January 25, 2017

Rising Rates and Trumped Up Income

Income Opportunity Strategy 4Q 2016 Commentary

The fourth quarter was a productive one for the Income Opportunity Strategy, which returned 2.43% (net of fees)1, significantly better than the investable versions of the high-yield index. The HYG ETF and JNK ETF returned 0.85% and 1.28%, respectively, during the fourth quarter, while the uninvestable BofA Merrill Lynch US High Yield Master II index printed a 1.88% return.

We are especially pleased with the Strategy’s performance this quarter, because it happened in conjunction with the second-largest single-quarter percentage increase in interest rates since Income Opportunity’s launch in April 20092; rising interest rates would tend to have a negative effect on many traditional “fixed income” strategies. The ten-year US government note began the quarter at a yield to maturity of 1.59%, while it ended the quarter (and year) at 2.44%, which represented an increase of 85 basis points, or 53%. The bulk of the move came after the election, which appeared to coincide with a major shift in investor sentiment. Markets appear increasingly hopeful that a unified government could mean lower corporate taxes, greater stimulus spending and reduced regulation, all of which are likely bullish for the economy and for equity markets in the near term.

In light of these dynamics, it is interesting to look at the Strategy’s intra-quarter performance before and after the election. Income Opportunity did especially well between the election and quarter-end, while its high-yield ETF competition fared less well.

9/30/16 – 11/8/16 11/8/16 – 12/31/16
Income Opportunity -2.30% 4.59%
JNK -0.32% 1.61%
HYG -0.58% 1.45%

Performance is supplemental. Please click here to access annualized performance and here to access the composite performance disclosure.

It is especially rewarding to demonstrate what we have said since the Strategy’s launch – namely, that Income Opportunity’s pro-cyclical tilt should allow it to perform well as interest rates move higher. The overwhelming majority of our holdings stand to benefit and potentially pay higher dividends as rates rise, as only about 20% of the portfolio is in true “fixed” income, while roughly 80% of the holdings distribute cash from a residual earnings stream. For instance, the business development companies and real estate lenders in which we invest should see improving credit performance while also lending at higher rates. Our alternative asset managers are likely to see their portfolio holdings grow their revenues and earnings, thereby increasing the price at which the managers can sell the companies. Even our debt holdings stand to benefit from an accelerating economy, as the market perceives many of them as over-levered, or having too much debt relative to their revenues and costs. If these companies see accelerating prospects against a large load of fixed-cost debt, their debt should appreciate in value as investors worry less about their ability to service their debt.

Clearly, there is no guarantee that the recent trends will continue, but Income Opportunity remains positioned for an improving backdrop. As the largest investors in the strategy, we remain optimistic about our prospects, and we welcome any questions or comments.

Strategy Highlights

During the fourth quarter of 2016, Income Opportunity Strategy returned 2.43% (net of fees).1 In comparison, the Strategy’s unmanaged benchmarks, the BofA Merrill Lynch US High Yield Master II Index and the S&P500 returned 1.88% and 3.82%, respectively.

We initiated five positions and eliminated eleven during the quarter, ending the quarter with 36 holdings.

Top Contributors

  • The GEO Group Inc. (GEO) rebounded during the fourth quarter, rising 52.92%. The company benefited from the election results, as investors believe that the Trump administration will reverse the Bureau of Prisons stated objective to reduce the use of private correctional facilities.
  • NorthStar Realty Finance (NRF) ended the quarter up 18.22%. During the period, NRF and the two other tri-party merger companies amended deal terms to improve corporate governance and sweeten the special dividend for NSAM shareholders, which helped clear the way for shareholder approval in December.
  • New Residential Investment Corp. (NRZ) was up 16.95% during the quarter. The company announced that it was buying mortgage servicing rights (“MSRs”) on approximately $72B worth of unpaid principal balance from PHH Corporation in addition to the $10B from Walter Capital. New Residential maintained its dividend at $0.46, implying an 11.7% annualized yield.

Top Detractors

  • Community Health Systems Inc. 6.785% 2/22 fell -16.96% during the quarter. Management pre-announced a weak Q3, with EBITDA 18% below consensus estimates. The company also cut 2016 EBITDA guidance for the third consecutive quarter, as costs were higher than anticipated. The company continued to remain under pressure, despite announced asset sales, due to worries that the new administration would roll back government-funded healthcare assistance.
  • VEREIT Inc. (VER) ended the fourth quarter down -14.98%, largely because the market tends to punish triple-net lease REITs as interest rates move higher.
  • Frontier Communications Corp. 11.125% Preferred declined -11.78% during the quarter. Selling pressure was strong after the company released Q3 results showing continued subscriber losses and revenues that missed the consensus estimate by 1.9%. Management expressed its commitment to the dividend (12.4% annualized yield), which is covered ~2x by expected free cash flow in 2017.

1Income Opportunity Strategy performance reflects the deduction of an annual model investment management fee of 1% (the highest fee for separate accounts under our fee schedule) and certain other expenses. For important information about Income Opportunity Strategy performance, please click on the Income Opportunity Composite Performance Disclosure. Past performance is no guarantee of future results.

2Since the Strategy’s launch on April 3, 2009, the largest increase in interest rates for the 10-year occurred in 2Q 2009 and the second-largest increase was in the recent 4Q 2016, at 87 bps and 85 bps respectively. Source: Bloomberg.

Contact LMM to obtain information on how Top Contributors and Top Detractors were determined and/or to obtain a list showing every holding’s contribution to Strategy performance.

Investment Risks: All investments are subject to risk, including possible loss of principal.

The views expressed in this report reflect those of the LMM LLC (LMM) strategy’s portfolio manager(s) as of the date of the report. Any views are subject to change at any time based on market or other conditions, and LMM disclaims any responsibility to update such views. The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results.

©2016 LMM LLC. LMM LLC is owned by Bill Miller and Legg Mason, Inc.

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