Q4 2022 Market Review
Most major equity indices finished 2022 on a high note with the S&P posting a 7.6% return in Q4, though the Nasdaq continued its underperformance, posting a -0.1% return for the quarter. Energy was once again the best sector in 2022, generating a 59.3% return, while Communications Services was the worst at -28.7%. 2022 wasn’t just about poor equity returns, as bonds not only failed to offset equity returns but instead compounded investors’ misery. According to UBS, in 2022 60/40 (equity/bond) portfolios had the fifth worst return over the last 100 years. Most of the negative return in the fixed income space came from a vicious interest rate sell-off as the Fed increased its target rate by 425bp. Q4 saw a relatively mild sell-off with the 2-year Treasury rate rising 15bp while 10-year increased by 5bp. The 2-10 yield curve inversion worsened to negative 54bp. Treasury yields have been volatile throughout the year with 10-year reaching a high of 4.25% before ending Q4 at 3.75%.
Corporate credit bonds, both Investment Grade and High Yield, had a positive finish to a difficult year as corporate spreads tightened in Q4. IG Corporates posted a 3.63% return in Q4 and -15.76% for 2022. Corporate spreads tightened by 34bp in Q4 from 204bp to 170bp. Combined IG Corporate and High Yield issuance was down 32% in 2022 relative to 2021. While fixed income mutual funds saw a staggering $523bn of outflows in 2022, bond ETFs had over $197bn of inflows. Many of these ETF inflows came into IG Corporates and High Yield bonds, and hence offset some of the outflows from bond mutual funds. The Corporate High Yield sector saw a more dramatic spread tightening in Q4 with HY spreads dropping by 70bp, lifting the HY return to 4.17% in Q4 and -11.19% for 2022. While the IG Corporate spread increased by 51bp and High Yield spread by 180bp in 2022, both sectors remain close to long-term averages (IG Corps at 170bp vs 171bp avg, HY at 503bp vs 493bp avg) and do not appear attractive considering a possibility of recession. On the other hand, structured credit sectors did not benefit from ETF inflows and suffered from lack of demand due to mutual fund outflows, causing spreads to remain attractive within the sector.
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
2023 Economic Outlook
We believe that US economic growth will moderate to near zero in 2023, with unemployment climbing toward 5% by late 2023 or early 2024. US consumers, who already have reduced their savings rate from 9% in 2019 to 2.3% in mid-2022 amidst the worst inflationary outburst in 40 years, could continue to pare back their expenditures in 2023. Consumer spending retrenchment has the potential to exacerbate the impending economic slowdown in 2023 and beyond. After peaking at 9.1% in Q2 2022, CPI has declined to 6.5% due to a combination of factors including lower energy costs, a reduction in used car prices, and loosening of supply related bottlenecks. Fed chairman, Jerome Powell, reiterated the Fed’s absolute commitment to reduce inflation to 2% and ruled out any leeway on that target. After misjudging earlier inflationary pressures as transitory, Powell will want to prevent another policy mistake and thus will be hesitant to cease tightening too early or to revert to an easing stance upon the first sight of disinflation or economic slowdown. We expect the fed funds target rate to top out at 5.00% by the middle of 2023 and stay there until the end of the year. We don’t expect the Fed to start easing rates upon the first sign of recessionary pressure, but we think it will be under consideration by the end of the year if the economy is recessionary at that point. We expect the yield curve to remain inverted for at least the first half of the year, with the 2-year ranging between 3.75% and 4.50% and the 10-year between 3.25% and 4.00%. 2022 was one of the most difficult years for fixed income markets ever. Lower credits widened more than higher credits, resulting in credit curve steepening across rating categories. The Investment Grade (IG) Corporate Index saw 48bp of spread widening, while the High Yield (HY) Corporate Index widened by 189bp. Given our view of a slowdown in corporate earnings growth in 2023, we expect spreads on both IG Corporates and HY bonds to widen from current levels, with further credit curve steepening across rating categories. As default levels potentially increase from current historically low levels, we believe IG Corporates could widen as much as 50bp while HY bonds could widen another 100-150bp. However, we do believe that high overall yields, limited supply, and a light maturity schedule in 2023 will mitigate further corporate spread widening.
Structured Credit Commentary and Outlook for 2023
In 2022, structured credit sectors outperformed corporates of similar credit quality on a total return basis, due to higher yield and lower duration. Entering 2023, given higher yields resulting from 2022’s spread widening, structured credit sectors are even better positioned than last year to outperform corporates, particularly on a duration-adjusted basis.
RMBS:
RMBS fundamentals remain strong. The combination of significant home price appreciation, nationwide home prices have risen 7.5% in 2022 and 40% since the start of Covid pandemic, and low leverage, has pushed housing equity to the highest percentage as a share of housing assets since the early 1980s. High homeowner equity will discourage borrowers from voluntarily defaulting in the event of home price declines, as was the case in 2008. Given the vast amount of embedded equity in homes, borrowers’ delinquency rates remain at record lows of 3.45% according to MBA. In the longer run, a 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. Another positive factor is that mortgage underwriting standards have tightened considerably since 2008. Despite the backdrop of robust credit fundamentals, non-Agency RMBS sectors underperformed IG and HY Corporates in Q4.
CMBS:
CMBS fundamentals and performance were a mixed bag in Q4. While industrial and multifamily property borrower credits are on solid footing and lodging performance has experienced a significant improvement from Covid shutdowns, office and retail properties look to be the most tenuous among CRE subsectors. Higher rates and higher inflation have caused a repricing across CRE assets due to higher cap rates, higher expenses and uncertainties related to rental income. Looking at the universe of CMBS loans, retail and office contributed most to CMBS loan losses in 2022 at 47% and 31%. CMBS delinquencies increased in Q4 after a steady downtrend since 2020. The overall CMBS delinquency rate was 3.04%, lower by 1.53% relative to 12 months ago. The Retail and Lodging delinquency rates were at 6.97% and 4.40% respectively, which were the highest amongst CMBS property sectors.
CMBS fundamentals are at the highest risk among structured credit sectors in 2023. Higher rates and high inflation have caused repricing across commercial real estate assets due to higher cap rates, higher expenses and uncertainties related to rental income. Office properties have the highest risk for asset repricing due to the longer-term work-from-home trend that has raised vacancy rates to the highest level (18.4%) since 2007 (REIS data), while rents have stayed relatively flat since 2019. 2013-2014 vintages that are coming due in 2023 & 2024 have coupon rates from 4.5% to 5%, while the current conduit CMBS coupon rate is above 6%. Hence, refinancing risks are taking center stage and we might see increased maturity extensions, loan modifications (coupon and principal forbearance) and maturity defaults across the CMBS universe.
ABS:
The ABS consumer market began to face several fundamental headwinds in 2022 as 40-year high inflation, negative real wage growth and whittling down of record pandemic-related excess savings started to weigh on consumers’ discretionary spending habits. US personal savings rate dropped to the lowest since 2005 at 2.5% and $6.5trn of pandemic related savings declined to $492bn at the end of Q4 (BLS), with some consumers now tapping into their credit cards. After paying down credit card debt from $1.1trn at the end of 2019 to $900bn by the end of 2020, credit card revolving balances have spiked back up to $1.18trn, an all-time high. However, a percentage of disposable income household debt remains at 100%, still below the 20-year average of 110%. The rise in the cost of living has particularly impacted lower credit borrowers as is evidenced by a recent rise in delinquencies and losses among subprime auto loans and unsecured consumer loans that collateralized many consumer ABS deals.
CLOs:
CLOs outperformed other structured credit sectors on an absolute basis due to their short durations but still underperformed Corporate IG and HY on a spread basis in 2022. Despite challenging arbitrage conditions, CLOs saw the second highest new issuance volume in 2022 at $126bn. Q4 saw marginal spread tightening across the CLO credit spectrum. On a credit front, the trailing 12 months default rate continued to be subdued at 0.72%, but cracks are starting to appear with the ratio of downgrades to upgrades rising. Given the floating nature of leveraged loans, we expect defaults to pick up significantly in 2023 and 2024 which should cause increased price volatility at the bottom of the credit stack.
CLO fundamentals at the top of the capital structure should hold up well, but increased defaults and ratings downgrades will impact lower rated mezzanine tranches in 2023. Lower corporate profits will put a stress on interest rate coverage ratios as Libor/SOFR rates rise to 5%. Lower collateral prices will cause interest to be diverted from equity and potentially BB/B mezzanine tranches. Higher rated mezzanine tranches (AA through BBB) should be able to withstand recession-triggered higher defaults and lower recoveries.
Source: Orange, JP Morgan Markets, Bank of America, Bloomberg.
Portfolio Attribution and Activity:
JSVIX posted -0.53% return in Q4 2022, underperforming the Bloomberg Aggregate Index by 2.40%. Q4 underperformance is primarily attributed to significant outperformance of IG Corporates that are a part of Bloomberg Aggregate Bond Index but are not represented in our portfolio. IG Corporates posted 2.89% excess returns in Q4 on the back of tightening in corporate spreads. In fact, our corporate holdings are dominated by Corporate Structured Notes (CSN), which were actually our worst performing sector for the quarter. CSN are issued by large financial institutions and carry coupons based on the differential between 30-year CMS and 2-year CMS (constant maturity swap). Thus, due to additional yield curve inversion and lack of demand for these 0% coupon securities from the retail buyer base, our CSNs were down significantly in price, contributing -0.93% to return.
During the quarter, we were active in turning over the portfolio and deploying available cash into securities with greater price upside and convexity. We’ve added several Prime 2.0 and Non-QM subordinate tranches from 2018-2021 vintages. Given our view that real estate prices will not decline more than 10-15% from current levels we think these subordinate tranches have plenty of credit support to absorb collateral losses. We expect these subordinate tranches to tighten from 7.5-8.5% yields to 6.5 -7.5% yields as investor demand shifts focus to structured credit from corporate bonds amidst larger flows into fixed income.
| Q4 2022 | Q4 2022 | Q4 2022 | 12/31/2022 | 12/31/2022 | 12/31/2022 | 12/31/2022 | 12/31/2022 | |
|---|---|---|---|---|---|---|---|---|
| Sector | Return | %Port | %Attrib | Allocation | Price | Yield | Eff Dur | Sprd Dur |
| RMBS | 0.90% | 44.00% | 0.40% | 46.80% | $81.70 | 8.70% | 2.1 | 3.6 |
| CMBS | -0.29% | 20.80% | -0.06% | 21.00% | $85.40 | 10.90% | 1.6 | 2.9 |
| ABS | 0.78% | 7.00% | 0.05% | 6.00% | $93.60 | 9.50% | 1.4 | 2.4 |
| CLO/CDO | 0.53% | 9.20% | 0.05% | 8.40% | $73.80 | 10.40% | 0.3 | 3.0 |
| CORP | -7.27% | 13.40% | -0.97% | 13.40% | $65.40 | 5.60% | 2.1 | 7.4 |
| GOVT | 0.00% | 3.00% | 0.00% | 0.00% | $0.00 | 0.00% | 0.0 | 0.0 |
| Cash | 0.13% | 2.60% | 0.00% | 4.50% | $100.00 | 0.50% | 0.0 | 0.0 |
| Total | 100% | -0.53% | 100% | $81.50 | 8.60% | 1.7 | 3.7 |
Summary:
We expect further liquidations from Structured Credit managers who have underperformed over the last few years and are forced to sell securities, which will offer great opportunities for our strategy. We do expect outflows from fixed income funds, which reached historical proportions in 2022, to reverse in 2023 as the yield and liquidity of fixed income securities now presents obvious relative value versus other asset classes such as equities and private credit. We do expect there to be significant volatility of credit spreads over the course of the year, as equities price in lower earnings caused by recessionary conditions. However, we believe increased demand for fixed income, particularly if accompanied by a decline in issuance, will provide a tailwind for credit spreads, resulting in price return on top of higher yields. Finally, given where spreads are in Structured Credit relative to Corporates of similar credit quality, we believe Structured Credit has significantly more potential for price upside than Corporates.
JSVIX is designed to capitalize on, and outperform during, stressed markets. It is an active, security-selection-focused strategy that seeks to acquire undervalued bonds in all market environments. In addition, we seek to manage portfolio risk tactically. We de-risk the portfolio by going up in credit, reducing spread duration, and building liquidity when volatility is low and spreads are tight, rather than be fully invested or go down in credit to seek higher returns. During these periods we rely on opportunistic, active trading, featuring our ability to source, analyze and acquire undervalued bonds at favorable prices. This positions the portfolio to help navigate and ultimately help capitalize on market dislocations in structured credit.
In 2023, we expect rates to remain range bound and credit spreads to remain volatile as the Fed completes its tightening cycle. As a result, we will maintain limited interest rate exposure and will concentrate our holdings in the highest rating tiers across all structured credit sectors, with very limited exposure to lower rated tranches in the CMBS and CLO market. We can take advantage of credit market dislocations very effectively due to our size and our active trading approach and will maintain a significant liquidity buffer to meet potential redemptions but also to take advantage of any opportunities that may arise from such dislocation.
We expect outflows from fixed income funds to reverse in 2023 as the yield and liquidity of fixed income securities now presents relative value versus other asset classes. We expect asset allocators to shift assets to fixed income in 2023 as fixed income, and structured credit markets, offer investors 7-9% returns for investment grade cashflows, something not seen in a generation. We believe that, as demand for fixed income increases, particularly in the absence of new issue supply due to higher yields, spreads will tighten, resulting in price return on top of higher yields. Finally, given where spreads are in structured credit relative to corporates of similar credit quality, we believe structured credit has significantly more potential for price upside.
| 12/31/2022 | QTD | 1-Year | 3-Year | Since Inception (8/21/2018) |
|---|---|---|---|---|
| I Shares | -0.53% | -6.27% | 3.85% | 4.71% |
| Morningstar Multisector Bond Category | 2.55% | -9.95% | -1.18% | 0.99% |
| Bloomberg U.S. Aggregate Bond Index | 1.87% | -13.01% | -2.71% | 0.24% |
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, 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.
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.
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.