TSI TCW Strategic Income Fund Inc

 

 

 

 

 

 

TCW is pleased to present the 2022 annual report for the TCW Strategic Income Fund (“TSI” or the “Fund”). TSI is a multi-asset class fund managed by TCW Investment Management Company LLC and is listed on the New York Stock Exchange under the ticker TSI. For the year, shares of TSI fell by 14.34% while the Fund’s net asset value (i.e., returns of the underlying assets) fell by 7.51%. The Fund’s twelve-month price-based return was below the return, as the share price moved from a premium to NAV of 1.4% at the start of the period to a 6.3% discount by December 31, 2022.

Over the past four quarters, the Fund paid dividends of approximately six cents per share each quarter, as well as a long-term capital gains distribution of 8.08 cents per share, and a special cash payment of 1.25 cents per share. This represents an annualized rate of approximately 32 cents per share, contributing to a realized trailing yield of approximately 7.0% as of 12/31/2022. As yield is a function of a number of parameters, the yield of TSI will likely differ from the trailing figure.

 

 

1

 

Much as any year brings its share of the unexpected, possibly the biggest surprise of 2022 was the Fed finding a long-lost resolve in the face of a capital markets-wide selloff precipitated by a rooted and flowered inflation, germinated in the pandemic (and seeded decades prior). As for the markets, the tumult of the year would be hard to overstate. Pricing weakness was felt across asset classes with broad stock and bond measures dropping more than 15%, a first for the record books and a nemesis to diversification. Compounding the deleterious effect of one of the most hawkish and synchronized central bank tightening campaigns in history, low bond yields and relatively lofty stock valuations to start the year set the stage for such disappointing results. What periodic relief there was in 2022 manifested itself as a pattern of sporadic bear market rallies and a near obsession with the word “pivot”, though optimism proved unsustainable. “Pivot” now follows “transitory” in the Fed lexicon…will it too be forgotten as Chair Powell stays a steady course? Although late to take action to combat inflation, the Fed initiated its aggressive tightening measures in March to eventually get through four consecutive 75 basis point (bps) increases to the Fed Funds rate, followed by an additional 50 bps bump in December, bringing the target range to 4.25% to 4.50% by the end of the year. Resilient labor markets – sub 4% unemployment – provide continuing cover for an expected 50 bps of further tightening early in 2023 and peak short rates near 5%. Fed action has historically worked with a lag, though the first effects of slowing economic activity thus far have already shown up in the interest-rate sensitive housing market. Existing home sales fell for ten consecutive months in 2022, and are now down over 35% on a year-over-year basis as mortgage rates rose off historically low levels and affordability sharply deteriorated for new homebuyers on the higher financing costs and still high prices, at least for now.

Finding 4% for the first time since 2010 in early October and reaching a high of 4.24% later in the month, the yield stabilized somewhat lower to close 2022 at 3.89%, though still nearly 240 bps above where it started the year. Fixed income remediated into the fourth quarter on reduced rate volatility, with the Bloomberg U.S. Aggregate Bond Index actually gaining 1.9%, but losses were too steep to overcome, falling a crushing 13%. Credit markets lagged in 2022 as spreads widened in both the investment grade and high yield markets. Despite widening, investment grade corporate spreads around 130 bps are still moderately tighter than their long-term averages and substantially narrower than they have been in recessions, suggesting there is room for them to widen further in 2023 if the economy endures a more significant downturn. For leveraged finance, despite a fourth quarter rally of 4.2%, high yield bonds were down 11.2% for the year and the amount of distressed debt in the U.S. alone jumped more than 300% in 12 months. Even more affected than the corporate market, agency mortgage-backed securities (MBS) spreads reached levels similar to where

 

2

 

they were in 2008, and delivered an 11.8% loss for 2022 despite clawing back 2.1% in the fourth quarter. Similarly, MBS spreads reflected weaker economic expectations than those priced by credit markets, resulting in deeply negative returns (though better than the agency MBS market). Meanwhile, commercial real estate remains vulnerable as the work from home dynamic has weighed on office properties, adding to stress in retailers and translating to lagging results and an increasing percentage of commercial mortgage-backed securities (CMBS) collateral loans going to special servicing. Both agency and CMBS tumbled approximately 11% on the year, with the agency market dragged down mostly on duration while CMBS experienced more pronounced spread widening. On the asset-backed securities (ABS) front, early signs of stress are emerging despite a modest current annual loss of 4.3%, with delinquencies and write-offs picking up, especially among pools with the highest-risk borrowers.

The path towards economic stability will be challenging as uncertainty over the trajectory of monetary policy, inflation, and geopolitical tensions renders the market susceptible to continued volatility. Without question, the effects of higher rates and tighter financial conditions will continue to be felt into 2023, with a recession the most likely outcome. However, unlike the last two recessions, this one is not likely to be crisis-driven (i.e., subprime meltdown or pandemic), but rather by the Fed, suggesting a different look than recent versions. As such, the team’s approach is to remain disciplined and opportunistic. Specific to the inflation picture in the U.S., prices appear to have peaked, with expectations for further deceleration as economic activity slows. As a corollary to that, it is anticipated that the yield curve will steepen significantly, with the rate dropping quickly to reflect an easing Fed (by 2022, the curve has steepened more than 30 bps from the cycle low). Positioning reflects this, under a belief that disciplined active managers should be well-situated to take advantage of market volatility and thus set the stage for the possibility of strong prospective returns.

 

3

 

 

 

Modest leverage can be utilized by the Fund through a Line of Credit facility ($70 million available) when market opportunity is abundant and management deems the use of leverage accretive to returns. Volatility in provided an opportunity to expand risk budgets and the Fund utilized approximately 2% leverage to take advantage of attractive entry points. Specifically, additions were made in corporate credit (banking) and the mortgage space (both agency pass-throughs and MBS collateral like low credit risk transfer deals and liquidating loans) where yield spreads were widening beyond what we viewed as fair value. As yield premiums remediated late in the year, the Fund took some gains and trimmed positions in these areas and in others, with proceeds used to reduce leverage to 0% by The management team stands ready to further utilize the leverage facility when market opportunity is again abundant and management deems the use of leverage as accretive to returns.

Finally, we express our gratitude to David B. Lippman, who retired as President, Chief Executive Officer and Director of the Fund and President and Chief Executive Officer of The TCW Group, Inc., at the end of 2022. Mr. Lippman is succeeded in those roles by Kathryn Koch, who previously served as Chief Investment Officer of Goldman Sach’s public equity business.

We greatly appreciate your investment in the Fund and your continuing support of TCW. If you have any additional questions or comments, we invite you to visit our website at www.tcw.com or contact our shareholder services department at or contact@tcw.com.

Sincerely,

Liz Kraninger

Executive Vice President and Chief Operating Officer

TCW Investment Management Company LLC (the “Advisor”)

 

4

TCW Strategic Income Fund, Inc.

Management Discussion

 

The TCW Strategic Income Fund (TSI) fell 7.7% return) for the period ending December 31, 2022, trailing the Bloomberg U.S. Treasury Bellwethers Index + 400 basis points by approximately 13.3%. With the Federal Reserve embarking on one of the most aggressive hiking cycles in decades by raising rates 425 bps through December the Fund’s positive duration profile was the largest detractor from performance throughout the period. Illustratively, the duration position was extended in a disciplined fashion from just under 2.0 years to start the period to 2.8 years in December alongside the evolving value proposition brought forth by higher yields. Meanwhile, the Fund’s position in securitized credit further held back returns, with residential mortgage exposure the second largest drag on performance. MBS holdings detracted as the sector widened on increased volatility, money manager outflows, and overall financial market stress, with a notable bifurcation between higher-quality issues that traded more frequently and less liquid issues. Ultimately, however, we believe MBS spreads reflect much more dire economic conditions than are indicated by credit markets. Also weighing on relative performance was the allocation to agency MBS, which experienced its best and worst monthly performance in history during 2022, but was ultimately weakened by sustained interest rate volatility. Corporate credit widened throughout the year, presenting opportunities to add exposure at attractive levels. Notably, the largest addition to the corporate basis was in large money center banks at attractive valuations as record issuance led to disproportionately wider spreads despite their well-capitalized balance sheets and strong fundamentals. While the sizable corporate position benefitted returns in 1Q and November when the corporate market outperformed, positioning generally detracted for the year, particularly the emphasis on communications, which was one of the worst performing sectors, and the allocation to high yield as yield spreads ended 186 bps wider. Finally, equity holdings in the Fund contributed overall due to energy names, though other equity exposure in the banking, REIT, and communications space were a drag.

With the bellwether Treasury yield above the team’s estimate of sustainable levels, the duration of the Fund was extended throughout 2022 from 1.9 years to approximately 2.8 years. On sector positioning, allocations dictate caution given that corporate spread levels remain insufficient. As such, the Fund emphasizes more resilient sectors and issues subject to less volatility, with the expectation that as recession unfolds, the move in spreads will allow for as valuations improve, while maintaining room to increase exposure during larger corrections. Unlike credit markets, both agency and MBS prices reflect economic pressure, and represent what we view as attractive value at this point. Expectations are that agency MBS could be used as buy liquidity for other opportunities in market volatility. As for holdings, especially long-seasoned legacy issues, these continue to exhibit good collateral performance, i.e., low delinquencies and improving ratios, though some volatility is possible, particularly if unemployment rises. The team remains selective in these sectors and, similar to credit, will look to reduce higher-quality holdings, using proceeds to migrate down the quality spectrum as valuations cheapen to improve the return outlook. Finally, exposure to other securitized issues is higher quality, particularly in the CMBS market, which faces stress in 2023 as rising delinquencies ultimately filter through to defaults and losses. ABS at the top of the capital structure provides what we believe to be fair compensation given robust structures, with an ongoing focus on sectors that offer more attractive yields than more traditional credit cards and auto receivables.