September was the 5th consecutive month of the Treasury rally. The yield curve bull steepened as rates in the front end and belly outperformed longer durations. The 2-year US Treasury and 5-year US Treasury moved lower in yield by 28 basis points (bps) and 14 bps, while the 10-year US Treasury and 30-year US Treasury rallied 12 bps and 8 bps, respectively. Meanwhile, risk assets also performed nicely. The major global equity indices fared well and investors saw spreads mostly tighten in fixed income risk products. Investment grade corporate spreads continued to grind in, as did the CCC rated class in high yield, while high yield BBs and single Bs actually widened. Agency mortgage-backed securities (MBS) saw strong demand and spread compression, while asset-backed securities (ABS) finished better bid as well.
The month’s activity was driven by U.S. economic data and the Federal Open Market Committee (FOMC or the Fed) meeting, with jobs data leading off as usual. Job openings fell more than anticipated and layoff and quit rates increased slightly, which monetary doves cited as further evidence of the slowing labor market. The more critical report, Nonfarm Payrolls, was released two days later and the headline number was below consensus and accompanied by another downward revision to the preceding two months. Most of the jobs added were from sectors like government and healthcare. Unemployment, however, was effectively unchanged, and average hourly earnings actually increased. Overall, the mixed report was still viewed by investors as clear evidence that the labor market had softened. Most commentators believed at this point that we hadn’t seen enough to warrant a 50 bps cut from the Fed later in the month, although recent Fed speak from Federal Reserve Board of Governors members Waller and Williams had leaned dovish.
The following week, Consumer Price Index (core CPI) was above expectation at 0.3% for August, while the headline number arrived on target. The positive was that goods prices failed to heat up and it was shelter which drove the overall increase. In response to the higher core reading, Treasury rates sold off, as the inflation figures seemed likely to support just a quarter point rate cut at the impending meeting. However, two days later, Nick Timiraos of the Wall Street Journal released an article indicating a 50 bps move hadn’t been ruled out.
The piece was prescient. The Fed cut 50 bps on the 18th, lowering its benchmark rate to a 4.75%-5.00% target range. The only dissenting vote was from Governor Bowman. The move surprised many, although rates futures markets had considered the quarter vs. half point decision as closer to a coin flip. Only one of the large global banks in a 25+ analyst survey called successfully for 50 bps. The Fed’s year-end, midpoint funds targets for 2024 and 2025 were updated to 4.375% and 3.375%, respectively, while the futures market anticipated a slightly more dovish path.
In his press conference, Fed Chair Jerome Powell emphasized the notion of policy “recalibration” rather than easing. He voiced confidence that inflation was heading toward a “sustainable” 2% target and that the rate cut provided breathing room in maintaining a strong labor market. Investors took this as a clear acknowledgement of the dual risks of the policy path, with some Fed attention shifting from inflation to the threat of unemployment moving higher. Markets undeniably read into the large cut as the Fed having concern over the labor market. The oscillating, yet contained, price action in yields that followed seemed to hint at a new world in which 2% could become a floor for inflation. Back in July, Powell had indicated that a half point cut wasn’t being considered.
“When something is 'new and improved', which is it? If it's new, then there has never been anything before it. If it's an improvement, then there must have been something before it.”
- George Carlin
I’m at that age where I am somewhat skeptical of any product advertising itself as new or improved. I’ve lived long enough to know that any “new” product I have actually liked or saw a need for are merely a few months away from a flurry of bad press because some part of it is easily detached and swallowed by toddlers and it will be off the market shortly. Things touted as “improved?” When a food product I like has “improved flavor” slapped across its packaging it causes me to question what kind of defective tastebuds I actually have because I really liked the original taste. “Improved formula” reminds me that I shouldn’t be eating a food where “formula” is important to it. “Improved design” makes me feel like I am lucky to have cheated a certain death given the original design flaw. Suffice to say, “new” or “improved” isn’t welcome news around here.
Both words promise one thing though, and that is innovation. The interesting part of innovation in the fixed income markets is that there isn’t any. Well, not really. There have been attempts. Some getting more fanfare than others, but I’ve been around long enough to recognize in the end they are generally just old ideas or structures that withered and died years ago that someone has revived and slapped a new name on them. In fact, perhaps the most “recent” innovative thing we have seen in the fixed income market has been the advent and rise of the asset-backed securities (ABS) market. And by “recent,” I mean it’s been fewer than 50 years. Not sure I’d call that recent, but here we are.
It's new enough though that the investor base remains a pittance of the one that buys corporate debt, and there are still a solid number of large, and in some cases, well known investors that don’t buy ABS. There are myriad reasons for that. ABS can be complex. It also on occasion takes its lumps as an overall sector. And there are plenty of investors and members of boards who still hold a grudge and pin the Great Financial Crisis (GFC) on ABS. Memories can be long. Nevertheless, ABS issuance is back! Corporate bonds are getting most if not all the press in terms of its historic primary issuance march, but make no mistake, ABS issuance is seeing historic levels as well. As of the end of September 2024, ABS issuance levels are pretty much right at the high of the past 10 years and there is still another quarter of issuance to be had.
Source: Barclays
The large primary issuance is easily being met by excessive demand, leading to solid secondary trading in the space.
Source: Barclays
Furthermore, as illustrated below, dealers are anxious to participate in the moment, with the level of dealer positioning of ABS paper well above the average one would normally expect to see. This combination of historic issuance, coupled with strong secondary trading levels, and dealer positioning of paper, indicates a high degree of liquidity in the overall ABS market. It also means excessive demand. In ABS though that isn’t always a great thing.
Source: Federal Reserve
We have been here before. The problem is that as things become popular, and the financing for the tried and true become tighter, a less than fickle investor base emerges and becomes less discerning and willing to reach for anything resembling ABS. We recently focused on the reawakened appetite for esoteric ABS, but the demand for that paper is just one part of a by-product of the current supply and demand technicals. One other is by-product can be relative value. Or even lack thereof. For that, we want to look at unsecured consumer lending, also known as marketplace lending (MPL).
The rise of MPL as one of the newer ABS sectors is pretty impressive. As little as around 7 years ago, the sector was new enough that at a certain point only one rating agency was actively rating transactions. Newer ABS sectors can take time building a base, and so it was with MPL. But with demand ramping up, dealers are eager to feed the market with ABS, and MPL has been quite active. In fact, MPL has carved out a solid place, with issuance to be of enough size as to keep it out of the “other ABS” category.
Source: Federal Reserve
MPL as a sector has come of age during a relatively benign credit environment. Its only true test, and it was a short lived one, was during the pandemic. But the impact of the pandemic on the asset class was relatively tame, met with massive amounts of liquidity pumped into the financial system and low interest rates. And so, the sector really hasn’t gone through a rough patch or even a less accommodating environment, such as one of lower employment growth, up until now. Nevertheless, what we are seeing recently is probably indicative of future issues.
Source: Barclays
As we look to ABS for diversification benefits and relative value choices, we continue to press upon our preference for being further up in the credit stack, but also sticking with the older asset classes with ABS, such as equipment leasing and auto loans. The reasons are simple, we have many years, decades, of performance data to rely upon for those sectors, through multiple peaks and valleys, and thus have a relatively firm idea of how those deals should perform. MPL, given the age of the sector, offers far less to look back at. As can be seen below, a quick look at delinquencies and losses gives us an idea of how volatile MPL can be.
Source: JP Morgan
Source: JP Morgan
This is especially true when compared to an older, more established asset class such as equipment leasing. As one can see below, the overall performance of equipment leasing ABS is relatively stable. It operates within a tight band. That is a big comfort when one considers how fast conditions can change. In this case, for instance, delinquencies, even if we go to a tighter window of 30+ instead of 60+ for MPL, are typically inside 3%, while MPL can and has moments where it can spike up near 10%. The cumulative losses are also quite different. Because MPL are for the most part unsecured consumer risk, recoveries are not very robust, and certain vintages hit near 30%, while equipment leasing loss rates are already far more palatable and recoveries help with cumulative losses for all vintages seen well below 1.5%.
Source: JP Morgan
Source: JP Morgan
And thus, the question of relative value. We know MPL truly hasn’t been tested yet, and already we see the volatility in delinquencies and levels of losses. The risk is that during a downturn those react even more violently. The question becomes would you rather own a far riskier, less proven ABS sector with a less dedicated investor base, or one that has historically settled into a fairly benign, more comfortable level? As illustrated below, the spread difference between 3-year BBB rated equipment leasing ABS and 3-year BBB rated MPL ABS bonds is quite noticeable. That is for a reason. There is more risk, as we see it, with the potential spread widening in MPL than equipment leasing. Furthermore, with a potential shift in performance, the negative risk in MPL is unknown, while equipment leasing, given its long performance history, is more of a known quality.
Source: Atlas
Source: Atlas
The difference between the two asset types is striking. At end of September 2024, 3- year BBB rated MPL bonds had a spread of some 260 basis points (bps), while equipment leasing 3-year BBB rated bonds were 123 bps. When things got rough for both asset types, equipment leasing widened out to 466 bps during the pandemic, but MPL during July of 2022 spiked to 650 bps. Worse, the reason that it didn’t necessarily spike even further during the pandemic is that the markets were closed to asset types such as that and really only opened to those the market had more trust in, such as equipment leasing. It is a testament to equipment leasing’s investor base that even during the moment when the bulk of the financial markets were closed to new issue, investors were still eager enough to add that type of risk.
The last point in terms of relative value harkens back to the issuance and secondary trading levels of ABS as a whole. We are at a point where there is excessive demand for ABS, any ABS, and there is a grabbiness in the market. The issue as we have seen and noted is that once the environment shifts or a downturn returns, liquidity will initially dry up for less known, less trafficked asset sectors with more limited history. That ultimately could lead to large negative price movements in these bonds when investors, the less fickle, decide to sell at any price.
We continue to be more interested in sticking to the more liquid, well known asset classes in ABS. Spreads are still favorable, and the overall liquidity profiles and credit characteristics make the value more apparent in things you can trust. As history has shown, at the wrong moment, “improved” and “new” are far better at attracting consumers to new flavors of breakfast cereals than investors to financial products.
What had been building for weeks, finally arrived. The Fed delivered its first rate cut and the market reacted in confusion. The initial reaction to what was perceived as a bigger than expected 50 bps was one of exuberance, and maybe, just maybe, a “finally.” But the cheers quickly dissipated as there instantly became a debate amongst market participants as to what that meant for rate expectations going forward, and after Chair Powell spoke even more confusion and perhaps even a little anger. Because conversations quickly focused on a lower than expected number and size of cuts going forward, and less surety, in many minds, that the path considered prior to the announcement was still valid. As such, rates pulled back, selling off, and the market has since settled into one in which while the rate cuts have begun and should and will continue on, the size won’t be what seemed possible even hours and minutes prior. We have anticipated this somewhat, as you never quite get what you want, and as such, while we have moved duration targets and issuer preferences in a manner we expect to capture a rate environment with a number of future rate cuts considered, we nevertheless kept ourselves in a more neutral position, understanding nothing was certain. We do continue to expect to eventually see more of a rally in the front end of the curve, and do see some more value a bit further out, but remain as neutral as possible to any sort of in-between bounces we might see in the markets as we motor toward a second rate cut, an election and year-end pressures.
Credit continues to chug along. We remain wary that conditions continue to deteriorate in the background some and are not fully appreciated yet. However, the overall credit market remains firm and there seems to be ample appetite for credit up and down the capital stack. There continues to be a rise in retail commercial real estate space, which would seem to indicate ongoing issues in that sector. This should indicate a rippling is not far off, but thus far, investors seem eager to add corporate credit. Given our estimates and outlook, we do feel agency mortgage-backed securities (MBS) are a better and more desirable asset in this case, given credit spreads are at historic tights with nowhere to go but wider and agency MBS have a similar if not better yield outlook compared to those corporate credits. We continue to expect more stress in the credit market, which to date has not shown up in a meaningful manner. We do feel that election year pressures and year-end exuberance with rates are masking some of what isn’t being fully appreciated in credit spreads. Furthermore, current treasury yields, even post-rate cut, are attractive compared to recent past levels and more than compensatory for our preferred credit targets. We continue to prefer the higher ground in terms of credit and anticipate this being the case well into year-end at current credit spread levels and treasury yields.
Issuance in investment grade, high yield and asset-backed securities continues to be heavy. There doesn’t seem to be any letup as each week we are seeing more and more issuance, and in a sign of health from the market, that is being met by significant demand. Furthermore, once free to trade, the primary issuance is seeing an invigorated secondary market eager to play in those new deals. The market liquidity is robust and there doesn’t seem to be any slowing in the near future. This should make even a credit slowdown potentially less painful as there is so much demand that even distressed credit can seemingly find an active market. Certainly as a result, the fixed income market seems healthy. We continue to use the moment to prune out of favor holdings, those we feel have reached full value, and sectors we expect to perform less well going forward. All at the same time to create potential cushion to invest in more opportune credits in the near-term.
The theme remains: favorable market conditions, including liquidity aiding our ability to continue adding to targeted opportunities. We stay wary of credit, expecting some widening in corporate credit spreads, and as such, feel more comfortable in sectors such as MBS (see below). Rate cuts will continue into year-end, but rates are expected to be choppy as the Fed finds a better voice.
Noted asset sector target or bias this month includes:
The beginning of the rate cuts signifies what market participants have been pushing over the past few months, which is that we are in a different rate environment. We fully expect days where rates sell off within this environment, depending on geopolitical events or even daily headlines, but we are in a moment where we expect rates to continue to be in rally mode overall. Economic data does seem to be supportive of this, and while still not exhibiting any signs of recessionary pressures, it does exhibit data points that support the concept of a softening economy. The Fed’s first rate cut, of what is expected to be at least one more before year-end, is meant to be supportive of this weaker economic moment. Nevertheless, treasury rates are still near recent highs, and as such, there is still value in finding the right duration and maturities in the proper credits. We prefer to stay focused on highly liquid, targeted defensive sectors and exposures, as well as seeking opportunities within rate movements at certain points on the yield curve with the potential for higher returns. We feel the front end of the yield curve, the 3 year maturity area, specifically offers value, as well as the 10 year maturity area. Both areas provide some duration benefits in the right name, and potential overperformance as the rate rally continues. Duration targets have moved slightly longer, as a result.
Definition of Terms
Basis Points (bps) - refers to a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%, or 0.01%, or 0.0001, and is used to denote the percentage change in a financial instrument.
Baby Bonds – a bond that has a face value of less than $1,000.
Curvature - A yield curve is a line that plots yields (interest rates) of bonds having equal credit quality but differing maturity dates. The slope of the yield curve gives an idea of future interest rate changes and economic activity.
Mortgage-Backed Security (MBS) - A mortgage-backed security is an investment similar to a bond that is made up of a bundle of home loans bought from the banks that issued them.
Collateralized Loan Obligation (CLO) - A collateralized loan obligation is a single security backed by a pool of debt.
Commercial Real Estate Loan (CRE) - A mortgage secured by a lien on commercial property as opposed to residential property.
CRE CLO - The underlying assets of a CRE CLO are short-term floating rate loans collateralized by transitional properties.
Asset-Backed Security (ABS) - An asset-backed security is an investment security—a bond or note—which is collateralized by a pool of assets, such as loans, leases, credit card debt, royalties, or receivables.
Option-Adjusted Spread (OAS) - The measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is then adjusted to take into account an embedded option.
Enhanced Equipment Trust Certificate (EETC) - One form of equipment trust certificate that is issued and managed through special purpose vehicles known as pass-through trusts. These special purpose vehicles (SPEs) allow borrowers to aggregate multiple equipment purchases into one debt security.
Real Estate Investment Trust (REIT) - A company that owns, operates, or finances income-generating real estate. Modeled after mutual funds, REITs pool the capital of numerous investors.
London InterBank Offered Rate (LIBOR) - a benchmark interest rate at which major global banks lend to one another in the international interbank market for short-term loans.
Secured Overnight Financing Rate (SOFR) - a benchmark interest rate for dollar-denominated derivatives and loans that is replacing the London interbank offered rate (LIBOR).
Delta - the ratio that compares the change in the price of an asset, usually marketable securities, to the corresponding change in the price of its derivative.
Commercial Mortgage-Backed Security (CMBS) - fixed-income investment products that are backed by mortgages on commercial properties rather than residential real estate.
Dry Powder – cash or marketable securities that are low-risk and highly liquid and easily convertible to cash.
Floating-Rate Note (FRN) - a bond with a variable interest rate that allows investors to benefit from rising interest rates.
Consumer Price Index (CPI) - a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care. It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them.
Gross Domestic Product (GDP) - one of the most widely used measures of an economy's output or production. It is defined as the total value of goods and services produced within a country's borders in a specific time period—monthly, quarterly, or annually.
Perp - A perpetual bond, also known as a "consol bond" or "perp," is a fixed income security with no maturity date.
Nonfarm payrolls (NFPs) - the measure of the number of workers in the United States excluding farm workers and workers in a handful of other job classifications. This is measured by the federal Bureau of Labor Statistics (BLS), which surveys private and government entities throughout the U.S. about their payrolls.
Net Asset Value (NAV) - represents the net value of an entity and is calculated as the total value of the entity’s assets minus the total value of its liabilities.
S&P 500 - The Standard and Poor's 500, or simply the S&P 500, is a stock market index tracking the stock performance of 500 large companies listed on exchanges in the United States.
German DAX - The DAX—also known as the Deutscher Aktien Index or the GER40—is a stock index that represents 40 of the largest and most liquid German companies that trade on the Frankfurt Exchange. The prices used to calculate the DAX Index come through Xetra, an electronic trading system.
NASDAQ - The Nasdaq Stock Market (National Association of Securities Dealers Automated Quotations Stock Market) is an American stock exchange based in New York City. It is ranked second on the list of stock exchanges by market capitalization of shares traded, behind the New York Stock Exchange.
MSCI EM Index - The MSCI Emerging Markets Index captures large and mid cap representation across 24 Emerging Markets (EM) countries. With 1,382 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
Nikkei - The Nikkei is short for Japan's Nikkei 225 Stock Average, the leading and most-respected index of Japanese stocks. It is a price-weighted index composed of Japan's top 225 blue-chip companies traded on the Tokyo Stock Exchange.
Shanghai Composite - is a stock market index of all stocks (A shares and B shares) that are traded at the Shanghai Stock Exchange.
Bloomberg U.S. Agg - The Bloomberg Aggregate Bond Index or "the Agg" is a broad-based fixed-income index used by bond traders and the managers of mutual funds and exchange-traded funds (ETFs) as a benchmark to measure their relative performance.
MOVE Index - The ICE BofA MOVE Index (MOVE) measures Treasury rate volatility through options pricing.
VIX Index - The Cboe Volatility Index (VIX) is a real-time index that represents the market’s expectations for the relative strength of near-term price changes of the S&P 500 Index (SPX).
Dow Jones Industrial Average - The Dow Jones Industrial Average is a price-weighted average of 30 blue-chip stocks that are generally the leaders in their industry.
Hang Seng - The Hang Seng Index is a free-float capitalization-weighted index of a selection of companies from the Stock Exchange of Hong Kong.
STOXX Europe 600 - The STOXX Europe 600, also called STOXX 600, SXXP, is a stock index of European stocks designed by STOXX Ltd. This index has a fixed number of 600 components representing large, mid and small capitalization companies among 17 European countries, covering approximately 90% of the free-float market capitalization of the European stock market (not limited to the Eurozone).
Euro STOXX 50 - The EURO STOXX 50 Index is a market capitalization weighted stock index of 50 large, blue-chip European companies operating within eurozone nations.
CAC (France) - is a benchmark French stock market index. The index represents a capitalization-weighted measure of the 40 most significant stocks among the 100 largest market caps on the Euronext Paris (formerly the Paris Bourse).
U.S. MBS Index - The S&P U.S. Mortgage-Backed Securities Index is a rules-based, market-value-weighted index covering U.S. dollar-denominated, fixed-rate and adjustable-rate/hybrid mortgage pass-through securities issued by Ginnie Mae (GNMA), Fannie Mae (FNMA) and Freddie Mac (FHLMC).
Duration Risk - the name economists give to the risk associated with the sensitivity of a bond's price to a one percent change in interest rates.
Federal Open Market Committee (FOMC) - the branch of the Federal Reserve System (FRS) that determines the direction of monetary policy specifically by directing open market operations (OMO).
United States Treasury (UST) - the national treasury of the federal government of the United States where it serves as an executive department. The Treasury manages all of the money coming into the government and paid out by it.
High Yield (HY) - high-yield bonds (also called junk bonds) are bonds that pay higher interest rates because they have lower credit ratings than investment-grade bonds. High-yield bonds are more likely to default, so they must pay a higher yield than investment-grade bonds to compensate investors.
Investment Grade (IG) - an investment grade is a rating that signifies that a municipal or corporate bond presents a relatively low risk of default.
Exchange Traded Fund (ETF) - an exchange traded fund (ETF) is a type of security that tracks an index, sector, commodity, or other asset, but which can be purchased or sold on a stock exchange the same as a regular stock.
Federal Family Education Loan Program (FFELP) - a program that worked with private lenders to provide education loans guaranteed by the federal government.
Business Development Program (BDC) - an organization that invests in small- and medium-sized companies as well as distressed companies.
Job Opening and Labor Turnover Survey (JOLTS) Report - is a monthly report by the Bureau of Labor Statistics (BLS) of the U.S. Department of Labor counting job vacancies and separations, including the number of workers voluntarily quitting employment.
Sifma - The Securities Industry and Financial Markets Association (SIFMA) is a not-for-profit trade association that represents securities brokerage firms, investment banking institutions, and other investment firms.
Duration - A calculation of the average life of a bond (or portfolio of bonds) that is a useful measure of the bond's price sensitivity to interest rate changes. The higher the duration number, the greater the risk and reward potential of the bond.
Trust Preferred Securities (TruPS) - hybrid securities issued by large banks and bank holding companies (BHCs) included in regulatory tier 1 capital and whose dividend payments were tax deductible for the issuer.
Treasury Inflation-Protected Securities (TIPS) - are a type of Treasury security issued by the U.S. government. TIPS are indexed to inflation to protect investors from a decline in the purchasing power of their money. As inflation rises, rather than their yield increasing, TIPS instead adjust in price (principal amount) to maintain their real value. The interest rate on a TIPS investment is fixed at the time of issuance, but the interest payments keep up with inflation because they vary with the adjusted principal amount.
You should carefully consider the investment objectives, potential risks, management fees, charges and expenses of the fund before investing. The fund's prospectus contains this and other information about the fund and should be read carefully before investing. You may obtain a current copy of the fund's prospectus by calling 1-800-544-6060.
Fixed income investments are affected by a number of risks, including fluctuation in interest rates, credit risk, and prepayment risk. In general, as prevailing interest rates rise, fixed income securities prices will fall.
Past performance is no guarantee of future results. The investment return and principal value of an investment will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. There is no guarantee that this, or any, investing strategy will succeed.
Diversification does not ensure a profit or guarantee against loss.
Yorktown funds are distributed by Ultimus Fund Distributors, LLC. There is no affiliation between Ultimus Fund Distributors, LLC and the other firms referenced in this material.