Q2 2023 Market Review
Resilient is probably the best word to describe US and Global markets during Q2 as risk assets marched higher against a wall of worry built by both the cumulative impact of the Fed’s 500 bps of rate hikes on the economy as well as their continued hawkishness. Entering Q2, Fed Funds futures indicated the market expected just one additional rate hike from the Fed, and for the Fed to pivot in the second half of 2023 by delivering upwards of four rate cuts by January 2024 in response to a potential recession. These rate cut expectations were in clear contradiction to Powell’s repeated assertions about the additional amount of work needed to bring down inflation to the Fed’s long-term target of 2% and that rate cuts were not going to be on the Fed’s radar any time soon. However, a combination of sticky inflationary data, robust employment reports and unrelenting consumer spending managed to push short term rates significantly higher, seemingly validating the Fed members’ projections. At the end of Q2, Fed Funds futures implied two additional rate hikes at the next two meetings followed by rate cuts starting by late Q1 2024. The resiliency of the US economy was evident with the 2% annualized q/q real GDP growth it posted in Q1, the bulk of which came from consumer spending that increased 4.2% q/q. Consumer confidence was bolstered by an extremely robust labor market with the unemployment rate reaching the lowest rate since 1969 at 3.4% in Q2. However, May labor and inflationary data have shown some deceleration in employment and wage growth with the unemployment rate rising to 3.7%, wages increasing by just 0.3% m/m, and the average work week falling in three of the last four months.
While US consumers continue to benefit from excess savings accumulated from the pandemic stimulus, the recent, more gradual increase in the US savings rate and the 17% quarterly increase in credit card balances in Q1, point to dwindling excess savings balances and deteriorating consumer fundamentals. The repricing of the Fed’s rate hike probabilities pushed the 2-year Treasury up by 87 bps to 4.90% by the end of Q2 and resulted in an additional 50 bps of curve inversion. The 2-10 year Treasury Yield spread finished Q2 at -105 bps, almost matching the lowest level seen in early March prior to a string of bank failures.
Against this rate backdrop, there has been significant dispersion in terms of performance across risk assets. On the credit side, all fixed income sectors except for CMBS outperformed Treasuries in Q2. The Bloomberg Aggregate Index posted a negative return of -0.84%. Agency MBS underperformed Corporates in Q2 with a 0.76% return versus 1.31% for Corporates. Agency MBS continued to be negatively impacted by supply fears following the forced selling of MBS securities from SVB and First Republic failures. At the same time, IG Corporate spreads saw 15 bps of spread tightening in Q2 with spreads ending the quarter at 153 bps, similar to the 10-year average.
RMBS
Residential real estate resumed its upward trend during Q2. After posting a few month-to-month declines in the second half of 2022 home prices have seemingly reached a trough and have resumed their upward trajectory. Core Logic Home Price Index posted its fourth consecutive positive home price appreciation m/m in May with a 0.9% increase as nationwide home prices are now 0.7% higher than the 2022 peak. Existing home sale inventory has increased by 120k units relative to the December 2022 low of 960k units, but remains close to all-time lows. Buying a home is cheaper than renting in only 2% of metropolitan areas, which provides a steady support to rent levels. After posting four consecutive negative prints, the Zillow Rent index had four consecutive positive m/m increases from February to May with May rents showing a healthy 0.64% m/m (7.7% annualized) increase. We are also witnessing several strategists revise their home price projections for 2023 from negative to flat as fears of an imminent recession have failed to materialize and inventory of existing supply remains depressed.
Spreads across RMBS credit products tightened in Q2 as favorable technicals combined with robust fundamentals to encourage money managers, insurance companies and some hedge funds to add RMBS to their portfolios in Q2. Unlike H2 2022, which saw $180B of outflows from fixed income funds, H1 2023 had $23B of inflows as investors started to get more comfortable with higher interest rates. Against the backdrop of normalizing asset flows was a significant reduction in primary issuance across RMBS credit sectors. H1 2023 saw just $36B in new issuance, a 65% drop from H1 2022. Legacy RMBS returns trailed those of other RMBS sectors as the sector has been mired in relative illiquidity compared to the new issue on-the-run RMBS. For H1, Legacy RMBS returns have been around 3-3.5% with spreads tighter by 10-15 bps in Q2.
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.
CMBS
CRE and CMBS continued to be the unfavored sector of the structured credit market with challenging cyclical and structural fundamentals and a lack of liquidity being central themes. Capital markets appear frozen to CRE issuers in H1 with just $17B of private label issuance done YTD compared to $73B in 2022. Higher interest rates, higher cap rates, the impact of a potential economic slowdown, and longer-term secular headwinds in the retail mall and office markets have negatively impacted CRE fundamentals in 2023. Higher interest rates have triggered significant declines in property values with CoStar’s repeat sales index reporting the ninth-straight m/m decline in CRE property prices as of April 2023.
While conduit delinquencies have gradually improved from the Covid related spike throughout 2021 and H1 2022, Q2 2023 saw an uptick in CMBS conduit 30+ day delinquencies with office collateral replacing the retail mall as the most problematic property type for CMBS investors. CMBS performance in Q2 varied by sector. Investors seem to be staying away from the vast majority of seasoned subordinate CMBS tranches out of fear that they are likely to be downgraded soon by rating agencies. According to JPM, since the beginning of 2023, 747 CMBS tranches had rating changes with 84% of these rating changes being downgrades. The continuation of rating downgrades will put additional selling pressure on more seasoned subordinate CMBS tranches. Within the SASB subsector, AAA floating rate tranches backed by office and retail ended the quarter at mid-200s spreads which represent some of the highest available spreads for floating rate AAA assets. Small Balance Commercial (“SBC”) continues to lack sponsorship with spreads wider than RMBS and more aligned with Conduit and SASB CMBS deals despite having more credit support and better structural features such as excess spread. CRE CLO spreads were about unchanged from Q1 amidst low trading volumes.
ABS
Unlike the RMBS and CMBS markets, ABS issuance continued at robust pace as higher interest rates didn’t deter issuers in autos, credit cards, equipment and student loans from bringing new deals to the market. Through 1H 2023, ABS issuance totaled $127B, just below the $137B issued through 1H 2022. Auto ABS led the way with $71B as 2023 auto production and sales were solidly above 2022 and 2021 numbers. Credit card and equipment ABS rounded out the top 3 ABS issuance segments. ABS deals have attracted a healthy amount of demand from asset managers, insurance companies, hedge funds and banks. ABS spreads ended up Q2 at the tightest levels of the year after retracing March widening. Subprime Auto AAAs finished Q2 at 110 bps after widening to 170 bps in early March. According to KBRA, credit performance was mixed in Q2. Annualized losses declined on subprime auto collateral to 5.8% in May compared to 8.5% earlier in the year but were still higher than 2022 loss levels.
CLOs
CLO spreads retraced the wide levels from early March and finished Q2 close to the tights of the year. Demand was driven by high overall yields available on solid investment grade assets. For instance, AAA CLO yields are currently approaching 6.5% which is quite attractive for investors needing the highest rating category. Leveraged loans benefited from stronger than expected economic growth in H1. The leveraged loan TTM default rate ticked up to a 2-year high of 2.8%, approaching the long-term average of 3.1%. Leveraged loan recovery rates are running below long-term averages at 44% driven primarily by lower recovery rates on Loan Only Issuers. Nonetheless, LSTA Leveraged Loan Index price increased to 94.4 at the end of Q2 almost reaching the highest level of 2023 from February.
Current Fund Breakdown
JSVIX posted a 1.47% return in Q2 2023 outperforming Bloomberg Aggregate Bond Index by 2.31%. Q2 outperformance is primarily attributed to lower duration of the Fund relative to the Bloomberg Aggregate (2.1 yrs vs 6.3 yrs) and its higher carry. Within the sectors, the main contributor was RMBS which comprised 40% of the portfolio and contributed 1% to portfolio return. Corporate Structured notes finally saw some positive price action despite a bear curve flattener and the return to the most inverted yield curve in 40 years. This pricing action is indicative of a bottoming, pricing-wise, for our corporate CMS floaters as they, in spite of their 0% coupons, now yield in excess of 5% in many cases due to accretion to par. ABS was the main detractor in spite of comprising only 6% of the portfolio due to a servicing transfer event that impacted a particular subprime auto ABS issuer.
There was a significant amount of trading activity in the portfolio in Q2 with continued focus on security selection. Most of the sales were shorter duration Prime and Alt-A RMBS securities trading close to par at yields below 7% while purchases were concentrated in RMBS, Small Balance Commercial and CMBS conduit securities at yields above 8.5%.
Fund Outlook
While inflation is expected to decelerate into the 3 – 4% range by the end of 2023, we believe it will be difficult for the Fed to bring it back to 2% without a more severe economic decline due to the sticky nature of services and wage-related components. We maintain our projection that the 10-year Treasury will remain rangebound within 3.25%-4% in H2 2023 given that weaker economic growth will be countered by sticky inflation and continuing QT that will put pressure on the long-end of the yield curve. We also expect the 2-year to re-enter our projected range of 3.75% and 4.50% during 2H23 as the potential rate cuts begin to be priced in. While the curve may not re-steepen in 2023, we do expect it to end the year much less inverted.
While credit spreads have tightened across sectors, there has been limited spread tightening in Legacy RMBS and an actual spread widening in CMBS sectors including Small Balance Commercial, where we increased our exposure during Q2.
The Legacy RMBS space is suffering from poor sponsorship given its small outstanding amount (less than $175B) but loss-adjusted yields above 8.5% are hard to pass up on seasoned assets backed by residential real estate with a massive amount of built-up equity. In the CMBS space we have mostly focused on the top of the capital structure (senior tranches and investment-grade subordinate bonds with plenty of credit support). The pricing on these senior and IG subordinate bonds is quite punitive and accounts for deep recessionary scenarios with significant amounts of extension. In addition to our core 70% position in RMBS, CMBS and ABS we are maintaining a 13% allocation to liquid investments in cash and Treasuries. We expect increased spread volatility in the near term and we are looking to capitalize on that by adding RMBS, CLOs and ABS upon any meaningful credit spread widening.
| Q2 2023 | 6/30/2023 | |||
|---|---|---|---|---|
| Sector | Allocation | Price | Eff Dur | Sprd Dur |
| RMBS | 40.43% | $79.56 | 2.19 | 3.86 |
| CMBS | 23.05% | $83.64 | 1.80 | 3.08 |
| ABS | 5.72% | $91.30 | 1.20 | 2.40 |
| CLO/CDO | 4.20% | $75.33 | 0.08 | 3.28 |
| CORP | 12.88% | $66.67 | 3.08 | 7.01 |
| GOVT | 9.00% | $98.59 | 3.18 | 0.00 |
| Cash | 4.72% | $98.61 | 0.00 | 0.00 |
| Total | 100% | $81.11 | 2.05 | 3.45 |
SOURCE: Orange, JP Morgan Markets, Bank of America, Bloomberg.
| 6/30/2023 | QTD | YTD | 1-Year | 3-Year | Since Inception (8/21/2018) |
|---|---|---|---|---|---|
| I Shares | 1.47% | 3.10% | 1.09% | 2.62% | 4.87% |
| Morningstar Multisector Bond Category | 0.54% | 2.92% | 3.16% | 0.44% | 1.48% |
| Bloomberg U.S. Aggregate Bond Index | -0.84% | 2.09% | -0.94% | -3.97% | 0.64% |
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.
Glossary
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%.
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.
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.
Small Balance Commercial (SBC): Small balance commercial loans are financial products specifically designed for small businesses. Small balance commercial loans are characterized by their low loan amounts, which typically range from $50,000 to $500,000. They are designed to provide accessible funding options for businesses that may not qualify for larger loans or that have limited collateral.
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 SHOULD BE CONSTRUED AS FACT, PREDICTION OF FUTURE PERFORMANCE OR RESULTS, OR A SOLICITATION TO INVEST IN ANY SECURITY.
17205041-UFD 08/01/2023