“There will always be rocks in the round ahead of us. They will be stumbling blocks or stepping stones; it all depends on how you use them.”
-Friedrich Nietzsche
We are getting closer and closer to that time of the year when all the local towns around mine seem to be in a street fair frenzy. Weeks away from that moment when you turn down a Main Street and come to the realization that in your quest to make your wife happy by taking her to her favorite yarn store, you have made a horrific mistake as the street has been shut down for this week’s street fair. I don’t really mind street fairs in general. If I am planning on going, fully mentally prepared, they are typically a fine way to spend a nice day. But I have found while they do promise a lot, the payoff never meets that level of promise. The food options are the first chink in the armor. The immediate response in my brain is that there are a lot of food options at them. There seems to be unlimited options. But on closer examination, you realize it’s all pretty similar. And absolutely none of it is good for you. I am older now, so this can be like tip-toeing through landmines. I’m older now, so I am attempting to eat healthier. The younger me would plow through the endless deep-fried offerings. The older me is looking for the guy making asparagus smoothies. Eating healthy isn’t super easier. And at the street fair, almost impossible. Not sure what food group the deep fried twinkie is a part of, or just where on the food pyramid the deep friend Oreo resides, but pretty sure anything that could be buried in the desert for 100 years and once dug up, still be recognizable as a deep fried twinkie, isn’t super healthy for me. But boy there sure is a lot available at the street fair. A. Lot.
For the fixed income market, “a lot” these days seems to describe the private credit market. The headlines are endless, and so it seems is the capital available for this exploding sector. If there isn’t a headline about some large shop raising money yet again for another fund effort, there is a headline about how this shadow banking segment is taking vital turf away from the large banks that used to have the playing field all to themselves. We’ve discussed the sector before, but to refocus, we are talking about a lot of money pouring into the sector. According to Prequin, at the end of the second quarter of 2023: assets under management (aum) for the private debt sector was $1.7 trillion, including invested capital of $1.2 trillion and dry powder (commitments not yet drawn down) of $503.6 billion. But a recent JP Morgan report thinks those numbers are way short of what it actually is, as that estimate ignores segments like Business Development Companies (BDCs), and as a result, puts the aum figure at more like $3.1 trillion on a global basis, including dry powder. That is a lot.
Source: Federal Reserve, Prequin
There is usually much ballyhoo about how private credit can be a better fit or even represent a better credit risk than traditional senior secured loans, as the direct lending route often means that the lender is the only one on the deal and can dictate provisions to better insulate themselves in case of a credit disruption. But the obvious retort to that is simply: an entity wouldn’t go that route unless they had to. And that would seem to be the case, as JP Morgan indicated that private credit in March of 2024 was pricing some 160 bps wide of B3-rated syndicated loans, which is an actual improvement from year end 2023, when it was 188 bps. So the implication is that there is greater credit risk in the private credit space, simply as measured by credit spreads.
For our purposes here though, we want to consider just how influential the sector is becoming. The growth is directional, the headlines influential, and the risk is starting to become, well, potentially uncomfortable. There have been recent headlines starting to awaken to the fact that this is rapidly becoming a large barometer of what is happening overall in the credit space. Furthermore, as bank CEOs like to point out, it is an unregulated market. The Fed likes when risk is pushed into the private sector, and into the shadow banking system. Until, well, they don’t. It’s a tough balancing act. As we have seen historically, unregulated markets with outsized credit risk, can be a problem when they stumble. And a stumble on the rocks for this sector would surely create large problematic ripples across the credit markets.
And just how are we doing health-wise? Well, not great. It’s important to remember that most if not all the debt in this space is variable rate or floating rate, and with rates spiking that has meant these firms, at the lower end of the credit spectrum, are dealing with financing costs that are obviously putting a strain on them. As can be seen below, the ability to simply meet the interest owed is certainly being squeezed. Furthermore, firms have to keep using this as an option. According to Pitchbook, of those deals that have come to market in the private credit space, 47% is for general debt or corporate purposes and 21% is for debt refinancing. In other words, around 68% of the deals in this space are simply to keep the firms operating.
Source: Kroll Bond Rating Agency (KBRA)
For us, following this area of the market serves a few purposes. Given our near-term outlook with regards to corporate credit, we follow the private credit market for clues on how the overall credit market is going. We would consider it a proxy, a canary in the coal mine if you will, for how we expect near-term credit to respond to the high-rate environment. And those higher rates are clearly taking their toll in credit and in terms of credit spreads as well. Private credit markets are populated mostly with credits rated B- and lower. Below is an illustration of just how the CCC credit spreads overall are reacting to the stress of the higher rate environment.
Source: Federal Reserve, Prequin
We have been of the opinion that as we move through the cycle, and the economy cools, we prefer to be further up the credit stack. Our preference has been to be more concentrated in higher quality names. And with the influence of the private credit market growing, our expectation that it will stumble, causing bigger and bigger headlines, and the already weakening of credit spreads in the CCC space, we feel we are seeing more and more the risk of not doing that growing. There does seem to be some consensus in the markets to this already here. Indeed, the spread differential between BBB and CCC credits is now trending above the 3 year average; an average that prior to the rate hike cycle was benefitting from incredible appetite for yield and risk in order to scratch out returns with investors reaching for that yield. Furthermore, as we have discussed, corporate credit overall is current seeing historically tight credit spreads….well, except for here, where we are seeing widening.
Source: Federal Reserve
To further illustrate our current preference for higher rated securities, below is a chart illustrating the difference between single A credits and BBB corporate credit spreads. Here one can see that the spread difference between single A and this particular comparison, weaker BBB credits, are actually tightening. Or more importantly, trending in a vastly different manner than the BBB to CCC credit spread illustration above and more in line with what we are seeing overall in terms of corporate spread tightening. The trend in this case would be supportive of our view.
Source: Federal Reserve
We highlight the private credit and direct lending sectors due to their growing importance to the overall markets. As more and more money pours into the space, and it becomes not only more influential, it also has the ability to shake markets if there is a stumble. A rapidly growing, unregulated market like this has a potential to cause outsized movement, especially given it hasn’t been tested in a stress scenario. As such we watch it closely for clues how credit will handle a slowing economy. Furthermore, as a proxy for the overall CCC market. Given that market is already undergoing spread widening, during a time when the rest of the corporate credit markets are tightening, it makes us vigilant in watching for stumbles in that market as it could cause a spiking of spreads in the lower end of the credit stack.
Most importantly it confirms our view that in this market, we want to be higher up the credit stack. Indeed, given our long-term outlook on credit, we continue to prefer using this market and the yields available to move more into higher credit quality and more liquid names. The opportunity for overperformance seems to be far more available in a market such as this, and should provide some insulation if markets such as private credit stumble and even crack. To be clear, we don’t expect a massive credit mishap, but we do expect further widening and feel far more comfortable with the opportunities available for future overperformance by remaining more liquid and at the higher perches in the credit stack.
Funds Update
Rates and credit spreads, oh my. This month was a mixed bag of anxiety and fear in the market. Rates continued to be the story, with economic data continuing to push the inflation fear. The data continues to push the rate cut narrative back further in the calendar, despite the building of anticipation that it is only going to take a little nudge to get the market back into believing rate cuts are on the horizon. Nevertheless, the data has been stubborn, and by the end of the month, we started to see whispers that another rate hike might still be a possibility. The Fed seems to be taking this in stride, and we don’t necessarily see that type of response. Instead, we continue to see rates more in a holding pattern near- term, despite the overreaction on a daily basis to headlines. We still anticipate that we will see a rate cut or two prior to year-end, with the timing of those actions possibly skewed due to the calendar and the upcoming election. As such, our rates outlook remains similar to previously discussed, and we continue to position the portfolio in a manner to best take advantage of where we are in terms of those rates, including duration targets where we anticipate the best place to be camped once rate cuts do commence.
Credit spreads on the other hand continue to grind in. Corporate credit spreads are reaching levels not seen in quite some time, and ABS spreads have also been aggressively compressed. We continue to believe this to be more a response to investors blinded by the higher yields due to the rate environment, and willing to overlook the proper pricing of credit as a result. As such we remain wary about chasing corporate credit in a manner where spread reversal and widening to levels more appropriate for the risk being taken.
Part of the credit spread compression has to do with heavy demand still being seen in new issue. The primary market remains wide open and issuers have been aggressive about taking advantage of the investor demand. This has been especially true around financials and corporates near their reporting of most recent results. Secondary trading, while robust and with liquidity plentiful, has taken a backseat of late and there have been days where the heavy primary issuance calendar has made secondary trading an afterthought. Nevertheless, we would still consider liquidity in both the primary and secondary markets as readily available. As we continue to focus on properly reassessing the risk and performance of securities in the portfolio, the ample liquidity continues to provide us access to move out of positions that don’t meet credit preferences or have attained levels of performance and move into other exposures that we feel will provide a foundation for future overperformance.
We continue to categorize the current markets as flexing strength. Some credit cracks are beginning to surface, and as we anticipate some future downdraft in employment numbers, we feel that credit continues to be an important focus. We continue to feel a soft landing is not out of the question, but at this point, given corporate credit spreads, would anticipate any downward momentum will be perhaps overreacted to. As such, we remain on the same path as the past several months with a focus on: higher credit quality, liquidity and diversity.
Noted asset sector target or bias this month includes:
- Similar to corporate credit, ABS has seen significant spread tightening across the capital stack in new issue deals. There is a grabbiness to deals and some eagerness for esoteric asset classes. Recent esoteric deals include music royalty and art auction loan deals, as well as whole business. The landscape seems aggressive, and while we still find value in certain segments, we are wary of the reach by the investor base, especially those chasing the esoteric part of the market. We continue to find value in a few sub-sectors in ABS, including seasoned auto paper, and new issue equipment leasing. We consider student loan ABS and new issue credit card transactions as sectors to avoid, due to concerns on the political impact of the current administration’s efforts with regards to student loans and rising credit card delinquencies as the consumer grapples with the higher rate environment.
- As a sector, investment grade (IG) corporate credit overall remains neutral for us. We have a preference for short IG paper and securities. Given our rate outlook, we have interest in certain targeted names further out to the curve as we selectively consider certain duration levels and maturities we expect to be beneficial areas to be exposed to. We covet the liquidity profile of these credits, and expect if credit does begin to widen, those names will serve as flight to quality trade targets, helping mitigate any future overall corporate credit spread widening. As discussed, current credit spreads are tight in terms of historical levels, and as such, we want to avoid deep high yield, single B and CCC, exposures, which we feel will see sharp spikes in spread widening if economic conditions slow.
- Bank paper overall has been abundant as all corporate paper has, given the massive issuance schedule. However, within the bank sector, given the current rate environment, banks have been especially aggressive about calling preferreds and hybrids before the coupon changes from fixed to floating rate. As a result, there has been heavy new issuance in bank preferreds, which have been one of the better performing sub-sectors in fixed income. We continue to consider this sub- sector attractive. However, we also continue to prefer large global banks within this group, given their diverse balance sheets, global reach and strong capital positions over smaller, community bank exposures who still have balance sheets exposures to problematic commercial real estate loans to deal with.
- Agency debt is an attractive sector in this current rate environment. Paying attention to the optionality of the calls however is key to capturing full performance. Nevertheless, the sector provides the ability to front load and properly build the front of any bond ladder with the highest level of credit and liquidity. With the shape of the yield curve, it also means doing so with strong and valued coupons. We continue to find strong value in this sector.
- Agency MBS struggled in April following a positive March. Current coupon dollar prices were down close to two points with the basis widening around 15 bps and rates selling off substantially. Prepayment speeds started to pick up into the spring season but they remain muted greatly as nearly the entire mortgage universe is out of the money to refinance. At present we expect some volatility which may contribute to spread widening in the near term. Higher supply in the spring along with largely absent bank demand and some money manager selling represent possible headwinds. Nevertheless, our longer term outlook remains positive. Mortgage bond spreads are still relatively wide as technical MBS demand has not returned following banking issues a year ago. Notably, the current level of interest rates offers long-term performance potential for rate- driven products, leaving MBS return profiles highly attractive. Furthermore, we believe the asset class looks relatively cheap to corporate debt. Higher coupon securities at reasonable valuations offer sufficient carry to weather some of the aforementioned near-term market volatility in MBS, if needed. Furthermore, unlevered buyers can envision good longer-term total return profiles in the wings of the 30Y stack.
With rates at the forefront, credit spreads seemingly are flying under the radar. The excessive tightening in terms of credit seems likely to reverse near-term. The economy is starting to show some small signs of slowing, despite the most recent CPI report dominating most of the headlines. As such, we continue to feel comfortable maintaining our targets, using the moment to find some opportunities in highly liquid exposures in focused maturities. We continue to be more defensive, with the understanding that the current rate environment still provides future benefits in those securities that we treasure, including liquidity, strong credit and diversification. The front end of the curve, the 1-3 year maturity area, still provides near-term overperformance benefits, while certain names at longer durations represent significant longer-term upside. Duration remains similar to the last few months, and we expect it to stay in that area for the near-term.
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.
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.
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).
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.
Home Equity Line of Credit (HELOC) - A home equity line of credit (HELOC) is a line of credit that uses the equity you have in your home as collateral.
Government-Sponsored Enterprise (GSE) - A government-sponsored enterprise (GSE) is a quasi-governmental entity established to enhance the flow of credit to specific sectors of the U.S. economy. Created by acts of Congress, these agencies—although they are privately held—provide public financial services.
Qualified Mortgage (QM) - A qualified mortgage is a mortgage that meets certain requirements for lender protection and secondary market trading under the Dodd-Frank Wall Street Reform and Consumer Protection Act, a significant piece of financial reform legislation passed in 2010.
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.
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.