Core Plus Income Strategy : Commentary

Portfolio Managers: Nolan Anderson, Thomas Carney

As of 3/31/2016

The Core Plus Income Strategy returned +3.82% (gross of fees), +3.64% (net of fees), for the first calendar quarter, compared to a +3.03% return for the Barclays US Aggregate Bond Index (Barclays US Agg), our Strategy’s primary benchmark.  For the fiscal year ended March 31, 2016, the Core Plus Income Strategy returned +2.71% (gross of fees), +2.00% (net of fees), compared to a +1.96% return for the Barclays US Agg. 
Our portfolio outperformed the Barclays US Agg, in the past fiscal year despite its defensive positioning (i.e., shorter average life and duration relative to the Strategy’s benchmark).  Led by our energy-related corporate bonds, our credit investments turned in strong performance despite an overall widening in credit spreads during the fiscal year.  Overall portfolio metrics, as measured by average maturity and duration, changed modestly compared to a year ago.  The average maturity of our Strategy decreased to 4.4 from 5.5 years, while the Strategy’s average duration increased to 3.7 from 3.5 years as of March 31, 2015.  These measures provide a guide to the Strategy’s interest rate sensitivity.  A shorter average maturity and duration reduces the Strategy’s price sensitivity to changes in interest rates (either up or down). 
As of March 31, our high yield exposure was 21%, up from 19% the prior fiscal year (our maximum threshold is 25%).  Our high yield exposure continues to be concentrated in primarily higher quality, shorter-term (average duration of 3.5 years) bonds that we believe have attractive risk/reward profiles.  To highlight our preference for higher quality credits in the current market environment, approximately 55% of our non-convertible high yield corporate bond exposure is allocated to BB or split-rated companies (those rated as investment grade by one agency and non-investment grade by at least one other) that we believe have strong asset and liquidity positions. 
The vast majority of Strategy investments contributed positively to results in the past fiscal year.  The sections below highlight the key contributors and detractors.  

Top Fiscal Year Contributors

Non-Convertible Corporate Bonds – Despite the credit spread widening highlighted above, the Strategy’s corporate investments performed well in the past year.  The Strategy’s non-convertible corporate bonds, particularly our energy related corporate bond investments, performed well during the fiscal year and were the largest contributor to Strategy performance.  Key contributors in the investment-grade segment included the bonds issued by Equity Commonwealth, Kinder Morgan and Wells Fargo.  Key non-investment grade detractors included energy related bonds issued by Rose Rock Midstream, Antero Resources and Concho Resources. 
US Treasury Notes – US Treasury notes received a safe haven bid during the fiscal year marked by global economic uncertainty (primarily in China and other emerging markets) and increased market volatility.  Negative interest policies by other world central banks (notably the ECB and Japan) further aided the appeal of nominally small, but positive, US Treasury rates.  Our Treasury holdings primarily consist of intermediate treasury securities with an average maturity of approximately 5.5 years. 
Non-Agency Securitized Products (RMBS, CMBS, Auto ABS) – This segment of our portfolio continued to perform at or above our expectations with respect to credit performance and average life progression, while providing steady income and minimal price volatility during the fiscal year.  Key contributors in this segment included the commercial mortgage-backed securities (CMBS) bonds issued by Redwood Commercial Mortgage and Rialto Real Estate Fund LP, the non-agency residential mortgage-backed securities (RMBS) bonds issued by Oak Hill Advisors Residential Loan Trust and automobile asset-backed securities (auto ABS) bonds led by California Republic Auto Receivables Trust, Credit Acceptance Auto Loan Trust and Santander Auto Drive Receivables Trust.  

Top Fiscal Year Detractors

Select Energy Related Corporate Bonds – A portion of the Strategy’s corporate bond holdings in midstream infrastructure companies detracted from results in the past fiscal year.  The largest detractors were SemGroup, Williams Partners and DCP Midstream.  As midstream operators, all three companies face the risk of declining through put volumes, as US natural gas, natural gas liquids (NGL’s) and oil production declines.  However, we believe that each company is managing through the downturn and has a strong collection of midstream assets with exposure to some of the lowest cost US production areas, including the DJ Basin in Colorado, the Marcellus/Utica shales in Pennsylvania and Ohio, and the Permian Basin in Texas. 
Convertible Corporate Debt and Redwood Trust Common Stock – The Strategy’s investment in Redwood Trust common stock (down 20.6%) and the company’s 2- and 3-year convertible bonds detracted from results in the past fiscal year.  Despite difficult market conditions over the past few years, a volatile interest rate environment and increased competition, Redwood has remained profitable in each of its business segments.  The company recently took meaningful steps to right-size its cost and business structure in light of market conditions.  The company remains competitively advantaged across its platforms and is well positioned to benefit from potential government-sponsored enterprise reform, the eventual revitalization of private-label residential securitization and future commercial investment opportunities.  We continue to view the company as a “value investor” in mortgages and mortgage securities that has a culture of prudence, a renewed focus on growth in per share value and great skills in credit risk assessment.  We believe that the market valuation of less than book value now overly discounts Redwood’s future earnings capabilities. While we wait for the value to be realized, a dividend yield of nearly 9% should enhance future total return.   

Investment Activity

Despite portfolio metrics that were relatively unchanged on the year, it was a very active year for portfolio investment activity.  Despite base rates (US Treasury) that generally trended lower during the year, we were able to deploy approximately $8 million (representing approximately 40% of fiscal year end assets) of capital when Treasury rates temporarily trended higher and when credit spreads widened sufficiently (sometimes dramatically) to compensate for the embedded risks.   Investment activity was heavily weighted toward corporate bonds, both investment grade and non-investment grade, and securitized products, particularly automobile asset-backed securities (auto ABS) and commercial mortgage-backed securities (CMBS).  Examples include:
Corporate Bonds – High Yield Exploration & Production (E&P) Companies – We invested approximately 7% of Strategy assets in high yield E&Ps, including positions in Antero Resources, Concho Resources, CONSOL Energy and Range Resources. Collectively, these companies own vast acreage positions in two of the lowest cost US shale basins (the Marcellus/Utica and Permian Basin) and operate at or near the low end of the cost curve.  Each company continues to manage well through the downturn by lowering operating costs, maintaining commodity hedge positions, selling non-core assets and raising capital.   
Structured Securities – Automobile Asset-Backed Securities (ABS) – The Strategy invested approximately 11% of assets in auto ABS, backed by primarily subprime auto loan originators.  Our focus is on partnering with strong management teams with proven experience lending through numerous cycles such as Credit Acceptance Corp., DriveTime, Prestige Financial and Santander Consumer USA.  During the second half of 2015, auto ABS spreads began widening due to heightened fear of weakening underwriting discipline and the risk of lower used car prices.  Although overall credit trends are weakening, with rising delinquencies and higher net charge-offs, credit support for bond investors is also increasing, with higher overcollateralization and subordination levels.  We believe the combination of wider credit spreads and stronger credit protection has led to attractive relative-value opportunities in shorter duration (1-2 year weighted average life) assets, as compared to similar quality (A-rated and above) corporate bonds. 

Fiscal 2016 Review

2016 jumped off to the most volatile start since 2009, as a selloff in China’s stock market sparked fears of a global growth slowdown or contraction.  Energy prices followed worldwide stock prices down the rabbit hole, with oil prices dropping nearly 30% in the first three weeks of the year.  By the time Fed Chair Yellen sat before Congress in early February, global markets were jittery enough to push the intraday 10-year Treasury yield down to 1.5% on the mere mention of the possibility of the US following other central banks (namely, the European Central Bank and Japan) in implementing negative interest rates.  Calmer heads prevailed, however, when US payroll data continued to show solid growth and resilience in the US economy.  By the end of the first calendar quarter of the year, stocks and oil rebounded meaningfully, as fears of recession receded. 
During the past fiscal year (March 31, 2015 to March 31, 2016), US Treasury bond yields continued their relentless march lower.  For example, 5- and 10-year US Treasury bond yields declined approximately 16 basis points each to 1.2% and 1.8%, respectively (a basis point equals 1/100 of a percent).  Declining interest rates resulted in price gains for existing bonds (bond prices and changes in interest rates are inversely related), adding to the coupon returns for most fixed-income investors, our Strategy included. Corporate bonds and other credit sensitive securities underperformed Treasury bonds in the past year, as credit spreads (the incremental return investors demand above US Treasury bonds for owning corporate debt) widened, particularly for non-investment grade or high-yield bonds.  A broad measure of corporate bond spreads compiled by Merrill Lynch rose to 170 basis points as of March 31, up 34 basis points year over year.  The repricing of credit risk in the high-yield market was more pronounced, with spreads increasing by more than 200 basis points, or a full 2 percent.  While the overall marketplace remains expensive by historical standards (i.e., low absolute yield levels), last year’s credit repricing presented pockets of opportunity to invest favorably relative to ultra-low US Treasury rates. 

Outlook

In spite of setbacks in certain areas of the credit markets (namely energy given the significant decline in commodity prices in the past year), bond investors continue to have the “wind at their backs,” thanks to the largesse of central banks worldwide.  Ultra-low interest rates in the US government bond market and negative interest rates in much of the remainder of the non-US sovereign bond world seem rather “absurd,” as Wally and Brad outline in their investor letter for this quarter.  Distortions of markets that defy conventional investing logic seem unlikely to end well–much like the creation of Frankenstein’s monster.  Therefore, we will continue to position the Strategy defensively relative to interest rate exposure, while we patiently seek out areas of opportunity like those mentioned above. We will invest one security at a time, relying on a fundamental, research-based investment approach and remain well positioned to take advantage of any market weakness. 


Contributions to performance are based on actual daily holdings. Securities may have been bought or sold during the quarter. Return shown is the actual quarterly return of the security. The holdings identified do not represent all of the securities purchased, sold or recommended for Weitz Inc.’s advisory clients. Contact Weitz Inc. to obtain the methodology for the calculations above. You may reach Weitz Inc. at 1125 S 103rd Street, Suite 200, Omaha NE 68124, at 1-800-304-9745 or at weitzinvestments.com.

Performance information in this letter is the weighted-average performance of accounts managed by Weitz Investment, Inc. (“Weitz Inc.”) under its Core Plus Income Strategy (the “Strategy”). Performance of particular securities in this letter is shown for an entire time period. All other portfolio holdings information is for a particular “Representative Account” in the Strategy.

The returns above also include fee waivers and/or expense reimbursements, if any; total returns would have been lower had there been no waivers or reimbursements. Contributions to performance are based on actual daily holdings. Comparative returns are the average returns for the applicable period of the Barclays U.S. Aggregate Bond Index. The Barclays U.S. Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS and CMBS (agency and non-agency).  Index performance is hypothetical and is shown for illustrative purposes only.
Investors should consider carefully the investment objectives, risks and charges and expenses of the Strategy before investing. Past performance does not guarantee future results. Portfolio composition is subject to change at any time and references to specific securities, industries and sectors in this letter are not recommendations to purchase or sell any particular security. Current and future portfolio holdings are subject to risk.