Market Summary: Spurred by record corporate profits, a booming economy with healthy wage gains and $2.7 trillion of excess savings amassed during the pandemic, risk assets had a strong finish to 2021 as they successfully navigated a “wall of worry”, including a Federal Reserve that is becoming less accommodative. The S&P 500 posted an 11.0% return in Q4 and 28.7% for all of 2021, while hitting 70 all-time-highs during the year. However, looking beneath the surface, there are reasons to be concerned about the likelihood for a continued bull market.
The most obvious two issues that threaten to derail the rally across risk assets are inflation and rising interest rates. The Federal Reserve’s recent announcement that they will target an end of their QE program in March 2022, along with expectations of interest rate hikes, caused significant flattening of the US Treasury curve. The yield on 2-year Treasury notes rose by 46bp to 0.72%, while the 10-year ended the quarter up only 2bp to 1.51%. We believe the reason the long end did not sell off more, despite the tapering of asset purchases, is that investors fear a Fed policy mistake in the form of excessive hawkishness which could derail economic growth, plunging the US economy into a recession. Once investors are comfortable that the rate of tightening can meet the mandate of controlling inflation and maintaining economic growth, we believe the long end will begin to sell off.
RMBS: Despite robust fundamentals stemming from a 19% home price appreciation increase in 2021, most RMBS sectors saw slight spread widening in Q4 due to post-GFC record supply. CRT saw a massive increase in gross issuance in Q4, with 50% of the new issuance concentrated in B1 and B2 tranches at the bottom of the capital structure.
Trading activity was muted across Legacy RMBS sectors. Spreads were largely unchanged with Q4 returns ranging from 0.3% to 1% across Legacy RMBS sectors, while calendar year 2021 returns came in at 5.5-6.0%, as Legacy RMBS were largely insulated from the move higher in rates.
One of the more prominent themes in the RMBS space in 2021 was a considerable decline in secondary trading activity compared to 2020. According to BofA Research, trading volumes declined by 39% in 2021, from $141 billion in 2020 to $86 billion for non-investment grade RMBS tranches.
CMBS: CMBS supply for 2021 was the highest since 2007, with $155 billion in private label issuance and $180 billion in Agency CMBS issuance (JPM Research). SASB and CRE CLOs led private label issuance with $77 billion and $45 billion respectively as issuers found better execution in multifamily, industrial and office sectors via SASB/CRE CLO structures. With the Fed announcing its tapering plans and the Omicron variant again threatening travel and hospitality industries, market participants struggled to absorb the increase in CMBS supply and spreads widened in Q4. There is plenty of dispersion among secondary SASB deals, with retail and hotel deals trading much wider relative to multifamily, industrial, and mixed-use properties. Similar spread movements were observed in the CRE CLO space, which consists primarily of transitional multifamily properties. Nevertheless, CRE CLOs had very strong performance in 2021 as AAAs tightened by 5bp and BBBs tightened by 80bp for the year.
The CMBS delinquency rate saw its first uptick in 18 months in December, with a 19bp increase to 4.57% (Trepp), with most of the increase being due to several large office loans in NYC and Chicago becoming delinquent. CRE prices are projected to have increased 16% in 2021 according to CPPI indices with Industrial and Multifamily leading the way at 17%.
ABS: 2021 was a banner year for ABS new issues with a record $263 billion in gross supply (JPM) compared to $175 billion in 2020. Given substantial economic tailwinds in the form of low unemployment, a tight labor market, rising wages and healthy consumer balance sheets, fundamental credit performance has been strong across all ABS sectors. Unprecedented amounts of fiscal stimulus has helped drive delinquencies to record lows across many ABS sectors. Both defaults and delinquencies are expected to normalize to higher levels in 2022.
CLOs: The CLO market also saw record issuance in 2021, with $184 billion in new supply, pushing the outstanding CLO total to just over $800 billion. For the year, CLOs posted solid returns with BBs as the best performers, posting 9.6% total return in 2021 (BofA). Underlying leveraged loan prices were stable in Q4 with LSTA Index price ending the quarter flat at 98.6, close to a 7 year high. Despite retracing all of the 2020 spread widening, CLOs are still attractive compared to High Yield Bonds from a relative value perspective.
Portfolio Attribution and Activity: We slightly outperformed the Barclays US Aggregate Index. During Q4, we increased our allocation to cash and Treasuries, due to a dearth of opportunities with a desirable risk-reward profile. Due to the unprecedented supply wave in 2021, coupled with expectations of additional supply in 2022, there may be opportunities to add structured credit paper at wider spread levels moving forward.
In RMBS, we have reinvested paydowns and added some exposure to 2018-2019 vintage Non-QM and RPL subordinate tranches, close to par. These bonds are close to optional call redemption date but offer positive carry to call while spreads to maturity are over 250bp for BBB and BB rated tranches. These are safe short-duration investments, that are also attractive to banks given their low 20% capital charges. In CMBS we added 2017 vintage Small Balance Commercial fixed rate tranches at wider spreads relative to similar duration IG paper. We have also reinvested paydowns from CLO redemptions into other de-levering single-A rated CLO tranches from lower tier managers at discount margins around 300bp.
|Sector||Return||%Port||%Attrib||Allocation||Price||Yield||Eff Dur||Sprd Dur|
Q4 2021 Portfolio Outlook: Moving into 2022, interest rates will continue to be at the forefront of economic activity. While the long end of the curve may rally initially on policy mistakes and recession fears, we think the long end will gradually rise with the 10-year reaching 2.25%. We expect economic growth to moderate substantially, to 2.5% this year, though we don’t think a recession is likely in 2022.
From a portfolio perspective, we expect to maintain ample liquidity, with our cash and Treasuries allocation. Given that spreads are close to post-crisis tights, we expect to source most of our returns for this year from carry and opportunistic trading. Spread volatility should also increase compared to 2021 given the Fed’s increasingly aggressive tightening stance. Leveraging our team’s deep valuation and trading expertise, we continue to find select opportunities across the securitized sectors and have targets in all sectors should we encounter a risk-off market.
|Morningstar Multisector Bond Category||2.28%||5.51%||4.49%|
|Bloomberg U.S. Aggregate Bond Index||-1.54%||4.79%||4.56%|
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 19, 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 1.58%, 1.80%, 2.60% and 1.59% respectively; total annual operating expenses after the expense reduction/reimbursement are 1.53%, 1.78%, 2.53% and 1.16% respectively.1 2.00% is the maximum sales charge on purchases of A Shares.
ABS: Is a type of financial vehicle that is collateralized by an underlying pool of assets—usually ones that generate a cash flow from debt.
CRT: Credit Risk Transfer securities are general obligations of the US Federal National Mortgage Association, commonly known as Fannie Mae, and the US Federal Home Loan Mortgage Corporation, commonly known as Freddie Mac. TCRT securities were created in 2013 to effectively transfer a portion of the risk associated with credit losses within pools of conventional residential mortgage loans from the GSEs to the private sector.
CBO: A Collateralized Bond Obligation is an investment-grade bond that is backed by a pool of junk bonds. Junk bonds are typically not investment grade, but because the pool includes several types of credit quality bonds together from multiple issuers, they offer enough diversification to be structured as “investment grade.”
CCC: A credit rating used by the S&P and Fitch credit agencies for long-term bonds and some other investments. It is equivalent to the CAA rating used by Moody’s. A CCC rating rep resents an extremely high-risk bond or investment. CCC bonds are junk bonds.
DM: A discount margin is the average expected return of a floating-rate security (typically a bond) that’s earned in addition to the index underlying, or reference rate of, the security. The size of the discount margin depends on the price of the floating- or variable-rate security.
LCF: Last cash flow is the AAA bond which is set up to receive principal repayment last among the AAA bonds.
Non-QM: A non-qualified mortgage is a home loan designed to help homebuyers who can’t meet the strict criteria of a qualifying mortgage.
OAS: Option-adjusted spread is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is then adjusted to take into account an embedded option.
RPL: A reperforming loan is a mortgage that became delinquent because the borrower was behind on payments by at least 90 days, but it is “performing” again because the borrower has resumed making payments.
TruPS: Trust Preferred securities are hybrid investments issued by large banks with the characteristics of both stocks and bonds. The shares issued are considered to be preferred stock.
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.EasterlyFunds.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 19, 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.
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.