Total return approach, investing in below investment grade corporate securities.
Portfolio Review
Risk assets bounced back in a big way in the fourth quarter, bolstered by economic resilience, the continued slowdown in inflation and signs that the Fed may soon start to cut interest rates. The dovish December Federal Open Market Committee meeting was the cherry on top for markets, as Chair Powell stated that the Fed started discussing cuts for 2024. This was driven by another benign inflation print in November and resilient economic data. With the market moving to price in aggressive rate cuts for 2024, Treasury yields rallied, with the yield on the 10-year note declining from 4.69% at the beginning of the quarter to 3.88% by quarter-end.
This backdrop was positive for spread sectors within fixed income, including high yield (HY). The average credit spread of the Bloomberg High Yield 2% Issuer Cap Index (Index) tightened by 71 basis points (bp) during the quarter on an option-adjusted spread (OAS) basis, closing out the year at 323 bp. The Index returned 7.15% during the quarter, which brought the full-year return to 13.44%. From a credit quality perspective, total returns were relatively similar across ratings, as BB, B and CCC rated bonds returned 7.35%, 7.01% and 6.91%, respectively.
For the quarter, the Fund underperformed the Index on a NAV basis. From a sector perspective, security selection within technology as well as paper and packaging sectors was the primary relative detractor during the period, which was largely driven by an overweight allocation to Commscope and ARD Finance. Additional negative impacts resulted from security selection within chemicals and wirelines, primarily due to Trinseo and Level 3. In contrast, the Fund benefited from security selection within leisure and energy. The former was primarily due to an overweight allocation to Carnival Corp., while the latter was driven by an overweight allocation to a few midstream issuers.
Current Strategy and Outlook
The macro outlook for 2024 looks supportive for U.S. risk assets with low but positive growth and the Fed expected to begin cutting rates. Fundamental factors in HY remain relatively healthy, with limited credit deterioration. 2Q 2023 earnings were more mixed than in the prior quarters, but consensus earnings estimates call for a rebound in earnings growth from 4Q 2023 through 2024. We are somewhat more cautious, as we expect a trend of weaker topline growth as pricing power diminishes against the backdrop of disinflation and weaker consumer demand, leading to margin erosion for companies, with lower-rated issuers being incrementally impacted due to elevated borrowing costs. Market technical factors should remain supportive, with high all-in yields attracting buyers and the higher cost of debt limiting issuance. However, spreads begin the year at tight levels, skewing outcomes negatively in the event of any surprises.
In sector positioning, we remain positive on the healthcare space given higher utilization rates and easing labor cost, and the energy sector where commodity prices remain supportive and industry consolidation continues to offer upside to bond prices. In contrast, we’re less constructive on consumer-reliant business models with weaker credit profiles given our view of moderating consumer strength in 2024 and we remain selective in sectors that have faced secular challenges, such as telecom and media. From a ratings perspective, we maintain a single-B average credit profile, with a heightened focus on single-name risk.
Key Takeaways
Risk assets bounced back in a big way in the fourth quarter, bolstered by economic resilience, the continued slowdown in inflation and signs that the U.S. Federal Reserve may soon start to cut interest rates.
For the quarter, the Strategy underperformed the Index on a net asset value (NAV) basis.
We expect a trend of weaker topline growth as pricing power diminishes against the backdrop of disinflation and weaker consumer demand, leading to margin erosion for companies, with lower-rated issuers being incrementally impacted due to elevated borrowing costs.