Virtus Newfleet Multi-Sector Intermediate Bond Fund

3Q23

Market Review

As we enter the home stretch of 2023, the economic transitions we expected to see are proceeding across the globe. China struggles with a slowing economy amid calls for more stimulus despite having exited its strict zero-COVID policies earlier this year. Europe, too, is wrestling with a slowing economy and inflation that remains above official targets. In the meantime, the U.S. economy has proven remarkably resilient – unlike other major world economies, it defied expectations of a slowdown, leading to a building consensus that the Federal Reserve (Fed) may pull off the often-elusive soft landing. The main risk to this scenario is the unpredictable cumulative effect of 18 months of monetary tightening on the economy. Monetary policy works on the economy with a lag, presenting a challenge to central bankers trying to return inflation to target without the associated economic pain of higher interest rates. We will be paying close attention to the labor market data in the weeks and months ahead to help inform our view on the likelihood of a soft landing scenario.

Financial market performance was weaker during the quarter as central bankers fought to tame ongoing inflation. We have seen significant progress on headline readings as supply chains healed, demand shifted from goods to services, and energy prices rebalanced. Core readings of inflation, however, remain stubbornly above targets. That said, the market expects that we are approaching the end of interest rate increases across most major global central banks. Evidence of this is found in the Fed’s most recent summary of economic projections, which indicated one more rate increase. The Bank of England (BOE) has paused its rate hikes, while the European Central Bank (ECB) has signaled a pause.  However, market expectations of a quick reversal of tighter policy have moderated, and the higher-for-longer narrative is taking hold. The Fed has tamped down expectations of rapid cuts in 2024 and 2025, and the ECB and BOE remain committed to the inflation fight, which may lead to their rates staying elevated for longer as well. There is clearly still work to be done on the inflation front. With the backup in rates, most fixed-income sectors had negative total returns in the third quarter.  A majority of spread sectors outperformed U.S. Treasuries and spreads tightened. Within spread sectors, shorter duration and risk asset classes outperformed. The U.S. Treasury curve shifted higher during the quarter and the curve steepened somewhat. The 2-year Treasury yield increased 15 basis points (bps), the 5-year Treasury yield increased by 45 bps, the 10-year Treasury yield increased by 73 bps, and the 30-year Treasury yield moved 84 bps higher.

We continue to see value being restored across most of the fixed income sectors in which we invest. Yields remain elevated and bond prices are broadly discounted. We expect the Fed will be successful in returning inflation to acceptable levels over time. We continue to watch data releases to inform our views on the global economic trajectory. As the markets digest economic and geopolitical 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, in our view, ideally suited for the current environment.

How The Fund Performed

The Fund (Class I) returned -0.58% in the third quarter, outperforming the U.S. Bloomberg Aggregate Bond Index return of -3.23%.

The Fund’s shorter duration relative to the benchmark had a positive impact on performance during the period with the underperformance on the longer end of the U.S. Treasury curve. Allocation to and selection within corporate high yield bonds had a positive impact on performance. High yield had another positive quarter led by CCCs, with BBs underperforming due to the increase in Treasury yields. Earnings season, which saw a large portion of companies beating forecasts, also helped propel risk assets. In addition, technicals continue to play a positive role despite outflows for the asset class, with demand outpacing supply. Allocation to bank loans had a positive impact on performance. Loans rallied early in the quarter on the back of growing expectations for a soft landing and limited new issue supply in the face of surging loan repayments. The market change in sentiment to a higher-for-longer view on rates has also led investors to reassess the space. With rates still rising, loans are outperforming investment grade and high yield. Allocation to RMBS over agency mortgage-backed securities (MBS) and positioning within RMBS had a positive impact on performance. We continue to prefer non-agency residential exposure as credit performance remains stable, prepayments stay muted, and credit spreads are still wide of averages. With higher mortgage rates and a subsequent fall in housing activity, we see solid fundamental and technical backdrops.

The Fund’s duration and curve positioning within U.S. Treasuries detracted from performance as the backup in rates during the quarter negatively impacted maturities further out the curve. Selection within emerging markets (EM) high yield had a negative impact on performance. EM high yield outperformed EM investment grade during the period.  The drivers are still very much macro in nature and centered on China’s economic slowdown, the Fed’s inflation-fighting path, and global growth. The Fund’s underweight to investment grade corporates compared to the Bloomberg U.S. Aggregate Index had a negative impact on performance during the quarter.  Issue selection, however, was positive during the period as the Fund’s allocation outperformed versus the index. While the allocation to bank loans had a positive impact on performance, bank loan selection detracted from performance. More specifically, the Fund’s underweight to CCCs compared to the Credit Suisse Leveraged Loan Index detracted as lower-quality cohorts within the sector outperformed during the period.

Current Fund Strategy and Positioning

Reduced exposure to cash, corporate high yield, and investment grade corporates. Increased exposure to agency MBS, commercial mortgages (CMBS), and asset-backed securities (ABS). 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 (EM) and Non-U.S. Exposure: Strength in emerging markets continued in July, led by advances in the high yield portion of the index. August marked a reversal in returns as lower volumes and headlines on China’s slowdown hurt the markets. While the new issue market opened up in the first half September, rate volatility and uncertainty dampened enthusiasm for EM, causing it to quickly shutter. Tighter valuations largely persisted throughout the quarter despite the lackluster returns. We continue to maintain our preference for hard currency debt and have no local currency exposure in the Fund. The Fund’s positioning remains largely unchanged, with EM exposure near historical lows, though we did take advantage of some swaps in exposure throughout the period. Investment Grade Corporates: Yields ended the third quarter at a year-to-date high, while spreads approached year-to-date lows. Nearly all industries tightened, with REITS and the energy complex faring the best. Banks continued to lag due to regional bank concerns and heavy supply. Autos, amid strike uncertainty, was the weakest-performing industry. Technicals are in the driver's seat as yield buyers made their presence known. Fundamentals are broadly stable. With weak to negative earnings growth, credit metrics took a small step backward but are expected to improve as growth resumes in the second half. We see buying opportunities in banking and utilities, both of which have lagged. An overweight to BBB-rated bonds remains prudent, especially considering the pace of ratings improvements within that category. Corporate High Yield: The high yield market returns were slightly positive in the third quarter. Spreads tightened through July and remained rangebound until the last week of the quarter, when they widened about 25 bps and ended the third quarter 3 bps wider. As soft landing and higher-for-longer themes dominated the quarter, CCCs outperformed because they are less rate sensitive, more sensitive to a hard landing scenario, and have higher carry. Housing and leisure continued to post strong results while chemicals and parts of healthcare remained weak. Credit fundamentals are staying strong, though they may have peaked in the first quarter, in our view. Despite high yield issuance volumes up 60% versus 2022, technicals remain favorable as net supply is still negative. Securitized: Though total returns for securitized product were negative for the quarter, spreads for the asset class were marginally tighter versus U.S. Treasuries, thus generating positive excess returns versus risk-free assets. As rates rose, our exposure to short duration consumer-backed assets held up well. We maintained our overweight in ABS and RMBS. As the repricing within the commercial real estate market continues, we judiciously added to our CMBS exposure. Lastly, we increased our exposure to the agency MBS market as spreads reached historically wide levels versus their corporate investment grade counterparts. In our view, agency MBS afford our portfolios good liquidity and attractive yields.

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 surrounding 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 risk of a recession, the Fund's exposure to spread sectors that would typically be more negatively impacted, such as corporate high yield and emerging markets high yield, are at low levels relative to historical averages. 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
• BBB Corporate investment grade