Weitz Short Duration Income Fund Q3 2022 Commentary

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The Short Duration Income Fund’s Institutional Class returned -0.80% in the third quarter compared to a -1.50% return for the Bloomberg 1-3 Year U.S. Aggregate Index. Year-to-date, the Fund’s Institutional Class returned -3.83% compared to a -4.58% return for the index. Negative absolute results are never pleasant to report, especially rare back-to-back-to-back quarters of negative results – a historic first for the Fund. Longer-term results (3-, 5-, and 10-year) continue to outpace the index.

Overview

The Federal Reserve continued raising short-term interest rates in the third quarter as inflationary pressures in the U.S. economy provided little signs of easing. The Federal Open Market Committee’s (FOMC’s) monetary actions have lifted the benchmark federal funds rate from zero at the beginning of 2022 to a range of 3.00-to-3.25% as of the end of the third quarter – with historically outsized rate hikes of 0.75% at their June, July, and September meetings. The chart below shows the unprecedented pace at which the FOMC is raising rates to get high inflation under control.

The chart shows the unprecedented pace at which the FOMC is raising rates to get high inflation under control.

No other rate hiking cycle has begun this steeply since the 1980s (when the Fed started targeting the federal funds rate as its primary tool for conducting monetary policy). And the Fed’s newfound fondness for hiking rates appears set to continue well into 2023 with some economists predicting the benchmark federal funds rate to hit as high as 5% sometime next year.

While the steepness of the 2022 curve has negatively impacted year-to-date returns for nearly all fixed income investors, it has also set the stage for more favorable forward returns. This can be seen in the Fund’s improved yield-to-worst (YTW) metric. As a reminder, YTW has historically been a reasonable predictor of forward returns. The Fund’s YTW increased from 4.3% on June 30, 2022, to 5.6% on September 30, 2022 – exceeding the index’s YTW of 4.6% on September 30.

The positive variance is attributable to timely investments in the third quarter (detailed below) and to the Fund’s approximately 23% weight in floating-rate securities versus no exposure in the index. The YTW for our floating-rate securities incorporates the market’s current expectations for higher short-term interest rates of more than 4% by year-end. The improved year-over-year YTW is also worth highlighting (box below). The Fund’s YTW remains meaningfully higher than the Bloomberg 1-3 Year U.S. Aggregate index, while the Fund’s interest rate risk (duration) is much lower.

Yield to Worst / Duration Analysis

9/30/2021

9/30/2022

Change

% Change

Yield to Worst (%)

Short Duration Income Fund

1.15

5.68

4.53

394%

U.S. 1-3 Yr Agg Index

0.40

4.57

4.17

1043%

Average Duration (yrs)

Short Duration Income Fund

1.60

1.52

(0.08)

-5%

U.S. 1-3 Yr Agg Index

1.85

1.82

(0.03)

-2%

Portfolio Positioning

The table below shows the change in allocation to various sectors, from the prior quarter and from the prior year. This summary provides a view over time of how we have allocated capital. Since our goal is to invest in sectors that we believe offer the best risk-adjusted returns, our allocations may change significantly over time.

SECTOR ALLOCATION (% of net assets)

9/30/2022

6/30/2022

Qtr Over Qtr Change

9/30/2021

Yr Over Yr Change

Corporate Bonds

12.6

12.5

+0.1

15.9

-3.3

Corporate Convertible Bonds

2.3

2.3

0.0

2.7

-0.4

Asset-Backed Securities (ABS)

36.1

34.4

+1.7

29.0

+7.1

Corporate Collateralized Loan Obligations (CLOs)*

12.0

11.5

+0.5

10.6

+1.4

Commercial Mortgage-Backed Securities (CMBS)

11.0

11.2

-0.2

11.8

-0.8

Agency Mortgage-Backed (MBS)

4.0

4.7

-0.7

7.4

-3.4

Non-Agency Mortgage Backed (RMBS)

5.9

6.7

-0.8

8.0

-2.1

Municipal Bonds

0.0

0.0

0.0

0.0

0.0

U.S. Treasury

25.3

24.8

+0.5

20.9

+4.4

Common Stock

0.0

0.0

0.0

0.0

0.0

Cash & Equivalents

2.8

3.4

-0.6

4.2

-1.4

TOTAL

100

100

99.9

High Yield**

5.0

5.2

-0.2

5.3

-0.3

Average Effective Duration

1.5

1.6

-0.1

1.6

-0.1

Average Effective Maturity

3.1

3.2

-0.1

2.6

+0.5

*Corporate CLOs are included in the ABS segment in the Fund’s schedule of investments but are additionally called out separately for the purposes of the discussion.

**For the current period, high yield exposure consists of investments in the Corporate, Corporate Convertible, ABS and CMBS sectors. Totals may be greater or less than 100 due to rounding.

Investment activity remained strong in the third quarter as we sourced a little more than $106 million of new investments for the Fund, exceeding the Fund’s monthly/quarterly paydowns and maturities of securities (approximately $60 million in the third quarter). By design, the Fund has a distinct feature of having about 25%-30% of its holdings paydown or mature in any given year.

This allows for frequent reinvestment of investor capital into areas of the fixed-income market that we believe provide the best current relative value opportunities. While this continuous reinvestment has been an occasional headwind as rates fell to historic lows in recent years, it should provide (and has provided) return upside when interest rates, particularly short-term rates, move higher as has been the case so far in 2022.

Noteworthy additions included:

Asset-backed securities (ABS) issued by Lending Point (LDPT), Foresight Capital (FCRT), Ladder (LAD), Pagaya (PAID), Pawnee (PWNE), Conn’s (CONN) and Marlette (MFT), which are backed by automobile receivables, equipment, and unsecured consumer loans. Like most of our other ABS investments, these third quarter investments are short average life (less than 2.0 years), senior securities from recent securitizations. We had refrained from investing in most auto ABS in 2021 as we believed both base rates and credit spreads were too low to participate. Those decisions proved out in 2022 as nominal returns improved materially from rising base rates and credit spreads — all helping to meaningfully improve the Fund’s forward return prospects via improved an improved YTW metric.

Treasury securities, principally in the 2-to-3-year area, with late quarter additions in 5-year Treasuries.

Commercial real estate collateralized loan obligations (CRE CLOs) and middle-market collateralized loan obligations (MM CLOs) issued by Capital Four (C4US), Loancore Capital (LNCR), and Owl Rock (OR).

In terms of overall portfolio metrics, from June 30, 2022, to September 30, 2022, the Fund’s average effective maturity decreased from 3.2 years to 3.1 years, and its average effective duration declined from 1.6 years to 1.5 years. These measures provide a guide to the Fund’s interest rate sensitivity. A lower average effective maturity and shorter average effective duration reduce the Fund’s price sensitivity to changes in interest rates (either up or down). Another portfolio attribute to re-highlight is the Fund’s investments in floating-rate securities (mainly MM CLOs and CRE CLOs) — representing about 23% of Fund assets as of September 30, 2022. These investments have experienced increased coupon income due to the year-to-date tightening moves (increases in short-term interest rates) that the Fed has undertaken to combat inflation.

As of September 30, 2022, the Fund’s high-yield exposure as a percent of net assets was 5.0%, down from 5.2% on June 30, 2022. In last quarter’s Fund commentary, we commented favorably on high yield valuations — but a significant rally at the outset of the third quarter reduced favorable investment opportunities. Weakness in credit markets broadly as the third quarter came to a close has increased the relative attractiveness of certain high yield credits. Given the Fund can invest up to 15% of net assets in high yield, we are well-positioned to take advantage of any further valuation discrepancies and opportunities in the high yield area. Our approach, however, will most likely be focused on what might be termed “higher-quality high-yield.” That is, those companies whose business and balance sheet is strong and who can weather an economic disturbance caused by a possible recession.

Quarterly Contributors

  • CLOs (both CRE CLOs and MM CLOs) were the Fund’s top quarterly contributors as meaningfully rising coupon income from adjustable-rate investments more than offset market value declines. ABS investments broadly and corporate bonds issued by Redwood Trust and Starwood Capital were also noteworthy contributors.

Quarterly Detractors

  • U.S. Treasury, agency, and non-agency residential mortgage-backed securities (RMBS) were the primary detractors in the quarter as rates rose and mortgage-backed spreads widened.

While it is particularly unpleasant to report on this year’s Fund performance, we are pleased to report that most of our investments continue to have underlying fundamentals (credit quality) that match, or exceed, original expectations. This solid year-to-date credit performance has been recognized by rating agencies with meaningfully more upgrades to credit ratings than downgrades (more than 20-to-1). Additionally, prepayments have allowed for reinvestment at meaningfully higher returns, helping to enhance our YTW of 5.6% at quarter-end.

Yogi Berra – the famous baseball player well-known for his many Yogi-isms — is credited with saying “it’s tough to make predictions, especially about the future.” Good advice, especially in credit and equity markets. Our role as money managers, per one of the founders of Gavekal Research, is to “adapt” to market environments and not forecast.

Widespread worry/concerns/fears/confusion about the macro environment (further inflation, stagflation, possible recession, consumer spending slowdown, etc., etc.) often present opportunities for the fundamental investor. As a result, we are finding the best risk-adjusted return opportunities for the Weitz Short Duration Income Fund since the COVID pandemic. We are proceeding with caution, but with Treasury yields at or above 4% and higher-quality, investment-grade yields on offer at 5-7%, we believe that now may be a good time for investors to consider adding to their fixed income allocation.

We believe the Fed’s tightening cycle is in the later innings, possibly near the seventh-inning stretch in baseball parlance. Timing is always uncertain, and there could still be some price declines ahead. But despite the uncertainty as well as unsatisfactory year-to-date performance, we are increasingly encouraged by the forward return prospects of the Fund’s new and existing investments.

RETURNS (%)

TOTAL RETURNS

AVERAGE ANNUAL TOTAL RETURNS

Net Expense

Gross Expense

QTR

YTD

1-YR

3-YR

5-YR

10-YR

20-YR

30-YR

Since Inception (12/23/1988)

WEFIX Institutional Class

-0.80

-3.83

-4.06

0.31

1.16

1.43

3.00

4.02

4.60

0.48

0.62

WSHNX Investor Class

-0.73

-3.86

-4.11

0.25

1.04

1.26

2.90

3.95

4.54

0.55

0.90

Bloomberg U.S. Agg 1-3 YR Index

-1.50

-4.58

-5.11

-0.52

0.64

0.78

2.03

n/a

n/a

This material must be preceded or accompanied by a prospectus or summary prospectus.

Data is for the quarter ending 09/30/2022. The opinions expressed are those of Weitz Investment Management and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through 10/20/2022, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon.

Data quoted is past performance and current performance may be lower or higher. Past performance is no guarantee of future results. Investment return and principal value of an investment will fluctuate, and shares, when redeemed, may be worth more or less than their original cost. Please visit weitzinvestments.com for the most recent month-end performance.

Investment results reflect applicable fees and expenses and assume all distributions are reinvested but do not reflect the deduction of taxes an investor would pay on distributions or share redemptions. Net and Gross Expense Ratios are as of the Fund’s most recent prospectus. Certain Funds have entered into fee waiver and/or expense reimbursement arrangements with the Investment Advisor. In these cases, the Advisor has contractually agreed to waive a portion of the Advisor’s fee and reimburse certain expenses (excluding taxes, interest, brokerage costs, acquired fund fees and expenses and extraordinary expenses) to limit the total annual fund operating expenses of the Class’s average daily net assets through 07/31/2023.

The Gross Expense Ratio reflects the total annual operating expenses of the fund before any fee waivers or reimbursements. The Net Expense Ratio reflects the total annual operating expenses of the Fund after taking into account any such fee waiver and/or expense reimbursement. The net expense ratio represents what investors are ultimately charged to be invested in a mutual fund. Performance quoted for Investor Class shares before their inception (08/01/2011) is derived from the historical performance of the Institutional Class shares and has not been adjusted for the expenses of the Investor Class shares, had they, returns would have been different.

Effective 12/16/2016, the Fund revised its principal investment strategies. Since that time the Fund has generally maintained an average effective duration between one to three and a half years. Prior to that date, the Fund maintained a dollar-weighted average maturity of between two to five years. Performance prior to 12/16/2016 reflects the Fund›s prior principal investment strategies and may not be indicative of future performance results.

Short Duration Income Fund’s inception date is December 28, 1988. The investor class inception date is August 1, 2011. Performance for investor class shares before their inception date uses the historical performance and expenses of institutional class shares. Effective December 16, 2016, the Fund revised its principal investment strategies. Since that time the Fund has generally maintained an average effective income duration between one to 3½ years. Prior to that date, the Fund maintained a dollar-weighted average maturity of between 2 to 5 years. Performance prior to December 16, 2016, reflects the Fund’s prior principal investment strategies and may not be indicative of future performance results.

Index performance is hypothetical and is shown for illustrative purposes only. You cannot invest directly in an index. The Bloomberg 1-3 Year U.S. Aggregate index is generally representative of the market for investment grade, U.S. dollar denominated, fixed-rate taxable bonds with maturities from one to three years.

Holdings are subject to change and may not be representative of the Fund’s current or future investments.

Credit ratings are assigned to underlying securities utilizing ratings from a Nationally Recognized Statistical Rating Organization (NRSRO) such as Moody’s and Fitch, or other rating agencies and applying the following hierarchy: security is determined to be Investment Grade if it has been rated at least BBB- by one credit rating agency; once determined to be Investment Grade (BBB- and above) or Non-Investment Grade (BB+ and below) where multiple ratings are available, the lowest rating is assigned. Mortgage-related securities issued and guaranteed by governmentsponsored agencies such as Fannie Mae and Freddie Mac are generally not rated by rating agencies. Securities that are not rated do not necessarily indicate low quality. Ratings are shown in the Fitch scale (e.g., AAA). Ratings and portfolio credit quality may change over time. The Fund itself has not been rated by a credit rating agency.

Definitions: Average effective duration provides a measure of a fund›s interest-rate sensitivity. The longer a fund›s duration, the more sensitive the fund is to shifts in interest rates. Average effective maturity is the weighted average of the maturities of a fund›s underlying bonds. Commercial real estate collateralized loan obligations (CRE CLOs) are a type of asset-backed security backed by a pool of commercial loans. Investment Grade Bonds are those securities rated at least BBB- by one or more credit ratings agencies. Middle market refers to smaller companies, generally with earnings before interest, taxes, and amortization of generally less than $75 million. Non-Investment Grade Bonds are those securities (commonly referred to as “high yield” or “junk” bonds) rated BB+ and below by one or more credit ratings agencies. Yield to worst (YTW) is the lowest potential yield that can be received on a bond portfolio without the underlying issuers defaulting.

Consider these risks before investing: All investments involve risks, including possible loss of principal. These risks include market risks, such as political, regulatory, economic, social and health risks (including the risks presented by the spread of infectious diseases). In addition, because the Fund may have a more concentrated portfolio than certain other mutual funds, the performance of each holding in the Fund has a greater impact upon the overall portfolio, which increases risk. See the Fund›s prospectus for a further discussion of risks related to the Fund.

Investors should consider carefully the investment objectives, risks, and charges and expenses of a fund before investing. This and other important information is contained in the prospectus and summary prospectus, which may be obtained at weitzinvestments.com or from a financial advisor. Please read the prospectus carefully before investing. Weitz Securities, Inc. is the distributor of the Weitz Funds.


Original Posted On 9/22/22

Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.