The third quarter of 2022 was a tale of two halves for US markets. In July, investors, buoyed by another strong quarterly corporate earnings season, pushed US equity markets to the best monthly performance since November 2020. S&P 500 earnings in Q2 2022 increased by 9.7% Y/Y with 77.6% of companies beating analyst forecasts according to Refinitiv. While inflation continued to accelerate with June’s CPI reading of 9.1% Y/Y, the market consensus seemed to coalesce around inflation peaking in June with sharp deceleration on the way. Indeed, a popular narrative began to form around the Federal Reserve being forced to pivot from its tightening bias as early as Q1 2023 given a seemingly inevitable recession around the corner. Some FOMC members’ comments regarding the need to decelerate the pace of rate increases following July’s 75bp rate hike reinforced the market’s belief that the worst might be over for bond and equity markets. However, this sanguine attitude toward the current market conditions couldn’t have been more misplaced and, as we have alluded to in previous commentaries, the volatile and turbulent times returned by the second half of Q3 2022. Markets began to sour in the second half of August with Jerome Powell’s speech at the Jackson Hole Economic Symposium catalyzing the end of a “bear market rally”. Powell reiterated the Fed’s commitment to bringing inflation down to its long-term target of 2% and issued a stark warning to investors that some economic pain will be necessary. There was no indication of a potential pivot or deceleration of monetary tightening conveyed by the Fed.
Just as the market began to reprice risk assets to a more aggressively hawkish Fed policy, the higher than consensus 8.3% August CPI print further accelerated the ascent of Treasury yields and the decline of risk asset prices. The August print was especially disappointing as inflation increases had been expected to ebb given gasoline prices had seen significant declines. However, this time around, energy declines were more than made up for by housing and healthcare related increases. The rise in rents was expected as CPI rent components continue to catch up to the 30% in post-Covid home price increases and near 20% in y/y rent increases based on Zillow data. US inflation data has also been relatively tame compared to European countries where inflation is well entrenched in the double digits due to skyrocketing energy prices stemming from the impact of Russia’s invasion of Ukraine and natural gas shortages due to curtailed US production. Equities posted another weak quarter with the S&P 500 TR Index down 4.9% and the Nasdaq 100 Index down 4.4% bringing YTD returns to -23.9% and -32.4% respectively.
Turning to bond markets, it was once again the short end of the curve that won the race to higher rates with 2-year yields jumping 132 bp to reach 4.3%. The short end of the curve was logically driven by higher-than-expected fed fund rates with the September dot plot indicating fed funds topping at around 4.75-5.00% in 2023. In a worrisome development for risk assets, a Fed pivot to lower rates is now not anticipated until 2024 according to the same dot plot. 10-year and 30-year yields increased by 82 bp and 59 bp respectively, with the yield curve finally inverting in Q3 and finishing the quarter with 46 bp of inversion between 2s and 10s. Both the short and long end of the treasury curve have been negatively impacted by the start of QT (quantitative tightening) which started in earnest during September.
With the Fed gone as the largest buyer of treasuries, the treasury market has struggled to find liquidity as foreign institutions, banks, and money managers have also retrenched from the treasuries for various reasons. Foreign central banks have suffered from the dramatic rise of USD against other currencies. The USD has appreciated 17% in 2022 against a trade weighted basket of foreign currencies while the Japanese yen has seen a dramatic 25% decline versus the USD. A strong dollar has reduced returns from US treasuries available to Japanese investors to below 0% by increasing their hedging costs. This has caused Japanese pension funds and insurance companies to pull back their US treasury purchases while at the same time the Bank of Japan has been selling longer dated US treasuries to bolster the value of yen. US commercial banks purchased the least amount of Treasury bonds in Q3 2022 since Q4 2020, as bank deposit growth has slowed down sharply due to the Fed’s tightening policies. Money managers have seen substantial outflows from fixed income funds in 2022 which made them net sellers of treasuries. This liquidity vacuum in the treasury market caused interest volatility to spike to levels not seen since March 2020 with the MOVE index (Merrill Lynch Option Volatility Estimate) climbing to 160. According to Bank of America Research, 2022 has been the 4th worst year in 300 years of recorded history of bond markets with the Bloomberg Global Treasury index down by 21.3% YTD.
US Corporate and High Yield indices had mixed results relative to US Treasuries with credit spreads widening in September after tightening in July and August. The Bloomberg IG Corporate index declined 5.06% in Q3 with most of the negative return attributed to the rise in treasury rates. The Bloomberg Corporate High Yield index declined 0.65% in Q3. The IG Corporate curve flattened in Q3 with BBB spreads tightening while AAs and As widened at the margin. The HY Corporate credit curve steepened in Q3 due to a 50bp decline in BB Corporate OAS while CCC Corporates saw a slight spread widening in Q3. Both corporate and high yield markets benefited from a significant reduction in primary issuance with IG corporate issuance down 50% and high yield issuance down 84% in Q3 due to many corporate issuers locking in all time low funding rates in 2020 and 2021. US HY Corporate TTM default rate has held below 1% at 0.8% since May reflecting benign credit fundamentals.
Portfolio Attribution and Activity
Source: Orange Investment Advisors. Attribution represents net-of-fees mutual fund performance
SEC 30 Day Subsidized Yield: 4.12% | SEC 30 Day Unsubsidized Yield: 4.02%
JSVIX posted a -1.43% return in Q3 2022 outperforming the Bloomberg US Aggregate Bond Index by 3.33%. Most of the outperformance in Q3 is attributable to lower effective duration (1.7 vs 6.1 for the Aggregate index) given that rates sold over 100 bp. JSVIX also has an over 200 bp yield advantage relative to the Aggregate index. The portfolio’s largest exposure continues to be in RMBS at 41%. As the largest allocation, RMBS had the largest negative impact on returns at -0.67%. Corporate structured notes contributed -0.43% while CMBS, ABS, and CLO/CDOs and CMBS, which make up just over 1/3 of the portfolio, contributed -0.37% bp of return in aggregate.
Among notable trades, we added Non-QM subordinate tranches at wider spreads and lower dollar prices. We like the price convexity of lower dollar-priced Non-QM subordinate tranches as they are being priced to full extension scenarios and prepayment speeds can pick up in the future causing these discount securities to shorten significantly. We believe that the housing sector will experience a mild correction with home prices potentially declining by 10-15% at most but given the sufficient amount of equity and subordination in these RMBS deals, we don’t expect that BBB and A rated Non-QM tranches are in jeopardy of suffering principal writedowns. In CMBS we added slightly seasoned Small Balance Commercial subordinate tranches at deep discounts to par and AS tranches off seasoned 2013 Conduit deals at a deep discount to par. In the ABS sector, we acquired a short average life subordinate BB rated tranche off a 2020 deal at yield in excess of 10%, as well as multiple subordinate tranches off 2007 reverse mortgage deal at a base case yield of 10-11%.
We still feel that residential real estate fundamentals are strong. We do expect modest declines in home values due to higher mortgage rates, near record historical appreciation since the pandemic and increasingly strained consumer budgets due to record inflation. By one measure, from a historical perspective relative to nominal GDP, home prices are ~10% overpriced nationwide (Amherst Research). However, given expected elevated inflation numbers over the next several years, housing prices don’t need to fall much to be in long-term equilibrium with nominal GDP. Meanwhile, a combination of robust home price appreciation and low leverage has pushed homeowner equity to its highest level since the early 1980s (Amherst Research). The high equity percentage will dampen the effect of home price declines and help avoid the voluntary defaults driven by negative equity borrowers that was at the heart of the previous mortgage crisis. In the long run, limited supply of homes exacerbated by building restrictions, higher input costs and inadequate financing will cause the supply-demand imbalance to continue to exert upward pressure on home prices.
The main issue facing fixed income markets has been net outflows from retail funds that have accelerated in the recent quarter. Aggregate withdrawals from bond funds have exceeded $400 billion thus far in 2022. Money managers are forced to sell structured credit investments into limited bids and often into liquidity vacuum conditions. This caused a significant spread widening during September. We expect challenging liquidity conditions to persist over the next 3-6 months as the Fed continues with its aggressive tightening cycle. The recent yield back-up and credit spread widening presents investors with phenomenal historical opportunities to add structured credit securities at very attractive valuations.
|9/30/2022||QTD||YTD||1-Year||3-Year||Since Inception (8/21/2018)|
|Morningstar Multisector Bond Category||-2.24%||-12.19%||-12.14%||-1.60%||0.43%|
|Bloomberg U.S. Aggregate Bond Index||-4.75%||-14.61%||-14.60%||-3.25%||-0.20%|
Past performance does not guarantee future results and current performance may be lower or higher than the performance data quoted. The investment return and principal value of an investment will fluctuate, so that shares when redeemed may be worth more or less than their original cost. Investors cannot invest directly into an index. For performance information current to the most recent month-end, please call 888-814-8180.
Source: Morningstar Direct. Performance data quoted above is historical.
The Fund’s management has contractually waived a portion of its management fees until March 31, 2023 for I, A, C and R6 Shares. The performance shown reflects the waivers without which the performance would have been lower. Total annual operating expenses before the expense reduction/reimbursement are 1.61%, 1.86%, 2.61% and 1.63% respectively; total annual operating expenses after the expense reduction/reimbursement are 1.51%, 1.76%, 2.51% and 1.14% respectively.1 2.00% is the maximum sales charge on purchases of A Shares.
ABS: An asset-backed security (ABS) is a type of financial investment that is collateralized by an underlying pool of assets—usually ones that generate a cash flow from debt, such as loans, leases, credit card balances or receivables.
Bloomberg US Aggregate Bond Index: A broad bond index covering most U.S. traded bonds and some foreign bonds traded in the U.S. The Index consists of approximately 17,000 bonds.
CLO: Collateralized Loan Obligation is a single security backed by a pool of debt. The debt is often corporate loans with low credit ratings or loans taken out by private equity firms to conduct leveraged buyouts.
CMBS: Commercial mortgage-backed securities (CMBS) are fixed-income investment products that are backed by mortgages on commercial properties rather than residential real estate.
Conduit: Are commercial real estate loans that are pooled together with similar commercial mortgages.
CRE CLO: Commercial real estate collateralized loan obligations. These securitization vehicles purchase mortgage loans secured by commercial and multifamily properties that are typically undergoing some type of transition and are short term floating-rate.
MOVE Index: (Merrill Lynch Option Volatility Estimate) Index is a measure of bond market volatility similar to the VIX for equity markets.
Non-QM: A non-qualified mortgage is a home loan designed to help homebuyers who cannot meet the strict criteria of a qualifying mortgage.
RMBS: A type of bond secured by a pool of residential mortgages. Typically, there are 100’s of mortgages grouped together in one bond.
Investors should carefully consider the investment objectives, risks, charges and expenses of the Fund. This and other information is contained in the Fund’s prospectus, which can be obtained by calling 888-814-8180 and should be read carefully before investing. Additional Fund literature may be obtained by visiting www.EasterlyAM.com.
Risks & Disclosures
Past performance is not a guarantee nor a reliable indicator of future results. As with any investment, there are risks. There is no assurance that any portfolio will achieve its investment objective. Mutual funds involve risk, including possible loss of principal. The Easterly Funds are distributed by Ultimus Fund Distributors, LLC. Easterly Funds, LLC and Orange Investment Advisors, LLC are not affiliated with Ultimus Fund Distributors, LLC, member FINRA/SIPC. Certain associates of Easterly Funds, LLC are registered with FDX Capital LLC, member FINRA/SIPC.
1. The Fund’s investment adviser has contractually agreed to reduce and/or absorb expenses until at least March 31, 2023 for I, A, C and R6 Shares, to ensure that net annual operating expenses of the fund will not exceed 1.48%, 1.73%, 2.48% and 1.11%, respectively, subject to possible recoupment from the Fund in future years.
There is no assurance that the portfolio will achieve its investment objective. A CLO is a trust typically collateralized by a pool of loans. A CBO is a trust which is often backed by a diversified pool of high risk, below investment grade fixed income securities. A CDO is a trust backed by other types of assets representing obligations of various parties. For CLOs, CBOs and other CDOs, the cash flows from the trust are split into two or more portions, called tranches. MBS and ABS have different risk characteristics than traditional debt securities. Although certain principals of the Sub-Adviser have managed U.S. registered mutual funds, the Sub-Adviser has not previously managed a U.S. registered mutual fund and has only recently registered as an investment adviser with the SEC.
MBS and ABS may be more sensitive to changes in interest rates and may result in prepayments which can include the possibility that securities with stated interest rates may have the principal prepaid earlier than expected, which may occur when interest rates decline. Rates of prepayment faster or slower than expected could reduce the Fund’s yield, increase the volatility of the Fund and/or cause a decline in NAV. With respect to the tranches, which are part of CLOs, CBOs, and CLOs, each tranche has an inverse risk-return relationship and varies in risk and yield that depending on economic factors such as changes interest rates can adversely affect the Fund.
Structured investments are formed by combining two or more financial instruments, including one or more derivatives. Structured investments may carry a high degree of risk and may not be suitable for many members of the public, as the risks associated with the financial instruments may be interconnected. As such, the extent of loss due to market movements can be substantial. Prior to engaging in structured investment Transactions, you should understand the inherent risks involved. In particular, the various risks associated with each financial instrument should be evaluated separately as well as taking the structured investment as a whole. Each structured investment has its own risk profile and given the unlimited number of possible combinations, it is not possible to detail in this Risk Disclosure Statement all the risks which may arise in any particular case.
Easterly Funds, LLC and Easterly Investment Partners, LLC both serve as the Advisors to the Easterly Fund family of mutual funds and related portfolios. Both Easterly Funds, LLC and Easterly Investment Partners, LLC are registered as investment advisers with the SEC. Mutual Funds are distributed by Ultimus Fund Distributors, LLC, member FINRA/SIPC. Although Easterly Funds, LLC and Easterly Investment Partners, LLC are registered investment advisers, registration itself does not imply and should not be interpreted to imply any particular level of skill or training.
THE OPINIONS STATED HEREIN ARE THAT OF THE AUTHOR AND ARE NOT REPRESENTATIVE OF THE COMPANY. NOTHING WRITTEN IN THIS COMMENTARY OR WHITE PAPER SHOULD BE CONSTRUED AS FACT, PREDICTION OF FUTURE PERFORMANCE OR RESULTS, OR A SOLICITATION TO INVEST IN ANY SECURITY.