Payden Global Income Opportunities (GSF0008AU) Report & Performance

The U.S. Consumer Price Index (CPI) slowed to 3.0% year-over-year due to falling energy prices, but core CPI, which excludes food and energy prices, remains elevated at 4.8%. Labour markets are especially resilient as the unemployment rate decreased to 3.6% in July, near its cycle low. The Federal Open Market Committee (FOMC) hiked interest rates in July, bringing the federal funds rate target range to 5.25%-5.50% and leaving the door open for possible hikes later in the year if inflation fails to head back toward the 2% target. In reflection of a stellar job market, the U.S. economy grew at a 2.4% annualised rate from the previous quarter. Globally, the fight against inflation continues. The euro area also saw good news in inflation as the Harmonised Index of Consumer Prices (HICP) slowed to 5.5% year-overyear. Like the U.S., however, services prices remain elevated, and the unemployment rate reached a record low. As a result, the European Central Bank (ECB) hiked rates by a quarter percentage point. The Bank of Japan (BOJ), on the other hand, decided to retain its basic yield curve control framework. The Japanese central bank will still target long-term yields at 0% but will allow 10-year government bond yields to float up to 1.00% from 0.50% previously. Like other central banks, inflation drove the BoJ’s decision after June headline inflation readings rose back to 3.3% year-over-year.

The month of July was largely positive across the board as risk assets rallied on a combination of stronger U.S. economic data, solid second-quarter corporate earnings, more benign headline U.S. inflation data, and a relatively patient Federal Reserve (Fed). In particular, spreads broadly declined across corporate credit, emerging market debt, and securitised product. Front-end developed government bonds lost some ground due to stronger-than-expected 2023 global GDP forecasts. In terms of positioning, the team reduced credit risk and will likely be reducing credit risk further. This risk reduction has been focused in areas that represent larger positions, like emerging markets debt, which would likely be vulnerable to higher energy prices and Eurozone weakness. In addition, the team is not constructive on high yield corporate valuations in the US and Europe and consequently reduced high yield corporates as well. The team invested risk reduction proceeds into higher quality parts of CLO and consumer ABS to not overly erode carry, preserve optionality in these more liquid areas, and offer protection from adverse outcomes in the most senior part of the capital stack.

The combination of shifting sentiment in recent months and asset price trajectory strongly suggests a soft landing (from the Fed) is largely priced into fixed-income markets. The fixed-income market appears to be signalling that cyclical inflation is in the rearview mirror and growth/earnings will normalise in the next 12 to 18 months, alongside Fed easing and US equity multiple expansion. If rates move higher from here, risk assets should suffer as correlations become more positive and the easing of financial conditions is dampened. Ironically, more growth (not less) could set-up the economy for a hard landing. This scenario does not appear to be priced into financial markets and the strategy team believes it to be a reasonably plausible outcome that needs to be considered. Thus, the balance of risks does not seem to reward an elevated degree of interest rate duration nor credit spread. The Fund remains more defensive, skewed toward higher quality segments of corporates, emerging markets, and securitised product with reduced exposure to interest rate duration.

The second quarter began with a hangover from the banking crisis in March. Investors then shrugged off fears of further bank failures and shifted their focus back to unyielding inflation with global central banks either hiking short-term rates in 25-50 basis point increments or advising the increased likelihood of further hikes on the horizon.

On average, global developed market bond yields increased nearly 1% for maturities within 5 years on fears of further rate hikes. Commodities were also less fortunate with gold, oil, copper and iron ore prices markedly lower in the second quarter.

Ultimately, financial markets experienced a euphoric quarter posting positive excess returns. Corporate, emerging market debt, and broadly non-agency securitised product spreads compressed on average between 15bp to 55bps. Floating-rate asset classes such as CLO and loans benefited from higher interest rates posting the best performance in the first half of the year since 2011.

The relatively resilient economic backdrop continued to be supportive for corporate fundamentals, with performance of lower quality segments of the market (CCCs) outperforming higher quality bonds (BBs). For a similar reason, residential mortgage credit benefited due to a combination of positive technical tailwinds and investor expectations that the Federal Reserve (Fed) is nearing the end of its hiking cycle.

Financial markets were swayed throughout May by two crucial issues: debt ceiling negotiations and enduring inflationary pressures. Initially, yields on U.S. Treasury bills maturing near the expected debt ceiling “X-date” almost reached 7% before retreating once an agreement to raise the debt ceiling appeared. Concurrently, the high U.S. inflation rate, highlighted by a 4.7% core PCE in April, worried investors as goods prices unexpectedly increased. Responding to persistent inflation, Federal Reserve officials increased the federal funds rate target to 5.00-5.25%, the highest since August 2007. The U.S. was not alone in battling inflation, with U.K. core inflation rising the fastest since 1992. Some cracks have appeared due to the monetary policy tightening over the last year. For example, the German economy contracted in the first quarter by -0.3%, making this the second consecutive quarter of contraction. Still, the service sector expanded globally in May, with the global services purchasing managers index (PMI) rising to 55.5, indicating a healthy expansion continues.

Returns in fixed income markets struggled during the month of May due to heightened levels of volatility due to U.S. debt ceiling concerns, resulting in higher U.S. Treasury yields and wider spreads in the U.S. high-yield corporate market. The rate selloff dragged almost all segments of global credit to negative returns for the month. High yield bonds ended the month in negative territory for the fifth time since the depth of the pandemic.

Within emerging market (EM) sovereigns, high-yield rated issuers outperformed investment-grade issuers, although in EM corporates investment-grade issuers slightly outperformed. EM local markets lagged hard currency as most currencies depreciated against a stronger U.S. dollar, reflective of relatively strong US economic data prints in May. The Fund’s securitised holdings primarily delivered positive performance for the month, with subprime autos and residential mortgage credit among the top performers. In terms of portfolios positioning, secured consumer ABS remains the only area within securitised where the strategy team is sourcing exposure down the capital stack. Additionally, the strategy team has rotated up-inquality within credit risk transfer (CRT) to further reduce risk in the sector.

The outlook for fixed-income assets appears to be more balanced as recently uncovered financial sector risks suggest that central bank tightening has reached late stages. That said, the market transition from inflation to growth and financial stability is likely expected to accelerate in the coming months if Fed policy remains restrictive. The Fed may prioritise financial stability and avoidance of a deep recession, particularly heading into an election year. With the risk of recession rising, the strategy team remains more defensive, skewed toward higher quality segments of corporates, emerging markets, and securitised product. Additionally, interest rate duration is playing a more prominent role in portfolios today with a portfolio duration of 3.0, well above the historic duration range between 1.0 and 2.0.

In April, financial markets faced turbulence due to two primary factors: persistent concerns about the banking system’s stability and the looming U.S. debt ceiling issue. First, the collapse of another major bank in April dashed hopes that the previous month’s bank runs were isolated incidents. Although markets have downplayed systemic risk concerns as the FDIC and Federal Reserve continue to offer support, potential hazards persist. Second, bond investors’ apprehension over the debt ceiling is reflected in the significant yield spread between generic 1-month and 3-month Treasury bills. This disparity highlights investor preference for bills maturing within the next month and their reluctance to engage with those expiring around when the Treasury might face a cash crunch this summer (if the debt ceiling is not raised).

Despite ongoing market concerns in April, returns were positive across most fixed-income markets, with income being the primary driver of returns and spreads mostly flat. Global credit returns stayed positive overall, while the US dollar and commodities broadly underperformed in April. The strategy team took advantage of the more sanguine market environment by reducing less favorable IG corporate names. Emerging market returns were broadly positive driven by income and rates, with continued gains in local EM and FX. The team is currently looking to add more local opportunities across various regions

In February, economic data releases alleviated recession concerns in the near term. The U.S. economy saw a robust January jobs report, with the unemployment rate falling to a cycle low of 3.4% and consumer spending remaining well above trend. In addition, the Chinese and euro area economy saw a sharp rise in their Purchasing Managers Indices, specifically with their service sectors returning to expansionary territory. The flip side of a continued economic recovery is that inflation is stickier than most investors expected at the start of the year. In the U.S., core PCE (the Fed’s preferred inflation measure) rose to 4.7% year-over-year in January, rising 0.6% month-over-month. In the euro area, core CPI rose 5.6% year-overyear in February, a record high. Unsurprisingly, market expectations of the “terminal” policy rate in both economies rose. In the U.S. and the euro area, the market-implied terminal fed funds rate was 0.5% higher at the end of February compared to January.

February’s fatigue was a sharp contrast to January’s bliss. Risk assets broadly produced negative total returns for the month as continued inflationary pressures and concerning data releases pushed interest rates higher and spreads mixed. Floating-rate securities outperformed fixed, with securitised broadly outperforming corporates and emerging market debt in February. Despite overall market weakness, primary markets were open and in some cases allowed issuers to refinance near-term maturities, a good sign for market liquidity.

For investment-grade corporates, the most active February issuance on record weighed heavily on spreads which widened 5-10 basis points. In terms of activity, the fund team further reduced loan exposure and subordinated CLO (BBB/BB) as risks continue to increase for rising loan defaults and downgrades.

Given the significant rise in U.S. Treasury yields (0.3%-0.6% higher in February), the fund team increased interest rate duration by +0.5 to 2.4, and bond exposure more skewed to fixed-rate securities. From a credit standpoint, the fund remains more favourable toward a combination of corporate credit, emerging markets debt, and government securities for the enhanced liquidity profile and attractive all-in yields of fixed-rate assets. The fund team’s focus has been to reduce overall credit risk given the rally to start the year and fatter tail risks associated with persistent inflation, continued monetary policy tightening, and trajectory of economic data prints. To address risks of a hard landing, the team has implemented macro hedges via puts on Nasdaq futures and calls on TLT (20+yr U.S. Treasuries).

In January, the U.S. GDP for Q4 2022 showed that the economy continued to expand at a 2.9% annualised rate, closing out the year with the U.S. economy expanding 1.0% in 2022. In addition, the December jobs report showed that the unemployment rate declined to 3.5% while initial claims for unemployment insurance remain subdued, despite the layoff announcements that grabbed headlines. After dealing with an energy crisis and the spillovers from the war in Ukraine, the Euro Area economy also expanded in the fourth quarter. Declining energy prices after a warmerthan-expected winter meant that euro area consumer sentiment improved, as seen by the service sector PMI which returned into expansionary territory (50.8) after being in contraction for most of the second half of 2022. China began reopening the economy after a year of the “zero-covid” policy. Financial conditions continued to ease ahead of the Federal Reserve meeting that began on the last day of the month.

The Fund team was leaning more constructive on credit risk for the balance of 2022 and into the first quarter of 2023. Recession fears had become too consensus at the end of last year, but in recent weeks the market responded accordingly with a dramatic shift to price in a goldilocks scenario for the Fed. While lower bond yields offset what appeared to be broadly weaker economic growth data, credit risk premiums declined across most asset classes, with Emerging Markets Debt and Corporates leading the pack. Given the significant move in both rates and risk premia, the Fund team reduced credit risk by about 20-30%. The reduction in risk is consistent with the team’s prior narrative to further reduce Securitised exposure in favour of Emerging Markets and Corporates as areas of Securitised are most vulnerable if rates stay higher for longer. In ABS, the team has taken steps to monetise exposure added at the end of 2022 as spreads declined 100bps+ from their peak close to 400bps, particularly in prime and subprime Autos.

In Emerging Markets, the supply spigot was turned on from a very dry 2022, and the Fund team participated in many new deals as the primary market offered healthy concessions that led to positive performance, particularly in the tactical bucket.

The tail risk associated with an overly hawkish Fed, wage price spiral, and near-term recession have been largely removed from the market. The Fund team struggles to see a significant catalyst in credit, especially if the market is relying on further Fed dovishness and cuts to be the main driver for risk assets going forward. The bottom line is spreads could tighten further, but the current balance of outcomes is more fair, if not skewed toward downside versus the upside the team identified at the end of 2022. As a base case, the Fund team will likely reduce risk another 10-20% commensurate with further credit spread tightening of 10-15%, on average, across spread sectors. As the market focus shifts from inflation to growth, correlations should normalise and therefore duration will provide better balance in a credit portfolio when compared to 2022. Thus, the team expects duration to remain elevated relative to 2022, but will be mindful of ranges. We plan on keeping liquidity elevated for the foreseeable future, especially given investors are paid to wait, with areas like short-term U.S. bills yielding circa 4.5%.