Q1 2023 Market Review
While Q1 held the potential for uncertainty around the path of the Federal Reserve’s interest rate decisions, many were caught off guard by the events that transpired. Unexpected developments such as the second largest bank failure in US history, the demise of Credit Suisse, a 167-year-old Swiss financial institution, and the Treasury volatility index rising to the highest level since 2008, all failed to stop risk assets from posting positive gains during the quarter. However, it is reassuring that household debt as a percentage of GDP has fallen for eight straight quarters and is below 75% for the first time since 2001. Additionally, debt service as a percent of income has declined to the lowest level in 20 years.
One of the key performance drivers for the quarter was duration, with long duration assets posting the best performance among risk assets. Over the course of the first quarter, the 2-year yield dropped 40bp, the 10-year yield was down 41bp and the 30-year yield declined 31bp. Additionally, the rates market saw the largest 2-10-year inversion since 1981 occur on March 7th, only for the 2s-10s curve to steepen by 65bp a few days later. The January CPI report also came in above expectations, bolstering views that the Fed had a lot of work left to do on the inflation front. The 2-year yield increased by almost 100bp to over 5.00% and the curve flattened by 40bp, with prominent economists calling for a 6% Fed Fund’s rate.
March brought the unexpected failure of Silicon Valley Bank (SVB), the 2nd largest bank failure in US history, with $209 billion assets on the balance sheet. The failure was spurred by an unsuccessful equity raise that was necessitated by large deposit withdrawals from technology companies. SVB’s run on uninsured deposits exposed the bank’s inadequate asset-liability management and a duration mismatch between long-term assets and short-term deposits. By the time regulators came up with a solution, the Bank Term Funding Program (BTFP), another large regional bank Signature Bank, with over $100 billion in assets, was forced to be taken over by the FDIC, representing the 3rd largest bank failure in US history. A forced takeover of Credit Suisse a week later, by its Swiss rival UBS, only added to rate volatility.
The market shifted its expectations from 4 additional rate hikes in 2023 to 4 rate cuts by the end of 2023 after the March FOMC meeting when the Fed hiked rates by 25bp.
Corporate credit indices posted positive returns in Q1, with IG Corporates gaining 3.50% and HY Corporates up 3.57%. IG Corporates returns were due to duration and carry, as the OAS widened by 6bp in Q1. The IG Corporate credit curve remained relatively unchanged with no noticeable difference in performance between rating categories. IG banking and financial issues underperformed other corporate sectors following the fallout of SVB. HY Corporates posted a 1.23% excess return relative to Treasuries in Q1 as HY spreads tightened by 28bp. The HY market was again aided by low new issue supply, with only $40 billion of HY issuance, the lowest volume in 7 years. The Fed’s swift actions following SVB’s failure, along with expectations of the Fed taking its foot off the pedal on rate hikes, helped drive HY spreads tighter. The HY Credit curve flattened with CCCs and Bs outperforming BB credits. The Bloomberg Aggregate index posted a gain of 2.96%.
The Easterly Income Opportunities Fund (JSVIX) returned 1.61% for the quarter, while the Bloomberg Aggregate Index returned 2.96%. The difference was primarily attributable to the fund having a lower duration relative to the index (1.98 years vs 6.12 years) in a period where rates rallied significantly. Main contributors to return were RMBS, CMBS, and ABS while CLOs, CDOs, and Corps were slightly negative. A couple of our middle market CLO positions saw downward price revisions and that offset the carry from our CLO allocation, which now makes up only 2.7% of portfolio. Given the lack of convexity once prices reach the high 90s, we trimmed our CLO position by selling a few CLO senior and subordinate tranches in the upper 90s while picking up similar yields and better convexity in RMBS and CMBS bonds at lower dollar prices. Despite spread widening across the credit spectrum, our 21% CMBS allocation managed to produce a positive return in Q1 due to its favorable carry. We were quite active during the quarter, repositioning the portfolio to take advantage of numerous investment and trading opportunities we saw across RMBS and CMBS which stemmed from account transitions and liquidations where sellers were likely acting on non-economic motives.
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. For performance information current to the most recent month-end, please call 888.814.8180.
RMBS sectors underperformed their fixed income credit counterparts in Q1 on a spread basis as liquidity dried up in March amidst bouts of extreme rate volatility. The RMBS sector continues to benefit from robust credit fundamentals. The February Core Logic Home Price Index (HPI) increased 4% year-over-year and is only 3% below its 2022 peak. The inventory of available homes remains low by historical standards, but has a distinctly regional component as the Sunbelt and West Coast are showing a rise in availability. Rental growth remains robust but is decelerating, as the Zillow nationwide rental index is up 6.3% year-over-year but down 0.5% from its Q3 2022 high. We expect rents to increase higher relative to mortgage payments as it is more economic to rent in 98% of metropolitan areas. As a result of continuing strong house price appreciation, borrower delinquencies are reaching rock bottom levels, with 60+ day delinquency rates reaching 1.5% in February and Non-Agency 60+ day delinquency rates declined to 5.9% from 7.7% a year ago. The Non-QM sector continued to see the largest amount of new issue supply at $8.6 billion in Q1 and now makes up just under 10% of all Non-Agency RMBS. Non-QM also accounted for the vast majority of the $35 billion of Non-Agency RMBS that traded in secondary markets during the quarter.
CMBS was the exception to the otherwise positive performance of risk assets during Q1 and had the misfortune of becoming one of the financial scapegoats during the bank panic. Even before the collapse of SVB, investors were feeling apprehensive about the future Commercial Real Estate (CRE) maturity wall. With close to $450 billion of CRE loans set to mature in 2023 and $168 billion of that in CMBS, questions were being asked about how these loans would be refinanced following a 300bp rise in funding costs. Additionally, about 30% of upcoming CMBS maturities are concentrated in the office sector, which is facing structural headwinds from the post-Covid work-from-home (WFH) environment. The office sector saw vacancy rates rise as companies continue to reduce their footprint due to WFH and additionally, rental rates declined by 1.6% year-over-year.
Following the collapse of SVB and the ensuing regional bank panic, CMBS spreads widened as trading essentially halted and liquidity evaporated. Regional banks have become instrumental in providing funding to the CRE market, accounting for 27% of lending volume in 2022. Thus, the likely tightening of lending standards by regional and community banks are seen as major headwinds for the CRE and CMBS markets over the next few years.
The two key credit metrics for evaluating CRE loans collateralizing CMBS are Loan-to-Value (LTV) and the Debt Service Coverage Ratio (DSCR). Within the CMBS structure, credit enhancements can prevent losses on the underlying CRE collateral from flowing through to the CMBS bondholder. Therefore, although certain property types of CRE appear to be under economic stress, that does not necessarily imply credit losses on CMBS, particularly higher-rated tranches with significant credit enhancement. In fact, over time since the GFC, loss rates on CRE loans have been trending lower because CMBS underwriting standards have been consistently improving. Specifically, LTVs have been dropping and DSCRs have been rising. In addition, rating agencies have been requiring greater credit enhancement on investment grade tranches.
ABS new issue supply declined 11% from Q1 2022, which contributed to the continuation of the tightening trend that began in December. Spreads on AAA and BBB subprime autos settled in at 100bp and 275bp, respectively. Investors feel confident about structural protections offered by these ABS sectors where there are multiple lines of defense against collateral losses (excess spread, subordination, reserve accounts, etc.). From a fundamental credit point view, we continue to see performance deterioration across both prime and subprime credit tiers for both auto and MPL collateral. Prime and subprime auto losses and delinquencies have risen to levels seen prior to Covid-19, after being suppressed during the pandemic due to record fiscal stimulus.
CLO spreads tightened marginally in Q1 with the bulk of outperformance coming in January as real money accounts put money to work as expectations of a Fed pivot rose. Spreads widened in February as the risk of a hard landing took hold of the market. Spreads continued their upward ascent in March before the Federal Reserve, along with other regulatory bodies, calmed market fears with a comprehensive package to help shore up bank balance sheets and stem the outflow of deposits. For the quarter, CLO spreads tightened between 10 and 20bp, depending on the credit tier, leaving AAA spreads, for example, at 175bp.
Q1 was marginally positive for Corporate Structured Notes as the swap yield curve steepened by 10bp between 2s and 30s, rates rallied, and corporate OAS tightened slightly for larger banks. Lower multiple Constant Maturity Swap (CMS) floaters rallied into the 60s on the back of a strong demand for discount bonds that have yields in excess of 6% despite zero coupons. Higher multiple Morgan Stanley issued CMS floaters have been trading in the mid-60s to mid-70s depending on the multiple and maturity. Credit Suisse issued CMS floaters underperformed in Q1 due to credit concerns surrounding their forced sale to UBS.
The fund now yields 5.8%, has an average dollar price of $80.07 with an effective duration of 1.98 years and spread duration of 3.56 years. By contrast, the Bloomberg Aggregate Index has a 4.4% yield and an average dollar price of $91 with effective duration of 6.3 years and spread duration of 6.3 years.
We believe the best Structured Credit investment opportunities lie within the CMBS and Legacy RMBS sectors. CMBS is battling negative headlines, which include higher interest rates that make refinancing current loans difficult amidst declining property values, secular issues confronting the office sector, and a lack of financing options amidst a regional banking crisis. These negative headlines have stressed the CMBS market with current holders not adding to existing positions and potential investors waiting for more distress in the CRE market as the economy is set to enter a long-awaited recession.
We believe that Structured Credit sectors offers higher yield and lower duration risk than traditional fixed income for a number of reasons. While the Aggregate index has a high credit quality due to a large portion being composed of Treasuries and Agency MBS, within the credit portion of the Agg (i.e. Corporates), Structured Credit bonds arguably have more credit protection for a given credit rating than Corporate bonds, while typically providing more yield. Another reason contributing to the relative value of Structured Credit stems from the fact that it is outside the Aggregate Index and therefore not subject to the persistent demand of passive index investors and Index ETFs. We also believe it is unfamiliar to a large number of investors relative to traditional index fixed income sectors, which causes it to be under-represented in fixed income portfolios, further contributing to its relative value.
Current Fund Breakdown:
30-Day Subsidized SEC Yield: 4.62%
30-Day Unsubsidized SEC Yield: 4.53%
|Sector||Allocation||Price||Eff Dur||Sprd Dur|
Source: Orange, JP Morgan Markets, Bank of America, Bloomberg.
|3/31/2023||QTD||1-Year||3-Year||Since Inception (8/21/2018)|
|Morningstar Multisector Bond Category||2.39%||-3.67%||2.77%||1.45%|
|Bloomberg U.S. Aggregate Bond Index||2.96%||-4.78%||-2.77%||0.86%|
Unsubsidized SEC Yield: 4.78% Subsidized SEC Yield: 4.90%
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, 2024 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 1.61% respectively; total annual operating expenses after the expense reduction/reimbursement are 1.55%, 1.80%, 2.55% and 1.18% respectively. 2.00% is the maximum sales charge on purchases of A Shares.
The Fund’s investment adviser has contractually agreed to reduce and/or absorb expenses until at least March 31, 2024 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.
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.
Agency MBS: These are mortgage-backed securities (MBS) backed by government-sponsored entities such as Fannie Mae, Freddie Mac and Ginnie Mae.
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.
CDO: A bundle of loans ranked below investment grade with the investor receiving the debt payments form these underlying loans.
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.
Credit Spread: The difference between the yield on two debt instruments of the same matruity but different credit quality. The spread is measured in basis points, 100 basis points in 1%.
FOMC: Federal Open Market Committee is made up of 12 members. 7 members of the Board of Governors of the Federal Reserve System, the president of the NY Fed and 4 of the remaining 11 Reserve Bank presidents who serve rotating 1 year term. Through 8 meetings per year they review economic and financial conditions and determine the appropriate stance of monetary policy.
LSTA Leveraged Loan Index: Is a daily tradable index for the U.S. market that tracks the performance of the largest institutional leveraged loans, which are loans to companies with high debt or low credit ratings.
MOVE Index: The Merrill Lynch Option Volatility Estimate measures the markets expectation of implied volatility in the US bond market based on 2-year, 5-year, 10-year and 30-year treasuries.
Non-QM: A non-qualified mortgage is a home loan designed to help homebuyers who cannot meet the strict criteria of a qualifying mortgage.
OAS: Option adjusted spread is used for bonds with embedded options. It represents the spread between the risk-free rate of return and a fixed income security after adjusting for or removing the bond’s option.
RMBS: A type of bond secured by a pool of residential mortgages. Typically, there are 100’s of mortgages grouped together in one bond.
S&P Case Shiller National Index: An economic indicator that measures the change in value of U.S. single-family homes on a monthly basis.
TruPS: These are trust-preferred securities issued by banks and bank holding companies. They usually offer higher periodic payments than preferred stock but have been largely phased out following the 2008-09 financial crisis.
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.
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.
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.