The first half of 2022 was a challenging market environment, for both equities and bonds. A combination of rapidly rising interest rates, inflation, and slashed earnings forecasts weighed heavily on equity valuations in the second quarter, with the market officially entering a bear market. The S&P 500 declined -16.10% during the quarter and is down -19.96% for the first half of the year, its worst first six months of a calendar year since 1970. Our Income Opportunities Fund (JSVIX) returned -2.57% during the quarter, while the Bloomberg US Aggregate Bond Index returned -4.69%.
After raising the fed funds rate by 25bp in March and ending its $5 trillion Quantitative Easing (QE) program, the Federal Reserve was forced to accelerate and escalate its tightening efforts by raising rates 50bp and 75bp at its May and June meetings. After the CPI reached a new high of 8.6% YOY in May, Chairman Powell admitted that the Fed had made policy errors, including deeming inflation to be a transient phenomenon caused by supply chain disruptions and that the high inflation from earlier this year would eventually taper by year-end. The reacceleration of inflationary pressures led by energy, food, and services components forced the Fed to reaffirm its commitment to maintaining a 2% inflation target and to raise rates by 75bps for the first time since 1994 (despite Powell all but ruling out the possibility at the May meeting). Supply chain disruptions stemming from the military conflict in Ukraine and its related sanctions on Russian energy supplies, along with disruptions of Ukrainian grain exports, continue to create inflationary pressures. China’s Covid related lockdowns have also added to supply chain disruptions. Thus, in reaffirming their commitment to combatting high inflation, Fed members have pushed the median Fed dot to 3.375% by the end of 2022, well above their long term fed funds rate of 2.5%.
Any investors looking to find a refuge in the bond market were left deeply disappointed in Q2. Leading up to the Fed’s June meeting, both the 2-year and 10-year Treasury yields briefly surpassed the 3.5% mark as market participants and short sellers aggressively sold Treasuries following the higher than expected CPI print, the anticipation of hawkish Fed actions, and potential quality tightening effects. However, Treasury yields declined by around 60bp from mid-June to the end of quarter as a recessionary narrative began to take center stage and pushed aggressive Fed tightening into the background. While Jerome Powell remains confident of engineering a soft landing, he acknowledged that it will be very difficult to avoid a recession while dealing with inflationary pressures.
During the quarter, 2-year and 10-year Treasury yields went up by 62bp and 67bp respectively. The Bloomberg US Aggregate Bond Index suffered a -4.69% loss in Q2 bringing its total YTD return to a staggering -10.35%. Bloomberg IG Corporate Index has had a rough year, largely attributable to the rate move, although the Corporate Index option adjusted spread to Treasuries has widened about 65bp in 2022. High Yield spreads widened by 250bp in Q2 as a combination of financial tightening and elevated uncertainty regarding inflation and growth prospects weighed heavily on investors’ minds. Interest rate volatility has been extremely elevated and approaching levels seen during the GFC in 2008/2009, while liquidity has been poor in the fixed income markets, as the Fed’s backstop bid has vanished due to QT.
RMBS performance was dominated by the macro risk-off sentiment that was prevalent across all risk assets in Q2, even though housing fundamentals remained solid. Homeowners added to $11 trillion of tappable equity as home prices rose by 30% over the last 2 years and 9.5% since the start of 2022, based on S&P Case Schiller data. This additional home equity helped to accelerate deleveraging across RMBS deals and contributed to significant ratings upgrades. While seasoned RMBS deals were helped by house price appreciation growth, new issue deals faced challenges from rapidly rising mortgage rates. From November 2021 to June 2022, mortgage rates experienced an unprecedented doubling from around 3% to 6%. A combination of historical home price increases and higher mortgage rates has caused housing affordability to decline to the lowest level in 13 years. The dramatic rise in mortgage rates has also eliminated refinancing incentives for the majority of borrowers, which has lowered prepayments across the sector.
The CMBS market traded in line with general macro risk-off conditions, with investors first concerned about run-away inflation and the Fed’s hawkish response to it, followed by concern about the impact of higher mortgage rates and cap rates on the refinancing prospects of CRE loans. CMBS became further bifurcated along sector exposures and sponsorship quality with deals backed by multifamily and industrial properties and strong sponsors trading at a premium to deals backed by high office/regional mall exposures and weaker sponsors. So far cap rates have not kept pace with interest rate moves which means that cap spreads have tightened relative to treasuries. CRE delinquencies continued to tick down with 30+ day delinquency rates falling to 3.1% in May.
Similar to other securitized sectors, ABS spreads have widened with tightened financial conditions. Spreads on ABS senior and subordinate tranches have reached levels last seen in June 2020. Against this backdrop of wider spread levels is very solid credit performance. At 3.5% and 2.5% respectively, delinquency rates on subprime auto and marketplace lending are below 2019 levels, primarily due to increases in wages and disposable income, which is up 11% relative to pre-Covid levels. Roughly $3 trillion of excess savings built up from Covid stimulus packages have greatly contributed to lower ABS consumer delinquencies. ABS deals also benefit from structural advantages relative to RMBS/CMBS deals given the significant amount of excess spread built in. In addition to credit enhancement, which is currently around 2x expected losses for investment grade tranches, ABS securities deploy excess spread as the first line of defense against rising defaults and losses. So while delinquencies and defaults are expected to rise and normalize relative to current low levels, we do not believe that ABS securities are in danger of substantial write-downs as their structural protections should allow them to stand up to a recessionary environment.
CLOs and leveraged loans outperformed their fixed rate counterparts in the first half of 2022. Institutional and retail demand for floating rate assets offset some of the spread widening stemming from the macro-economic situation. Leveraged loan defaults remain at historical lows. However, given that spreads on CLO tranches are only slightly wider relative to non-recessionary averages, CLOs remain vulnerable to further spread widening.
Primary CLO volume has trailed the record issuance numbers of 2021 with $74 billion of new issuance in 2022 relative to $84 billion at the same point in 2021. During the quarter, there were some positive credit developments as the percentage of CCC loans in broadly syndicated deals dropped down to 3.8% vs. 5.7% a year ago due to ratings upgrades, allowing Over-Collateralization ratios to remain healthy. On the negative side, with S&P Leverage Loan index average price dropping from 98.64 to 92.16, market value collaterization (MVOC) for all CLO tranches declined in the first half of 2022 with MVOC for BB rated tranches falling 7 points below par bringing MVOC ratios back down to June 2020 levels.
CMS Linked notes continued to suffer from rate and spread moves in Q2, with the 2-year, 10-year and 30-year swap rates up by 72bp, 69bp, and 70bp respectively. Unlike the extreme curve flattening seen in Q1, the curve did not flattened as much in Q2, but the swap curve remains inverted between 2 and 10- years (-18bp) and 2 and 30-years (-33bp), causing the coupon for most CMS Linked notes to be zero in Q2. In addition to low coupon rates and higher discount factors, credit spreads on banks that issued these CMS linked notes have widened. Corporate Structured Notes offer excellent optionality to a steeper curve and, as deep discounts, are still generating approximately 3.5% from price accretion to par. In terms of actual credit risk, bulge bracket banks should be in a decent shape to absorb capital hits during a recession since they are much better capitalized due to reforms post-GFC. High multiple CMS spread floaters were down 10-12% in Q2, while lower multiple CMS spread floaters suffered 12-15% declines.
Portfolio Attribution and Activity:
|Sector||Return||%Port||%Attrib||Allocation||Price||Yield||Eff Dur||Sprd Dur|
Source: Orange Investment Advisors. Attribution represents Net-of-fees mutual fund performance
For the quarter, the Income Opportunities Fund (JSVIX) posted a return of -2.57% versus the Bloomberg US Aggregate Bond Index return of -4.69%. The second quarter completes one of the worst performing first half in the history of US bond markets. The Fund’s significantly lower duration and higher yield, relative to the Bloomberg US Aggregate Bond Index, accounted for most of the outperformance.
The strategy had an allocation to short duration, high carry securities trading around par that posted positive returns by offsetting small price declines due to spread widening with high coupons. Corporate Structure Notes continued to be the main drag on the performance. CMS spread floaters suffered additional declines in Q2 due to higher rates and corporate spread widening.
Among the notable transactions in Q2, we increased our allocation to shorter duration, higher carry RMBS securities, which behave like high yielding cash equivalents. These were purchased at spreads above 300bp despite their high credit quality. We also added Prime 2.0 investment grade subordinate tranches at spreads above 350bp.
We believe that the more transient drivers of inflation, for example supply chain disruptions and pent-up demand from Covid lockdowns, will begin to abate later this year. However, we believe that CPI statistics will likely remain elevated throughout 2022, as housing inflation, in the form of rent inflation and owners’ equivalent rent, converge with HPA increases and higher asking rents and become reflected in the inflation measure. Thus, we believe the Fed will have plenty of justification to continue with its hawkish path. Given the continued upward pressure on rates and their potential impact on economic growth, we believe credit spreads will remain volatile throughout 2022, potentially widening from current levels at times.
Due to expected spread and interest rate volatility, we plan to maintain our current 2-year duration on the overall portfolio and maintain ample liquidity in the form of cash instruments and Treasuries. We continue to focus on carry at the top of the credit stack in RMBS, CMBS, ABS, and CLOs, but are prepared to tactically add risk during periods of significant dislocation when compensated by wider spreads.
|6/30/2022||QTD||YTD||1-Year||3-Year||Since Inception (8/21/2018)|
|Morningstar Multisector Bond Category||-6.14%||-10.18%||-9.90%||-0.42%||1.05%|
|Bloomberg U.S. Aggregate Bond Index||-4.69%||-10.35%||-10.29%||-0.93%||1.06%|
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: Is a type of financial vehicle that is collateralized by an underlying pool of assets — usually ones that generate a cash flow from debt.
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.
CMBS: Commercial mortgage-backed securities (CMBS) are fixed-income investment products that are backed by mortgages on commercial properties rather than residential real estate.
CMS: Constant Maturity Swap is a type of interest rate swap where the floating portion of the swap is reset periodically against the rate of a fixed maturity instrument, such as a Treasury note, with a longer maturity than the length of the reset period. In a regular or vanilla swap, the floating portion is usually set against LIBOR, which is a short-term rate.
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.
CRT (CAS/STACR): 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. Two CRT structures are STACR (Structured Agency Credit Risk) and CAS (Connecticut Avenue Securities).
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.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 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.