The Litman Gregory Masters High Income Alternatives Fund opened the year with a 13.79% loss in the first quarter. Comparatively, the Bloomberg Barclays U.S. Aggregate Bond Index was up 3.15%, while the BofA Merrill Lynch US High Yield Cash Pay Index lost 13.12% in the same three-month period. For most of the quarter, the fund held up better than high-yield, only falling behind during the sharp risk-on rally late in the quarter. Since the fund’s inception (9/28/18), its annualized return is negative 6.38% compared to positive 9.07% and negative 3.49% for the Aggregate Bond and high-yield benchmarks, respectively.
Past performance does not guarantee future results. Index performance is not illustrative of fund performance. An investment cannot be made directly in an index. Short-term performance in particular is not a good indication of the fund’s future performance, and an investment should not be made based solely on returns.The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance of the fund may be lower or higher than the performance quoted. To obtain the performance of the funds as of the most recently completed calendar month, please visit www.mastersfunds.com. Investment performance reflects fee waivers in effect. In the absence of such waivers, total return would be reduced.
In the first quarter of 2020, we saw extraordinary turbulence in the markets triggered by growing uncertainty surrounding the economic impact of COVID-19. Initially, investors fled riskier parts of the credit market, but the headlines eventually caught up to the higher-quality segments that had shown some resilience. By mid/late March, the turbulence reached all corners of the credit market. Nothing was immune. U.S. Treasuries, prime money market funds, investment-grade corporates, high-yield bonds, floating-rate loans, municipal bonds, mortgage-backed securities, and collateralized loan obligations were all impacted. Investors wanted out. Their exit was swift and indiscriminate as investors scrambled for cash and cash-equivalent assets.
The fund’s performance over the three-month period was disappointing, but a closer look reveals that the fund behaved as we would expect. As the market fell abruptly and sharply, the fund held up better than high-yield thanks to relatively conservative positioning. The fund’s flexible credit managers came into the year emphasizing higher-quality, shorter-duration, and liquid assets believing valuations were expensive. But ultimately, even these assets were punished amid the indiscriminate selling. They got caught up in the forced selling from funds that were deleveraging and/or liquidating, pushing prices down far below what they should be based on fundamentals. In many cases, it was precisely these types of higher-quality assets that were hurt more in the short term by forced selling, as managers facing withdrawals or margin calls sold what they could at the highest dollar price, even if that meant far below a realistic fundamental value, rather than sell less liquid/lower-quality assets at pennies on the dollar.
Our equity-sensitive managers Ares and Neuberger Berman also faced sharp headwinds to their strategies and asset classes. Coming into the crisis period, Ares was also defensive relative to their benchmark and what they would consider their strategic positioning, holding over 20% cash and 10% in preferred securities (senior to the equity of the companies in their target sectors). But similarly, those securities sold off as badly or worse than riskier parts of the capital structure, while there was little to no differentiation between higher-quality and lower-quality business development companies (BDCs), mortgage real estate investment trusts (mREITs), and midstream energy companies. (Ares was focused on higher-quality players in these sectors.)
The Neuberger Berman out-of-the-money put-write strategy also struggled as COVID-19 set fire to global volatility markets. March 2020 was the most volatile month on record for the S&P 500, with the VIX jumping to a record close of just over 82 in mid-March. We think it’s important to note, however, that the Neuberger Berman strategy is essentially insuring equity markets on a fully collateralized basis. (It is not betting against the volatility of volatility—the strategy that blew up short volatility ETNs in early 2018). The strategy’s active risk management enabled it to outperform the relevant CBOE index significantly, and it stands to benefit going forward from the dramatically higher option (insurance) premiums associated with the high-volatility regime in which we are currently living.
As prices declined in March and opportunities arose, the fund’s managers started to selectively take advantage of attractive valuations. Guggenheim and Brown Brothers opportunistically added to investment-grade corporate bonds, higher-quality structured securities, and floating-rate secured loans. Ares got back to fully invested as they felt valuations were too cheap to sit on the sidelines. Neuberger executed its systematic process and started collecting elevated premiums. The fund rebounded strongly from its trough in mid-late March.
While we have always said the fund is long risk assets/exposures and that it would experience periods of drawdowns, we are of course not pleased with the losses during the quarter. We understand why they happened, and we believe they are reasonable in the context of an unprecedented, global pandemic-driven economic shutdown. But as investors in the fund ourselves, we recognize the experience is quite disappointing. Looking ahead, it’s difficult to predict market reactions next week or next month, and nearly impossible to predict how things will play out in the global economy in the short run, although we expect a medium- to long-term recovery as treatments for COVID-19 emerge and economies reopen. But we are confident the skill of our managers in security/credit selection and risk management will prove out with higher risk-adjusted returns than high-yield, while still providing attractive absolute levels of income and total return. The setup for performance going forward appears strong, with attractive valuations/yields for all components of the fund. Having added to the fund personally, we fully expect to report much better results to fellow shareholders in the future.
Performance of Managers
During the first quarter, the two flexible credit managers, Brown Brothers Harriman and Guggenheim, lost 9.26% and 7.60%, respectively. Ares Management’s Alternative Equity Income sleeve fell by 38.65%, while Neuberger Berman’s Option Income strategy declined 11.97%. (All sub-advisor returns in this report are net of the management fees charged to the fund.)
The rapid economic shutdown of the U.S. and global economy has led to concerns in credit quality for both BDCs and mREITs, particularly in industries directly and immediately impacted by stay at home orders including, hotels, gaming, leisure, restaurants, and retail. With the escalation of stay at home orders around the globe during the quarter, the global supply/demand outlook for oil, natural gas, and natural gas liquids significantly deteriorated which put pressure on domestic exploration and production companies and their level of drilling plans for the remainder of 2020.
Liquidity issues have been at the forefront of our target industries with particular exposure in the mREITs using 3-6x leverage on their balance sheets. Several residential mREITs experienced margin calls with their credit facilities and were forced to sell investments at discounted prices which materially negatively impacted book values.
Levered exchange-traded funds (ETFs) and closed-end funds (CEFs) have experienced dramatic forced liquidations which led to significant sell pressure across all three asset classes. A large BDC 2x levered ETF and two large mREIT 2x levered ETFs triggered liquidation events in late March and a significant number of levered master limited partnership CEFs largely unwinding caused hundreds of millions of dollars in selling pressure.
While there has been some differentiation between high quality managers and weak mangers during the sell-off it is along magnitudes of declines with high quality managers across all three asset classes still showing 40-50% declines while weaker players are off much more.
Believing that technical selling pressures overwhelmed fundamentals, we have been upgrading in quality and moved the portfolio to fully invested, acknowledging that we might be a bit early. As of quarter end, the portfolio was yielding over 17%.
Brown Brothers Harriman
The BBH sleeve of the fund’s net of fee performance was negative 9.3% for a tumultuous first quarter of 2020. We are never pleased to post a negative performance result, but this was clearly an unprecedented quarter in the history of financial markets. The extraordinary drawdown in credit prices was driven by massive spread widening (amidst bond selling) at a speed that was worse than what occurred during the great financial crisis of 2008. For context, investment grade BBB-rated credit suffered a 10.3% performance decline in March, with high yield BB-rated credit falling a similar 9.7% decline. This was the bad news.
The good news is that credit prices are recovering quickly in these first two weeks of April while the yield on the strategy is over 7%. With wide swaths of the credit markets currently trading at attractive entry points, we are hard at work sifting through potential purchase opportunities that will be survivors through this sharp economic interruption. Throughout the first quarter, we were seeking to deploy capital into new ideas and maintain the spread duration of the strategy. As the spread widening storm of March became more intense, we continued to lean into the wind and add slowly to our existing credit positions at lower prices. We expect these additions will be additive to future performance as economic activity begins to recover, albeit with very uncertain timing.
Entering the first quarter of this year, valuations for credit were quite expensive and there were few new ideas that met our valuation requirements. Opportunities began to slowly emerge as bond prices began to fall in the middle of February. The speed of the sell-off over the following 30 days was so severe that almost the entire credit universe would pass our valuation hurdles and be flagged as a “buy” in our valuation framework as we exited the quarter. Through this volatility we slowly added more corporate exposure to the portfolio.
In the early part of the quarter we were able to add new opportunities across floating-rate secured loans, corporate bonds, and asset-backed securities (ABS). As the market volatility increased, portfolio additions were focused on adding exposure to existing positions that were now available at discounted prices. Descriptions of the new purchase activity for the quarter are included below.
We purchased the secured term loan of Allen Media at a coupon of 562 basis points (bps) over 3-month London Interbank Offering Rate (LIBOR) for a 7.1% yield. The company is a diversified media company that owns the Weather Channel, seven television networks, and 15 broadcast television stations that reach 150 million U.S. subscribers. The loan has low starting leverage, a significant unsecured debt cushion beneath our debt, plus an engaged CEO that owns 100% of the business.
We initiated a position in Kraft Heinz after the company was downgraded to high yield in February. The company’s stable product portfolio of well-known brands in the packaged food category produces significant recurring revenues and industry leading margins. A new management team has been brought in to re-invigorate product innovation and lower the leverage on the business, with a target of regaining its investment grade credit profile. We purchased long-dated 2039 bonds at a spread of 320 bps for a yield of 5.5%.
Stericycle is an industrial services company whose primary business line is the collection and disposal of regulated medical waste. The company was seeking to reduce leverage via asset sales the past two quarters, with slow progress. We were able to purchase a secondary piece of the two-year senior secured term loan at discount to par, which offered 380 bps of spread over 3-month LIBOR or a 6.3% yield to maturity. Shortly thereafter, the company announced a large asset sale that was just completed after the end of this quarter and should significantly pay down the discounted term loan at par.
Trinity Capital is a well-established venture debt lender that specializes in making loans to late-stage technology venture firms. With a conservative underwriting process as their foundation, the management team has a solid history of producing strong loan performance and low loss experience. The company also has a low leverage profile that will continue as it completes the process of shifting to a BDC. The five-year notes were purchased at an attractive spread of 535 bps for a 7% yield.
In structured products, we purchased an aircraft engine lease ABS from seasoned Asian issuer Total Engine Asset Management. SUNBD 2020-1A B finances a portfolio of long-term spare engine leases to global airlines that are critical to the operation of aircraft fleets. Spare engines are utilized to keep aircraft flying when installed engines are removed for repair and overhaul. The engine collateral for this deal service the most popular and current generation of narrow-body aircraft. Aircraft engines are the most valuable part of an airframe and hold their value over time due to their constant refurbishment. We were able to purchase the 5.7-year BBB-rated bonds at a spread of 330 bps for a 5.2% yield.
The remaining purchases were additions to existing positions or loan refinancings. As mentioned earlier in this commentary, over the course of the quarter we began slowly adding to favored credits in the fast-moving market. While we were consciously leaning into the volatility with our purchases, we were also mindful not to go “all-in” with position sizing. With such attractively discounted prices on offer in March, we were able to add to our positions in Western Digital, Power Solutions (Panther), and Alliance Data Systems. The only sale in the quarter was our loan position in hospital company HCA, which was executed in early March at an attractive price before the health and economic news became so deeply negative.
Finally, our investment process has always focused on investing in durable credits. For every credit we own we consider how it might perform in its industry’s worst historical episode. This pandemic is, obviously, a unique test case. Entire industries will not disappear, but stronger competitors will have better access to capital markets and can consolidate the weaker players. We are constantly reviewing our credits with a focus on those companies that can be consolidators and/or have high recovery values for creditors in stressed markets like we are experiencing. We thank you for being investors in the fund.
Business closures, shelter-in-place orders, and social distancing efforts have caused economic activity to plummet. Industries such as travel, hospitality, restaurants, and retail have seen the earliest impacts, but every sector of the economy is being affected. Layoffs over the past month already exceed total net job creation over the previous expansion. The unemployment rate is heading to 20% in the coming weeks, double what we saw in the last recession. Rising layoffs will weigh on incomes and depress consumer confidence further, leaving lasting scars on the economy even after the virus is contained. Business investment was already stalling out due to falling profits, the trade war, and political uncertainty. Now, the coronavirus shock will further depress capital expenditures, and the sharp decline in oil prices will severely curtail activity in the energy sector.
The virus is also wreaking havoc with global supply chains as production is shut down abroad. Many industries are already reporting shortages of key intermediate goods. The most impacted industries from supply chain disruptions include electronics, autos, machinery, metals, and apparel.
The coronavirus shock hit a U.S. economy that was already showing late cycle symptoms and rising recession risk. Corporate debt has climbed to record highs. With a sharp hit to demand unfolding, businesses will be forced into more cost cuts and layoffs in the months ahead, further weighing on the recovery. Expectations for a V-shaped economic recovery in the second half of 2020 will prove to be too optimistic. Output could be 10-15% lower than 2019 by the end of the year.
Unprecedented monetary and fiscal response, still not enough
The Federal Reserve has acted quickly to restore market functioning and cushion the economy, cutting rates to zero, engaging in massive asset purchases, and launching an array of lending facilities. With quantitative easing set to continue and the lending programs scaling up, the Fed’s balance sheet is headed to $9 trillion, more than double what it was to start the year.
The Fed’s policies are necessary, but not sufficient to deal with the current crisis. They can help prevent conditions from worsening, but have limited ability to lift economic demand. Congress has also acted much faster than in previous downturns, passing the $2 trillion CARES Act. This package included support for Fed lending, expanded unemployment benefits, small business support, and aid for state and local governments, hospitals, airlines, and households, among other measures.
Despite the unprecedented size of this fiscal response, it’s quickly becoming clear that it was not big enough and more will be needed. Additionally, processing delays in areas like unemployment benefits and small business lending are limiting the effectiveness of these policies at a time when every day counts.
Rates are headed lower and more downside is ahead for risk assets
With the Fed set for a protracted period at the zero bound, Treasury yields have further room to fall, with the possibility of much of the curve falling into negative rate territory.
Credit spreads are starting to offer some value, but the selloff is not over. A large number of investment grade bonds already have leverage ratios equivalent to high yield, and rating agency forbearance is dissipating. This would force as much as $1 trillion of investment grade bonds into high yield, driving further spread widening. Losses in corporate bonds will also be amplified by a coming wave of corporate defaults. The corporate sector went into this downturn with a record high leverage relative to gross domestic product. Equities also have further downside as the market wakes up to the full scale of the economic contraction. High valuations heading into this bear market and a severe recession suggest the peak-to-trough decline could be well over 50%.
Slowly increasing risk tolerance. Nibbling at value.
Coming into this year, we were very conservative, concerned that valuations were too high. This left our portfolios in a great position to opportunistically add risk in the current environment. One area we have been adding to is investment-grade credit.
We expect volatility to remain elevated due to concerns that the coronavirus will continue to have a negative impact on global growth. These concerns are made worse by the oil price war causing chaos in the energy markets. We continue to expect to see more dispersion within investment grade credit and its various sub-sectors. At this point, we are opportunistically trying to move from some of our more conservative investments to securities that, in our view, look attractive. This includes investment grade bonds where spreads have widened and prices have dropped – yet, with fundamentals that still look attractive. We will be avoiding sectors most negatively affected by the coronavirus, such as autos and hospitality.
The sleeve was yielding almost 7% at the end of the quarter.
In March, the S&P 500 Index lost a notable 12.35%, bettering the Russell 2000 Index’s decline of 21.73% by 938 bps. This resulted in quarter-to-date losses for the indices of 19.60% and 30.61%, respectively. In March, the CBOE S&P 500 PutWrite Index (PUT) lost a notable 13.42%, outperforming the CBOE Russell 2000 PutWrite Index (PUTR)’s loss of 23.59%, pushing their quarter-to-date declines to 20.68% and 30.16%, respectively.
For the quarter, the sleeve of the portfolio tumbled 11.97% (net of fees), underperforming its benchmark (40% CBOE S&P 500 PutWrite Index / 60% ICE BofA 0-3M US Treasury Bill Index) decline of 8.30%. Over the past 12 months, the return of the sleeve has decreased 5.82%, underperforming its benchmark decline of 4.60%, but bettering the CBOE S&P 500 2% OTM PutWrite Index (“PUTY”) decline of 15.51%. Average option notional exposure over the quarter remained consistent with strategic targets of 85% S&P 500 Index and 15% Russell 2000 Index.
Quarter to date, the sleeve’s S&P 500 Index put writing strategy has declined approximately 11.29%, achieving a better result than the 20.45% decline of the PUTY and substantially outperforming the S&P 500 Index’s decline of 19.60%.
The CBOE S&P 500 Volatility Index (“VIX”) surged 14.4 points to end the month at 53.5, averaging 56.2 over the period. A realized annual volatility for the S&P 500 Index of 91.3 resulted in an estimated negative implied volatility premium of 35.1. (Negative implied volatility premium is of course a bad environment for the strategy.) On the year, the VIX level has spiked 39.8 points from 13.8 at the start of the year, averaging 30.9 for the full period. Meanwhile, volatility on the S&P 500 Index has realized at 56.9, leading to a negative average implied volatility premium of 26.0 year to date.
Quarter to date, the sleeve’s Russell 2000 Index put writing strategy has lost approximately 18.35%, achieving a materially better result than the 30.16% decline of the PUTR and managing to avoid a portion of the Russell 2000 Index’s 30.61% loss. For the last twelve months, the sleeve’s Russell 2000 Index put writing strategy has declined approximately 11.87%, substantially outperforming the 23.79% decline of the PUTR and the Russell 2000 Index’s decline of 23.99%.
The CBOE Russell 2000 Volatility Index (“RVX”) soared 22.4 points to end the month at 60.5, averaging 57.8 over the period. A realized annual volatility for the Russell 2000 Index of 102.5 resulted in a staggering estimated negative implied volatility premium of 44.6. On the year, the RVX level has spiked 44.4 points from 16.0 at the start of the year, averaging 32.7 for the period. Meanwhile, volatility on the Russell 2000 Index has realized at 63.5, leading to a negative average implied volatility premium of 30.9 year to date.
Quarter to date, 2-Year US Treasury yields have declined 132 bps. The collateral portfolio has gained a modest 2.08%, lagging the 2.81% return of the ICE BofA 1-3 Year US Treasury Index over the period. 2-Year US Treasury yields have declined 202 bps over the past twelve months. As a result, the collateral portfolio has gained 4.37%.
As of quarter end, the annualized yield for writing 1-month, 3% out-of-the-money put options on the S&P 500 Index (a reasonable, though overly simplified proxy for the fund’s strategy) was over 55%. This compares very favorably to an annualized yield of less than 10% at the beginning of the year.
Sub-Advisor Portfolio Composition as of March 31, 2020
|Ares Alternative Equity Income Strategy|
|Brown Brothers Harriman Credit Value Strategy|
|Guggenheim Multi-Credit Strategy|
|Interest Rate Swap||-0.3%|
|Neuberger Berman Option Income Strategy|
|Equity Index Put Writing||100.0%|