-risked in the energy sector and trimmed a more aggressive healthcare position. We did add some risk via a technology name and a satellite firm. Securitized: Despite levels of volatility not seen in many years, all securitized sectors saw positive returns driven by the rate rally. We view the securitized market as offering some of the best yield opportunities within fixed income. Though fundamentals remain strong, we are being selective with our investments because we believe unemployment will trend higher and increase consumer delinquencies. On the mortgage side, delinquencies are at historical lows. With higher mortgage rates and a subsequent fall in housing activity, we will see less supply for the year, which sets up a favorable technical for the mortgage-backed securities market. As a result, our portfolios continue to have a significant weight to the sector.

Outlook

Our multi-sector relative value approach enables us to take advantage of opportunities when events that trigger volatility, such as inflation worries or concerns about the banking industry, affect valuations. In the current environment, we believe some of the best total return and yield opportunities can be found in spread sectors. However, given the increased risk of a recession, we have reduced some exposure to spread sectors that would typically be more negatively impacted, such as corporate high yield and bank loans. Credit selection and positioning remain key. Specific sectors that demonstrate the best relative value for us include:

• Out-of-index/off-the-run ABS
• Non-agency RMBS
• Corporate investment grade