FPA Flexible Fixed Income Fund Second Quarter 2023 Commentary

Dear Fellow Shareholders,

FPA Flexible Fixed Income Fund (FFIAX, the “Fund”) returned 1.20% in the second quarter of 2023 and 3.48% year-to-date through June 30, 2023.

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As inflation abated during the quarter, the Federal Reserve raised the Fed Funds rate by 25 basis points in May before pausing its tightening and leaving the Fed Funds rate unchanged in June.⁴ However, the Fed’s commentary and guidance for additional Fed Funds rate increases, coupled with uneven macroeconomic data, drove risk-free rates higher during the quarter. Yields on Treasury bonds with one-to-five- year maturities increased by approximately 60-80 basis points during the quarter, while yields on longer-maturity Treasury bonds increased by approximately 20-50 basis points. In general during the quarter, spreads decreased across investment-grade and high-yield bond markets, and bond yields increased.⁵ These lower spreads have limited our investment opportunities in Credit (investments rated BBB or lower, or “Credit”). Nevertheless, we continue to search for Credit investments that we believe adequately compensate us for the risk of permanent impairment of capital. Beyond Credit, on an absolute basis, we continue to see an attractive opportunity to buy longer-duration, high-quality bonds (rated single-A or higher – “High Quality”), which we believe will enhance the Fund’s long-term returns and short-term upside-versus-downside return profile. The Fund’s Credit exposure decreased to 27.7% at June 30, 2023 from 29.4% at March 31, 2023. Cash and equivalents represented 6.6% of the portfolio at June 30, 2023 versus 10.3% at March 31, 2023.

Portfolio Attribution⁶

Corporate holdings, collateralized loan obligations (CLOs) backed by corporate loans, and asset-backed securities (ABS) backed by loans to late-stage companies (mostly software-related) were the largest, second-largest, and third-largest contributors to the Fund’s performance during the quarter, respectively. In each case, the return was driven mostly by income, with some additional benefit from higher prices due to lower spreads. Of note, the vast majority of the Fund’s CLOs are floating rate and have benefited from increases in their coupons as rates have risen.

Treasury bonds and agency-guaranteed commercial mortgage-backed securities (CMBS) were the largest and second-largest detractors from performance, respectively, driven by lower prices resulting from higher risk-free rates. ABS backed by wireless towers or data centers were the third-largest detractors from performance due to lower prices resulting from higher risk-free rates and lower spreads.

Portfolio Activity⁷

The table below shows the portfolio’s sector-level exposures at June 30, 2023 compared to March 31, 2023:

Sector % Portfolio % Portfolio

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Credit is generally not attractively priced and has become less attractive over the past few months because of lower spreads. However, as always, we remain opportunistic investors in that part of the market and will selectively invest when we believe prices compensate for risk. Within the universe of investments rated BBB or lower, during the quarter we bought a BBB-rated corporate bond that we partially paid for by selling an existing shorter-duration and lower-yielding investment from the same issuer. We also replaced an existing leveraged loan investment with an investment in a pari passu high-yield bond from the same issuer that we believe has a more attractive return profile. Finally, we bought a BBB-rated CLO backed by middle market loans.

Beyond Credit, we continue to take advantage of higher yields by actively buying longer-duration, High Quality bonds. Most of our investment activity this quarter was focused on those types of investments. The duration of these High Quality investments is guided by our duration test, which seeks to identify the longest duration bonds expected to produce at least a breakeven return over a 12-month period if we assume that a bond’s yield will increase by 100 bps during that period. During the second quarter we bought Treasuries, ABS backed by equipment, agency-guaranteed CMBS, ABS backed by auto loans, utility cost-recovery bonds, ABS backed by cellular towers or fiber networks, and ABS backed by prime-quality credit card receivables. On average, these High Quality, fixed-rate investments had a duration of 4.3 years. We also bought AAA-rated, floating-rate CLOs backed by middle-market loans.

In addition to the corporate bond and leveraged loan sales referenced above, both of which were part of rotations out of existing investments into ones with more attractive risk-versus-reward profiles, we soldcertain bank loans and high-yield bonds because their risk-versus-reward profiles became unattractive. To fund investments in longer-duration High Quality bonds, we sold existing short-duration holdings including not only High-Quality ABS with an average duration of less than one year but also corporate loan CLOs. We also sold Treasuries to buy other similar- or longer-duration bonds.

Market Commentary

By many measures, such as the index shown below, inflation is declining, although it still remains meaningfully above the Federal Reserve’s target of 2%:

CPI Urban Consumers less Food and Energy year/year change

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After raising interest rates since March 2022 (while simultaneously implementing quantitative tightening, or a reduction in the size of the Federal Reserve’s balance sheet) and having made some progress in reducing inflation, the Federal Reserve raised the Fed Funds rate by 25 bps in May before opting to “pause” and leave that key monetary policy rate unchanged in June. The rationale for this pause was to provide time to see how Fed policy implemented thus far is affecting the economy. At the same time, however, most Federal Reserve policymakers believe higher interest rates will be necessary to push inflation closer to its 2% target. Therefore, the Fed’s most recent projections showed a higher terminal Fed Funds rate, which was also reflected in the Fed Funds futures market. The bottom line is that, as of June 30, the market expected the Fed Funds rate to peak at approximately 5.4% in November 2023 before the Fed begins cutting rates:

Implied Overnight Rate & Number of Hikes/Cuts

Fed Funds Rate Expectations

Note, however, and as shown above, the path of rates is not set in stone. For example, following the March 2023 bank failures, the market expected the Fed to begin cutting rates in June. But since March, the macroeconomic data has not painted a clear picture of the economy’s trajectory: while inflation has declined slightly, the job market and economic growth have remained resilient. Consequently, the Fed did not cut rates in June, the expected future Fed Funds rate nearly recovered to its pre-March level, and Treasury yields have risen since March, as shown below.

U.S. Treasury Yield Curve

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Lack of clarity in the macroeconomic picture is why we do not pretend to know either what the Fed will do over time or how interest rates will change. We place interest rate forecasting in the “too hard” pile. There are too many variables to predict. Further, it’s difficult to have conviction in any of those variables, because macroeconomic data are extremely challenging to measure in real-time and are subject to revision. Imagine investing in a company and believing it had huge earnings growth only to find out later that its earnings had significantly declined. Such a revision would likely affect your investment thesis and the returns on the investment you’d already made. Such is the challenge we face with macro-driven investing and, specifically, trying to predict the direction and magnitude of interest rate moves. To borrow an analogy from our colleagues: with macro investing we are driving with not only a windshield that’s cracked, dusty, and hard to see through, but also a dusty rear window.

What we can see clearly, though, is that yields are still near decade-plus highs, as shown by the following charts. The first chart shows the Aggregate Bond Index; the second chart shows the BB component of the high-yield index, excluding energy, an index we believe is a better indicator of high-yield bond pricing because it excludes both “noise” related to the more volatile energy sector and changes in ratings composition in the overall high-yield index over time.

Bloomberg U.S. Aggregate Bond Index

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Bloomberg U.S. Corporate High Yield BB excl. Energy

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While the market vacillates about the direction of the economy, yields remain higher than they have been in over a decade. On an absolute basis, we find longer-duration, High Quality bonds attractive for two reasons:

First, we believe that over the long term, investors will benefit from growing their capital at today’s yields for multiple years. One might wonder whether it makes more sense to hold cash or very short-duration bonds instead of longer-duration bonds. If we knew rates will rise further and the timing and magnitude of that increase, then certainly holding onto cash or very short-duration bonds would make a lot of sense. However, we don’t believe we can know such things with a high level of conviction. Therefore, we believe it makes sense to take advantage of yields available today. Thinking about the opportunity cost of this decision helps elucidate the rationale: if yields were to decline by 25 basis points (or 50 basis points, or some other large amount) we believe investors would regret not buying bonds at today’s yields when they had the chance.

Second, we believe longer-duration High Quality bonds offer a more attractive short-term return profile. Bond prices can, of course, move between today and a bond’s maturity so we want to be mindful of duration risk and short-term returns. Employing the duration test described earlier, if yields in the short term were to increase by 100 bps over the next 12 months, we believe these longer-duration investments would produce at least a breakeven return, limit short-term drawdowns, and preserve capital we could then seek to redeploy into higher-yielding investments. Alternatively, if yields were to decline for any reason, longerduration investments would meaningfully improve the Fund’s short-term total return. For example, at June 30, the Fund held a Treasury bond that matures in June 2028. As of June 30, that bond had a maturity of five years, a duration of 4.5 years, and a yield-to-worst and yield-to-maturity of 4.12%. If that bond’s yield increases by 100 bps over the next twelve months, one would expect a positive total return of 0.54% for that period. On the other hand, if that bond’s yield were to decline by 100 bps over the next twelve months, one would expect a total return of 7.72% for that period. 18 months ago, when yields were close to zero, one could only buy a Treasury that was slightly longer than one year in maturity and still expect to make money in a rising rate environment (assuming that rates rise by 100 bps over twelve months). Of course, such a short Treasury bond has very little upside over the course of a year if yields decline, because that bond will be close to maturity and be worth near par. In comparison to shorter-duration bonds in a low- yield environment, we believe longer-duration bonds at today’s yields have a more attractive asymmetry in their short-term upside versus downside return while also locking in an attractive yield (on an absolute basis) for the long term.

As yields increased over the past 18 months, we purposely extended the duration of the bonds we bought – guided by the 100 bps duration test described above – and, in the process, extended the Fund’s duration. Since the end of 2021, we have increased the duration of the Fund by 0.9 years from 0.98 years to 1.83 years today. Such a portfolio adjustment is what we believe active management is supposed to do: position defensively and preserve capital when the market is expensive and then go on offense when the market gets cheaper. With respect to duration risk, our strategy results in the Fund buying shorter-duration bonds when yields are low and then adding duration when yields are higher.

In contrast to the market for High Quality debt which we think is attractive, we do not generally view this type of debt as attractive for the Fund, particularly as spreads have recently decreased. We continue to search for attractive opportunities in Credit, but we often find that potential absolute returns are insufficient compared to the potential for permanent impairment of capital. We also often find that the extra return over highly rated debt that lower rated debt offers is insufficient in comparison to the incremental risk of permanent impairment of capital borne by lower rated debt.

In summary, broadly speaking, we believe today’s bond market attractively priced and among the most attractive we have seen in at least a decade. We are excited about the opportunities to enhance our investors’ long-term returns while continuing to limit their short-term drawdowns.

Thank you for your confidence and continued support.

Abhijeet Patwardhan

Portfolio Manager

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