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Perspective

Structured Credit Primer

Summary Highlights

  • Structured credit can help augment yield and total return in a low interest rate environment
  • Investors can benefit from its complementary risk/return profile relative to traditional fixed income
  • Structured credit can help investors address the risk of rising interest rates
  • Regulatory changes have mitigated many of the risks that led to the Great Financial Crisis
  • Easterly Income Opportunities Fund (JSVIX): The Fund seeks to provide a high-level of risk-adjusted current income and capital appreciation. Capital preservation is a secondary objective.

This primer provides an overview of these areas:

  • What is Structured Credit?
  • Key Features and Benefits
  • Evolution of Structured Credit
  • Case for Structured Credit in a Rising Rate Environment
  • Conclusions

What is Structured Credit?

Structured Credit includes non-traditional bonds securitized by specific pools of collateral, such as residential and commercial mortgages, consumer loans or commercial loans. Figure 1 summarizes the major sectors. Through a process called securitization, loans with similar characteristics are purchased and pooled in a trust-like entity known as a Special Purpose Vehicle (SPV). The SPV then issues securities backed by the principal and interest cash flows of the collateral pool that exhibit a variety of characteristics in terms of coupon, maturity, price, yield and credit quality.

Figure 1

MAJOR STRUCTURED CREDIT SECTORS
Non-Agency RMBSNon-Agency Residential Mortgage-Backed Securities: Backed by diversified pools of residential mortgages created by private entities
CMBSCommercial Mortgage-Backed Securities: Backed by a diversified pool of commercial mortgages
Consumer ABSConsumer Asset-Backed Securities: Backed by loans & receivables from consumers (e.g. Auto Loans, Credit Card Receivables, Student Loans)
Commercial ABSCommercial Asset-Backed Securities: Backed by commercial loans, leases and receivables as well as corporate leveraged loans (e.g. Collateralized Loan Obligations or CLOs)

Key Features and Potential Benefits of Structured Credit

Structured Credit can benefit investors in a number of ways, including the potential for relatively high risk-adjusted returns, attractive monthly income, portfolio diversification, and limited exposure to duration and credit risk.

Non-Indexed and Inefficient: Because non- agency structured credit exists outside of major indexes, it may provide investors access to fixed income market segments that have not been commoditized by major benchmarks and ETFs. In addition, the inefficient and complex nature of the space allows for highly experienced managers to exploit price dislocations.

Floating Rate: Many structured credit products offer a “floating” or variable rate. Similar to more commonly known bank loans, the coupon offered is typically a spread above a benchmark rate, such as LIBOR. This can be particularly appealing when interest rates are rising.

Risk-Adjusted Yield Premium: Structured Credit typically offers investors attractive yield per unit of duration relative to traditional fixed income. (See Figure 2)

Tranched Risk: While the collateral is made up of pools of loans with similar characteristics, Structured Credit securities are typically tranched into a capital structure through a process known as subordination (See Figure 3). Each tranche is offered separately, and each has a distinct risk/return profile. The more senior tranches typically have less exposure to credit risk and, as a result, have lower yields. Conversely, the more junior the tranche, generally the higher the levels of credit risk and yield. (See Figure 3) This allows investors a broad spectrum of options to satisfy their risk/reward preferences.

Credit Enhancement: In addition to subordination described above, structured credit may offer another advantage over traditional fixed income: credit enhancement, through overcollateralization and excess spread. This can help mitigate credit risk and can provide a buffer against loss.

Diversification: Structured credit potentially offers diversification at both the loan and the portfolio level. At the loan level, structured credit securities are typically collateralized by a diverse pool of similar assets such as loans. This diversifies the collateral pool, reducing idiosyncratic credit risk of all tranches in the deal. At the portfolio level, investors can gain exposure to a part of the fixed income market that exists outside major indexes and ETFs. In addition, structured credit has historically had low correlation among its sub- sectors as well as to traditional fixed income sectors.

Figure 2

Structured Credit Sectors Provide More Yield Per Unit of Duration 

Structured Credit - Figure 1

30-Day SEC Subsidized Yield: 2.86% | 30-Day SEC Unsubsidized Yield: 2.81%

Performance as of 12/31/2021

12/31/20211-Year3-YearSince Inception
(8/21/2018)
I Share4.79%8.65%8.21%
Morningstar Multisector Bond Category2.28%5.51%4.49%
Bloomberg U.S. Aggregate Bond Index-1.54%4.79%4.56%

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 19, 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 1.58%, 1.80%, 2.60% and 1.59% respectively; total annual operating expenses after the expense reduction/reimbursement are 1.53%, 1.78%, 2.53% and 1.16% respectively.1 2.00% is the maximum sales charge on purchases of A Shares.

Figure 3

CAPITAL STRUCTURE RESULTING FROM SUBORDINATION
Senior Tranches▪ Highest ratings; investment grade
▪ Last in capital structure to incur losses
▪ Receive principal payments first
▪ Lowest yield in capital structure
Mezzanine Tranches▪ Subordinate to senior tranches
▪ Typically investment grade or BB-rated
▪ Absorb losses only after junior tranches are written off
▪ Receive principal sequentially after seniors
▪ Yields between senior and junior tranches
Junior Tranches▪ Subordinate to senior tranches
▪ Typically investment grade or BB-rated
▪ Absorb losses only after junior tranches are written off
▪ Receive principal sequentially after seniors
▪ Yields between senior and junior tranches

Evolution of Structured Credit

Since the global financial crisis, the structured credit market has undergone significant changes and enhancements. Numerous regulatory changes, including the Dodd-Frank Act and the Volker Rule within the United States and Basil III globally, have resulted in tighter lending standards, increased disclosure and reporting, greater risk retention by originators and increased capital requirements. These changes have led to increased oversight and protections for investors as well as reduced abuses by originators. Below are several key examples of types of credit enhancements and safeguards offered within structured credit. 

Key Risks to Investing in Structured Credit

Every investment comes with risks. In fixed income, typical risks include interest rate risk, credit risk, liquidity risk and prepayment risk. Risks specific to structured credit include: 

Interest rate risk: Rapid and dramatic shifts in interest rates may affect the value of a structured credit bond. Rate movements may also indirectly affect pre-payment or extension risk, which are essentially the risks of a callable bond being called sooner or later than projected by the investor. 

Credit risk: Unlike an Agency bond that is backed by the U.S. Government, credit risk cannot be totally eliminated within non-agency structured credit, particularly in lower-rated, subordinate bonds. 

Liquidity risk: Structured credit products may trade less frequently than other fixed-income products, making them somewhat less liquid. This is directly related to the fact that they are non-index, which is also the source of market inefficiency. This risk can normally be effectively managed by experienced Structured Credit traders, but nonetheless will increase at times of heightened market volatility. 

Complexity risk: While pooling multiple loans helps to diversify idiosyncratic credit risk, the Structured Credit market is complex and diverse, made up of a variety of deal structures and collateral types that require specialized expertise and resources. 

The Case for Structured Credit in a Rising Interest Rate Environment

We believe there is a particularly compelling case for structured credit in today’s market environment. Interest rates have been historically low for the past dozen or so years, creeping up briefly from 2017 through 2019 before the COVID-19 pandemic spurred the Federal Reserve and other central banks to act swiftly to add liquidity to the capital markets. 

In this relatively low interest rate environment, investors seeking higher yields have had to go further out the yield curve or down in credit quality. As a result, many investors have increased their sensitivity to interest rates and credit risk in exchange for decreasing marginal yield. With yields so low, investors have greatly reduced their “yield cushion” to defend their portfolio’s total return from negative price return, which can result from higher rates or widening credit spreads. 

Despite the Fed’s dovish stance on rates, the 10-year U.S. Treasury’s yield rose 83 basis points (0.83%) in the first quarter of 2021, as market participants assessed the likely impact that unprecedented accommodative monetary policy and fiscal stimulus would have on inflation. As rates rise, exposure to longer durations means magnified interest rate risk. And when bond yields are low to begin with, that can mean negative total returns, or losses. This has already begun to happen, and we believe it will persist until rates ultimately reflect the market’s full inflation expectations. 

Figure 4

STRUCTURED CREDIT
A Unique Combination of Attractive Yields and Performance & Low Duration
Morningstar CategoryYTMAvg. PriceAvg. Duration1-Year ReturnsSI Returns*
JSVIX4.32%$94.311.880.01%8.21%
Bank Loan4.18%-0.610.49%2.95%
High Yield Bond4.34%$106.073.340.58%5.33%
Intermediate Core Bond1.88%$104.106.27-0.24%4.27%
Intermediate Core Plus Bond2.28%$107.126.17-0.17%4.80%
Multisector Bond3.95%$102.973.700.06%4.49%
Nontraditional Bond2.82%$100.342.24-0.22%2.89%
Short-Term Bond1.33%$102.932.83-0.48%2.60%

30-Day SEC Subsidized Yield: 2.86% | 30-Day SEC Unsubsidized Yield: 2.81% 

All data as of 12/31/2021 unless otherwise noted
*Annualized returns since 8/21/2018, the inception of JSVIX 

In the table above, we illustrate the low and even negative total returns that result from low yield and/or high duration in a rising rate environment such as the first quarter of 2021. Even short to intermediate-term bond fund categories had negative total returns, while strategies with greater credit exposure were still only marginally positive. 

By contrast, the Easterly Income Opportunities Fund, produced a total return of 2.66% over the same period largely due to its higher yield and lower duration. 

There is no guarantee that an investor would experience these results going forward, but it points to the potentially attractive features of structured credit, particularly in today’s environment of still relatively low but rising interest rates. 

Conclusions: A Niche Where Expertise Matters

Overall, we see structured credit as an important piece of a properly diversified portfolio. By including exposure to structured credit within their diversified bond portfolios, investors can potentially increase their overall risk-adjusted yield while including an asset class with low correlations to other market sectors. And in a period of rising rates, structured credit’s risk/return profile can be even more attractive. 

Because structured credit is a specialized part of the fixed income market, investors may benefit most from working with an experienced manager who can understand, identify and unlock the value that this may offer market offers. 

To learn more about structured credit and how you could potentially enjoy its numerous potential benefits, contact us at info@easterlyfunds.com or call (888) 814-8180. 

Glossary

30-Day SEC Yield (Subsidized/Unsubsidized): Represents net investment income earned by a fund over a 30-day period, expressed as an annual percentage rate based on the fund’s share price at the end of the 30-day period. Subsidized yield reflects fee waivers and/or expense reimbursements during the period. Without waivers and/or reimbursements, yields would be reduced. Unsubsidized yield does not adjust for any fee waivers and/or expense reimbursements in effect. 

Average Duration: Average duration is generated by Morningstar from the categories funds by weighting the effective duration of each fund’ portfolio by its relative size in the category. 

Average Price: Average price is generated by Morningstar from the categories funds by weighting the average price of each fund’s portfolio by its relative size in the category. 

Bloomberg Barclays U.S. Aggregate 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. 

Effective Duration: This measure of duration takes into account the fact that expected cash flows will fluctuate as interest rates change and is, therefore, a measure of risk. Effective duration can be estimated using modified duration if a bond with embedded options behaves like an option-free bond. 

Morningstar Bank Loan Category: Bank loan portfolios primarily invest in floating-rate bank loans instead of bonds. 

Morningstar High-Yield Bond Category: High-yield bond portfolios concentrate on lower-quality bonds, which are riskier than those of higher-quality companies. 

Morningstar Intermediate Core Bond Category: Intermediate-term core bond portfolios invest primarily in investment-grade U.S. fixed-income issues including government, corporate, and securitized debt, and hold less than 5% in below-investment-grade exposures. Their durations (a measure of interest-rate sensitivity) typically range between 75% and 125% of the three-year average of the effective duration of the Morningstar Core Bond Index. 

Morningstar Intermediate Core-Plus Bond Category: Intermediate-term core-plus bond portfolios invest primarily in investment-grade U.S. fixed-income issues including government, corporate, and securitized debt, but generally have greater flexibility than core offerings to hold non-core sectors such as corporate high yield, bank loan, emerging-markets debt, and non-U.S. currency exposures. Their durations (a measure of interest-rate sensitivity) typically range between 75% and 125% of the three-year average of the effective duration of the Morningstar Core Bond Index. 

Morningstar Multisector Bond Category: Multisector-bond portfolios seek income by diversifying their assets among several fixed income sectors, usually U.S. government obligations, U.S. corporate bonds, foreign bonds, and high-yield U.S. debt securities. 

Morningstar Nontraditional Bond Category: The Nontraditional Bond category contains funds that pursue strategies divergent in one or more ways from conventional practice in the broader bond-fund universe. 

Morningstar Short-Term Bond Category: Short-term bond portfolios invest primarily in corporate and other investment-grade U.S. fixed-income issues and typically have durations of 1.0 to 3.5 years. 

Spread Duration: The sensitivity of the price of a security to changes in its credit spread. The credit spread is the difference between the yield of a security and the yield of a benchmark rate, such as a cash interest rate or government bond yield. 

Yield per unit of duration: Is the funds yield to maturity divided by the fund’s duration. 

YTM: Yield to Maturity (YTM) is the total return anticipated on a bond if the bond is held until it matures. Yield to maturity is considered a long-term bond yield but is expressed as an annual rate. 

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. 

Important Fund Risks

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 19, 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. 

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. 

Diversification does not ensure a profit or guarantee against loss. 

14343993-UFD-02142022

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