Q4 2023 Market Review
Both equity and fixed income investors enjoyed a nirvana-like fourth quarter, as a Goldilocks economy combined with a surprising easing pivot from the Fed drove investment returns to historical heights. Instead, the US economy grew by 3.3% in Q4 after posting 4.9% growth in Q3. Annualized GDP growth is set to reach 2.6% in 2023, an improvement from 2.1% in 2022. The main surprising factor in 2023 was the indomitable consumer, as consumer spending increased by 3.1% year-over-year (YoY) despite a 5.25% increase in interest rates since Q1 2022. In addition to excess savings, US consumers benefited from the fixed coupon nature of their household debt. Moody’s Analytics estimates that 90% of household debt is fixed rate and US households greatly benefited from taking on or refinancing debt at low interest rates in 2020 and 2021. Despite the recent rise in consumer debt, the household debt servicing ratio remains under 10%, below the historical average of 11.1%. Additionally, the Fed achieved strong economic growth, and a close to all-time low unemployment rate of 3.7%, while making significant progress toward its aim of reducing inflation down to its 2% target rate. The Fed’s preferred inflation gauge, the PCE index, dropped to 2.6% YoY in November from a high of 7.1% in Q2 2022. The broad inflation CPI index was down to 3.4% in December after reaching a high of 9.1% in Q2 2022. The significant progress on the disinflationary front prompted Fed chairman, Jerome Powell, to perform a dovish pivot at the December FOMC meeting, suggesting that the rate hiking cycle is likely done and that the Fed is shifting its attention to eventual rate cuts in 2024. The FOMC’s December Summary of Economic Projections (SEP) increased the number of rate cuts to 3 from 1 in the previous SEP.
Aided by lower inflationary numbers and the Fed’s dovish pivot, the market experienced a dramatic turnaround in Q4 as it began pricing in the first rate cut in March 2024 and pushing the number of rate cuts in 2024 to 6. The price action at the long end of the yield curve was equally dramatic. The yield on 10-year notes almost reached 5% in late October before the quarterly refunding announcement, which was heavily tilted toward short-term debt issuance, forced short covering from accounts that had shorted the long end of the curve which drove the 10-year yield back down to the same level where it started 2023, 3.88%. The yield curve managed 18bp of steepening between 2s and 10s in 2023. Despite the limited overall move in rates by year-end, 2023 experienced similar elevated rate volatility to 2022 levels, with the BofA MOVE index consistently above 100.
Despite QT starting in Q2 2022 and accounting for $1.3B of the Fed’s balance sheet decline from Treasury and Agency MBS run-off, market liquidity was significantly boosted by the decline in the Fed’s RRP facility, which decreased from $2.5trn at the peak to $0.7trn by the end of 2023. This drop in the RRP facility helped fund the Treasury’s increased issuance without impacting bank reserve levels, allowing risk assets to move higher. The benchmark Bloomberg Aggregate Bond Index generated over 100% of its annual return in Q4, posted an impressive 6.79% to bring its total return to 5.53% for the year, despite being down almost 3.5% as of mid-October. For the year, the Bloomberg Aggregate outperformed equal duration Treasuries by 1.40%, as credit spreads tightened across all fixed income products. IG Corporates partly erased their miserable performance in 2022 with an 8.52% return in 2023 and a 4.27% excess return relative to Treasuries. IG corporate spreads tightened by 31bp in 2023, finishing at 99bp option-adjusted spread (OAS), the tightest level since January 2022.
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.
High Yield corporates posted a total return of 13.44% for 2023, outperforming Treasuries by 8.86%. High Yield spreads tightened by 145bp in 2023 to 323bp option-adjusted spread, the tightest level since April 2022. The High Yield sector has benefited from muted issuance volumes ($184B in net issuance in 2023) and strong inflows into corporate credit ETFs. From the credit fundamentals side, according to Fitch, the HY trailing 12 month (TTM) default rate increased to 3.1%, its highest level since April 2021. The leveraged loan default rate also climbed above 3% in November as elevated interest expense, and operational issues pushed six issuers to file for Chapter 11.
RMBS:
The Agency MBS index performed an amazing turnaround over the last two months of the year as it posted a 10% rally following a 5% decline through October. The current coupon 30-year nominal MBS spread tightened over 50bp from the October wides of 190bp to 140bp by year-end. The Bloomberg MBS Index outperformed Treasuries by 1.33% in Q4 and by 0.68% over 2023. The option adjusted spread (OAS) declined from a peak of 82bp to 45bp. The net Agency MBS issuance for 2023 dropped significantly to $234B from $431B, as homes sales suffered a meaningful decline.
Despite fears of a housing market slowdown, home prices increased on a national level by 4.8% YoY according to the S&P CoreLogic national index, as a limited supply of housing dominated high mortgage rates and low affordability. Non-QM was the largest new issue sector in RMBS, with around 40% of the volume despite 2023 issuance being down $10B.B Just like other RMBS sectors, Non-QM had a very strong finish to the year, especially as interest rates rallied from 5% to 3.8%.
CMBS:
Lower interest rates and greater prospects for a soft landing catalyzed CMBS spreads to tighten in Q4, as better prospects for loan maturity resolutions encouraged cash-heavy investors to push up CMBS prices. The spread tightening was not uniform across CMBS subsectors. Most of the interest was directed towards new issue on-the-run conduit bonds with investors particularly drawn by stronger underwriting standards and the higher starting interest rates of 2023 vintage collateral. Significant underperformance of CMBS relative to other fixed income sectors, along with a risk-on sentiment across the risk markets and favorable supply/ demand technicals, should push spreads tighter for all CMBS subsectors in 2024. CMBS looks increasingly cheap relative to Corporates, with the spread difference between OTR Conduit BBB- CMBS and High Yield in the 99th percentile over the last 10 years. Furthermore, the paltry $46.5B of gross supply in 2023, 54% below the already subdued 2022 issuance, against the backdrop of new money being raised to enter the distressed CRE space and the Fed hinting at an earlier than expected end to the QT program, creates compelling technical factors for CMBS going forward.
From a fundamental credit perspective, the Trepp 30+ delinquency rate increased to 4.51% in December, up from 3.04% 12 months ago and from 4.39% in Q3. The office sector continues to display the most problems with 30+ delinquencies accelerating from 1.68% in 2022 to 5.82% by the end of 2023. The Trepp special servicing rate increased by 1.67% in 2023 to finish the year at 6.78%. According to Trepp, the 12-month average loss severity on CMBS loans liquidated in 2023 was 56.4%, up by 3% from the end of 2022. Based on JPM Research estimates, about 73% of CMBS loans set to mature in 2023 were able to refinance on time. This percentage is likely to decline in 2024 amidst higher prevailing interest rates and worsening performance for office collateral.
ABS:
The ABS sector proved to be an exception among structured credit sectors with 2023 issuance exceeding 2022 by 5% ($256B vs $243B). Most of the issuance increase came from auto ABS and most of the increase was due to banks diversifying their Prime auto ABS funding through a securitization route as deposits became more expensive. Auto ABS accounted for $146B of issuance with credit card and equipment, finishing a distant second and third, at $23B and $22B respectively. ABS sectors had the best performance in terms of excess returns versus Treasuries among broad securitized sectors in the Bloomberg Aggregate. The Bloomberg US ABS Index outperformed Treasuries by 1.24% in 2023 with an absolute return of 5.54%. The ABS market benefits from high overall interest rates, and while ABS spreads are at the tightest levels in a year, they are still wider than they were before the pandemic. Higher rated ABS tranches carry with them a “recession proof” label and should outperform other credit sectors due to their structural advantages and strong historical credit performance. Based on JPM indices, Student Loan and Unsecured Consumer lending securities have been the best performing ABS collateral types with 6.63% and 6.37% return respectively.
CLOs:
CLOs finished 2023 on a strong note with another positive quarter. Morningstar’s LSTA Leveraged Loan Index price almost reached $97 at the end of the year, up 4.5 points from the March lows. The current loan prices have now reached April 2022 levels. CLO new issuance totaled $113B in 2023, down 12% from 2022 which was the second highest level in terms of issuance. The CLO credit curve continued to flatten in Q4. AAA tranches finished the year at 159bp DM, 30bp tighter relative to a year ago. BBBs were 82bp tighter and were trading at 438bp DM. BBs exhibited 103bp of tightening and managed to end the year at 875bp DM. The AAA CLO primary to secondary basis widened significantly in Q4 and was around 22bp at the end of the year.
Q4 2023 Fund Attribution and Return:
| SECTOR | ALLOCATION | RETURN | ATTRIBUTION |
|---|---|---|---|
| RMBS | 40.03% | 4.43% | 1.74% |
| CMBS | 29.30% | 2.62% | 0.75% |
| ABS | 4.68% | -1.24% | -0.06% |
| CLO/CDO | 3.98% | 1.62% | 0.07% |
| CORP | 11.72% | 1.69% | -0.21% |
| GOVT | 3.65% | 8.18% | 0.37% |
| Cash | 6.64% | 0.05% | 0.00% |
| Total | 100.00% | 100.00% | 2.66% |
Source: Ultimus Fund Solutions, Orange Investment Advisors
The Easterly Income Opportunities Fund (JSVIX) returned 2.66% for the quarter, underperforming the Bloomberg Aggregate Bond Index which returned 6.82%. Both RMBS and CMBS posted strong performance given their lower duration. The treasury position, being primarily 10-year maturity, contributed nicely. The underperformance is primarily attributed to the lower duration of the portfolio relative to the Bloomberg Aggregate (2.4 yrs vs. 6.1 yrs), as interest rates rallied by 75bp. Also, credit hedges deployed in the portfolio contributed a negative 55bp to the Q4 return. In Q3 and Q4, we implemented a credit hedge using a credit default swap on the HY index (CDX HY), intended to hedge the riskiest portion of our CMBS allocation. While we are aware of the basis risk between CMBS and Corporate High Yield, we liked the CDX HY hedge relative to CMBS because of how wide the CMBS sector was trading relative to High Yield, with the spread differential between on-the-run BBB- conduit CMBS and Bloomberg HY OAS reaching the 99th percentile over the last 10 years during the quarter. While the return on Corporate Structured Notes was positive for the quarter, after combining it with the aforementioned CDX HY short, overall Corp return was negative. Finally, our ABS allocation was a detractor to returns due to higher-than-expected losses on a subprime auto deal that followed the servicing transfer from a defunct servicer to Westlake. Among contributors in Q4 were our overweight positions in RMBS and CMBS as spread tightening and carry (6.5% annualized realized carry in Q4) in both sectors had a positive impact on the performance. Despite spread tightening across many of our positions, the portfolio till had a 9.11% gross yield to maturity at the end of Q4.
We were fairly active during the quarter. We turned over capital within the RMBS allocation by adding a seasoned Legacy RE-REMIC deal in the mid-60s while selling a few seasoned Prime 2.0 and Non-QM subordinate tranches that had reached their target prices. This trade replaced more liquid investment grade subordinate tranches at a 7% loss-adjusted yield with a less liquidity senior security at a 9% loss-adjusted yield. We are always monitoring structured credit sectors for these kinds of relative value opportunities, and this was an example of one. In CMBS, we particularly focused on adding longer duration AA/A subordinate tranches from the 2019-2021 vintages. Given the increase in rates since the start of Fed’s tightening cycle, these investment grade tranches have fallen into a price abyss due to lack of investor interest. However, given robust underwriting, these bonds are cheap relative to their credit fundamentals and can be acquired well below their intrinsic value. With the Fed’s dovish pivot firmly entrenched in the market’s expectations, we think these longer duration, higher credit quality tranches will benefit from their high nominal yields, relative underperformance to other structured credit sectors, and significant money available on the sidelines for distressed credit opportunities.
Outlook:
The Fund currently yields 5.52%* , which the Bloomberg Aggregate Bond Index** yields 3.14%, while exhibiting a dollar price 14 points lower. Meanwhile, both Effective and Spread Duration are significantly lower than the Aggregate Index. We generally avoid interest rate risk in the portfolio, maintaining an effective duration around 2 years. We expect the Fed to initiate its rate cutting program by the end of Q2, resulting in a Fed Fund’s rate in the 4.25-4.50 range and the 2-year potentially in the low 3s. We believe that the 10-year will trade in the 3.25 – 4.25 range in 2024, resulting in a re-steepening of the yield curve. This, along with any spread tightening due to demand for steepeners, should be a positive for the Corporate Structured Note position.
We expect RMBS, which makes up 40% of the portfolio, to continue to perform well on a credit basis, providing solid carry and potential price return from additional spread tightening. CMBS valuations, for the most part, already reflect the worst-case scenarios for property values and borrowers’ inability or unwillingness to refinance loans at maturity. We expect many problematic loans to be resolved via maturity extensions, forbearance plans, and other types of modifications rather than be liquidated at a fire sale level. We are assuming maturity extensions for many loan resolutions as a base case scenario when running cashflows to value bonds. Despite these conservative assumptions, we still calculate yields between 8-12% for many of the investment-grade conduit tranches in the portfolio at current spreads. Also, given that the differential between new issue CMBS BBB- spreads and high yield corporates is currently in the 99.9 percentile over the last 10-years, we expect CMBS spreads to tighten over the course of 2024.
Overall, we expect the Fund to perform well in 2024, given our outlook for rates and our belief that some of the seemingly insatiable demand for fixed income credit, currently concentrated in corporate sectors, will spill over to the smaller structured credit market due to compelling relative value.
| Q4 2023 | 12/31/2023 | |||
|---|---|---|---|---|
| Sector | Allocation | Price | Eff Dur | Sprd Dur |
| RMBS | 40.03% | 76.63 | 2.17 | 3.64 |
| CMBS | 29.30% | 77.43 | 2.18 | 3.33 |
| ABS | 4.68% | 83.27 | 1.02 | 2.52 |
| CLO/CDO | 3.98% | 73 | 0.08 | 3.31 |
| CORP | 11.72% | 65.92 | 4.61 | 3.65 |
| GOVT | 3.65% | 99.09 | 7.08 | - |
| Cash | 6.64% | $100.00 | - | - |
| Total | 100% | $77.39 | 2.67 | 3.26 |
SOURCE: Orange Investment Advisors, JP Morgan Markets, Bank of America, Bloomberg.
| 12/31/2023 | QTD | YTD | 1-YEAR | 3-YEAR | 5-YEAR | SINCE INCEPTION 8/21/2018 |
|---|---|---|---|---|---|---|
| I Shares | 2.66% | 5.91% | 5.91% | 1.33% | 4.95% | 4.93% |
| Morningstar Multisector Bond Category | 5.68% | 8.13% | 8.13% | 0.10% | 2.93% | 2.27% |
| Bloomberg U.S. Aggregate Bond Index | 6.82% | 5.53% | 5.53% | -3.32% | 1.10% | 1.21% |
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 0.96% 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 (excluding front-end and contingent deferred sales loads, leverage, interest and tax expenses, dividends and interest on short positions, brokerage commissions, expenses incurred in connection with any merger, reorganization or liquidation, extraordinary or non-routine expenses and the indirect costs of investing in other investment companies) will not exceed 1.48%, 1.73%, 2.48% and 0.89%, respectively, subject to possible recoupment from the Fund in future years. For more information, please refer to the Fund’s summary prospectus and prospectus.
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.
CDX High Yield (HY): High Yield CDS (credit default swap) index focused on North America.
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.
CMS: Also known as constant maturity swap floaters, are a variation of an interest rate swap in which one side is fixed or reset periodically against the rate of a floating rate reference index and the constant maturity side is reset each period relative to a fixed maturity instrument like a treasury note.
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 maturity but different credit quality. The spread is measured in basis points, 100 basis points in 1%.
DM (Discount Margin): Is the spread when added to the bond’s current reference rate equates the cash flows to the current price.
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 Funds.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. Effective 10/2/2023, the Easterly mutual funds are distributed by Easterly Securities, LLC. Easterly Investment Partners, LLC and EAB Investment Group LLC, LLC are affiliates of Easterly Securities, LLC, member FINRA/SIPC. Orange Investment Advisors, LLC and Ranger Global Advisers are not affiliated with Easterly Securities, LLC. Certain associates of Easterly Securities, LLC are registered with FDX Capital LLC, member FINRA/SIPC.
Easterly Funds LLC serves as the investment adviser to the Easterly Fund family of mutual funds and related portfolios. Easterly Funds LLC is an SEC registered investment adviser; see Easterly Funds’ Form ADV at www.sec.gov. Registration does not imply and should not be interpreted to imply any particular level of skill or expertise.
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.
IMPORTANT FUND RISK
Options involve risk and are not suitable for all investors. Writing a covered call option allows the Fund to receive a premium (income) for giving the right to a third party to purchase shares that the Fund owns in a given company at a set price for a certain period of time. There is no guarantee of success for any options strategy. Increased portfolio turnover may result in higher brokerage commissions, dealer mark- ups and other transaction costs and may result in taxable capital gains. Investments in lesser-known, small and medium capitalization companies may be more vulnerable to these and other risks than larger, more established organizations.
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.
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