Treasuries rallied for the 4th consecutive month as markets turned in a nice performance following heavy volatility to begin August. The curve bull steepened with the 2-year US Treasury lower by 34 basis points (bps) while the 5-year US Treasury and 10-year Treasury were better by 21 bps and 13 bps, respectively. In line with recent trends, the moves were driven by cooperative economic data which backed up the Federal Open Market Committee’s (FOMC or the Fed) current reading on labor conditions. Investors continued to plan for a September rate cut along with pricing in an additional three cuts by year end.
To begin August, the Institute Supply Management (ISM) Manufacturing Index declined more than expected with demand and output contracting. A day later, Nonfarm Payrolls had a big downside miss of 114k vs. an estimated 175k. The report brought more downward revisions and furthered a selloff in equities and credit that had started with a Japanese stock market rout. As a result, the market began pricing in more than four total rate cuts through year end, as the soft landing concept seemed to be losing plausibility to some. A jump in the unemployment rate and lower average hourly earnings especially seemed to support this, but with Fed easing and disinflation it still feels possible that recession can be avoided. While the jobs data certainly made a strong case for imminent Fed action, most investors remained in the camp of an initial 25 bps cut rather than 50 bps. Meanwhile, notably, into major market volatility the next week (along with an ISM Services Index beat), the yield curve briefly disinverted for the first time in two years.
Inflation data was up next in the week of the 13th. Wholesale inflation rose less than expected in July while the Consumer Price Index (CPI) showed up in line with expectations. July headline and core CPI were on track, while their 12-month counterpart figures each slipped by 0.1%. It was a solid report for the Fed and rates rallied accordingly as the slowing inflation trend continued. Undoubtedly, restrictive policy has dragged successfully on labor conditions, even if the year-over-year inflation rates still remain high.
A week later, the Bureau of Labor Statistics released its preliminary review of annual employment data which showed a downward revision of 818,000 jobs from March. It was the largest revision lower since 2009 and offered additional affirmation for the Fed. At the Jackson Hole Economic Symposium two days after, Jerome Powell pushed home the message. Powell said that the “time has come for policy to adjust.” While taking the usual line of data dependence, Powell cited a cooling labor market while expressing belief that inflation is on the 2% track. The risk balance has shifted a little more towards the labor market and a little more away from inflation.
“And so we're running just as fast as we can
Holding on to one another's hand
Trying to get away into the night
And then you put your arms around me
As we tumble to the ground and then you say
I think we're alone now
There doesn't seem to be anyone around
I think we're alone now
The beating of our hearts is the only sound”
Ritchie Cordell, as sung by Tommy James and the Shondells
I’m not a huge fan of horror films. Not really my thing. The last one I probably watched in a theater featured a doll running around town terrorizing people with a large knife. By the way, not typically a huge fan of rules to live by overall, but if someone is asking, here are three important ones: 1) if someone asks you to sit down in a room surrounded by candles and use a Ouija board, you should say no; 2) if for some reason you and seven friends are trapped in a house with a lunatic wearing a hockey goalie mask, don’t split up and definitely don’t take a shower; and 3) there isn’t any upside to following a disembodied voice urging you to step further and further into a foggy marsh. All the horror films I have seen seem pretty formulaic. And there is always one specific trope to count on: no matter what the location, you can pretty much count on that one scene where someone just starts running. They think they are running away from something or someone. Relief. Left all that danger behind. Eh, not really. Because when they stop running, it suddenly dawns on them and us that they have outrun everyone else and are now solo. No one else around. They always seem confused. As if they can’t figure out how they got there. But they are suddenly not so excited at what they did. They simply ran too soon and too fast.
One of the interesting things we have been paying attention to for a while has been the variety of opinions on what this higher rate environment means for high yield corporate credits. We have spent a great deal of time looking at credit spreads and what they may or might not mean for various sectors in the corporate landscape. We have spent some time looking at and analyzing the fallout for commercial real estate not only from the overall effects on office space due to the “remote working” impact on occupancy levels of various buildings, but the additional negative effects of the higher rate environment as it relates to financing and falling valuations, as well as delinquencies and ultimately defaults of those buildings. But now that rate cuts are in our sightlines, we are beginning to see an interesting pivot. There seems to be a deep sigh of relief. As if corporate credits have somehow managed to make it out of the forest of high rates unscathed. Even a rush to embrace a theory that with interest rate expectations now focused on rate cuts, all will be healed. In other words, we haven’t even gotten to the first cut yet, and there is a sense in the market that rate rallies are coming just in the nick of time to help bail out a bunch of troubled, weak corporate credits.
We might be spiking the football too soon.
High yield or sub-investment grade firms don’t always have the luxury of being patient when it comes to funding. One of the bigger reasons firms are typically rated below investment grade to begin with is that they utilize a large amount of leverage, and that heavy debt burden causes their balance sheet ratios to rise to levels where rating agency methodology dictates they must be rated below investment grade. Indeed, forget about cash needed for expansion or merger targets, a majority of those firms don’t have the ability to rely on cash flow to keep themselves operating, and thus require the ability to borrow to keep the doors open. As illustrated below, while firms tried their best to hold off issuance over the past few years, during the higher rates period, they just couldn’t wait forever and a decent amount of issuance occurred. Even for 2024, where we have seen a solid rate rally at the very best, one could argue these firms are getting a running start in terms of funding themselves, but least we forget, they are still doing so at a time where rates might be off highs, but are still at levels very much above what we have seen in the recent past.
Source: SIFMA
Source: JP Morgan
The relative good news is that we aren’t necessarily facing a daunting maturity wall for sub-investment grade corporates, whether they utilize the bond or loan market to get that done. It’s not great, but the bulk of the expected maturities, according to Bloomberg data, is not expected until we hit 2028. A lot can happen before we get there. It doesn’t however change the fact that near-term there is still some $1.0 billion still to be refinanced over the next two years. Thus, no matter how you look at it, unless something drastic happens, again, firms are going to still have to navigate refinancing in a less favorable environment than that which they feasted on post-covid when the 10-year treasury was sub-75 basis points (bps).
Source: Bloomberg
It also doesn’t change the fact that because of necessity these firms that inhabit the lower end of the corporate credit risk spectrum have already had to take down funding during a moment when interest rates were at their peak. A good example of that is illustrated below. One can see quite a shift from one year to the other in terms of expected bond near-term maturities. The significance is that as firms placed or refinanced debt further out, they did so at higher rates. For instance, for 2025 it would be almost 50% of the expected maturities.
Source: Bloomberg, Schwab
Make no mistake about it, for firms that don’t have a great deal of financial flexibility and have limited cash flow, these things are significant to their ability to not only stay competitive but also simply to stay operating. But how much are we really talking about in terms of cost? Below is a chart exhibiting the effective yield for sub-investment grade corporate credits. If we use effective yield as a proxy for new issuance coupon expectations, then one can see that the cost to a firm in terms of rates, or in the case of the chart, the effective yield over the past two years is being accomplished in an environment not seen in the past 5 years. The only exception during that time being the covid spike prior to the Fed flooding the markets with support and liquidity. And that is the point. For the covid spike was a blip in terms of time, a 3-month period at worst, in which firms, all firms, stepped away from the market. Whereas this time around, firms have had to deal with this for some 2 years and didn’t have the luxury of waiting for the market to calm down.
Source: Federal Reserve
We’re already seeing the impact in a few different ways. Some subtle, some not so. More subtle is the gradual deteriorating levels of interest coverage for firms in the sub-investment grade space. Below is an illustration of that interest coverage ratio. For high yield corporate credits, we continue to observe a shrinking margin. But make no mistake, it is indicative that the interest being paid on outstanding borrowings is eating into their safety cushion. These firms don’t have the flexibility nor the financial strength to withstand that for long. The not so subtle? We continue to see headlines of corporations failing. Every few months there seems to be a growing list of troubled sub-investment grade corporates hitting the bankruptcy dockets. In the last two months alone, we have seen some $7.0 billion of debt involved with these firms’ defaults because of their troubles, including Wheel Pros, ConvergeOne Holdings, 99 Cents Only Stores and Big Lots*.
Source: Standard & Poor’s
It’s important to note we continue to see an extension of the higher borrowing costs for firms on an on-going basis. Firms feasted on low rates in the past, and now, even as rates rally and borrowing costs drop off their highs, those firms are faced with refinancing at levels significantly higher than ones they had on that maturing debt. As such, it reminds us that it might be a little too early to relax. There is some tail risk, especially in high yield, as a result. There are beliefs in the market that we ran away from the higher rate bogeyman and made it to safely out of the house. We just want to make sure we didn’t run too fast before we take a deep breath of relief.
There is a longer tail risk than most seem to be appreciating. We continue to monitor the situation and stay vigilant. We prefer the higher ground in terms of credit still. We want to stay on-top of this situation, however, for we do feel down the road, once the smoke clears, we will see future opportunities as a result. That will allow us the moment to use dry powder on targeted sectors and firms to help build future overperformance.
Funds Update
Rates. The expectation of an impending rate cut is a daily drumbeat now playing the back of the financial markets. Every day, yields on treasuries seem to be illustrate the general market acceptance to this. Market news now reflects that feeling, with each report headline reinforcing this, no matter what the data may or may not exhibit. Additionally, Fed speakers are out in force, gently reinforcing the market expectations. The question no longer is whether this is going to happen in September, but now a debate on how much, 25 bps or 50 bps. We continue to lean into 25 bps, given this FOMC’s history and push of a narrative that they weren’t in a hurry on the way up in terms of rates and won’t be in a hurry on the way down. Data between now and then may shift that, but as of right now, that seems to be the proper narrative. Yields on treasuries continue to represent this market stance, with, as expected, the 2-year treasury rallying 23 bps over the month of August, which was far and away stronger than the 10-year treasury which rallied 8bps. With this move, the curve has started to no longer be inverted. We expect the trend to continue. The positioning of the portfolio is reflective of these rate expectations and further rate rallies. Especially the rally we expect to eventually see in the front end of the curve. Additionally of note is the back-end of the yield curve, which continues to rally as well, and offers some future overperformance opportunities in the right targeted issuers.
The rate rally has some wondering if the lower end of the credit stack is going to see some reprieve and be able to take advantage of easing of rates to refinance more favorably and potentially create a lifeline to some troubled credits. This seems unlikely. Those operating currently under stress will be challenged to take advantage of this, given the market will be uninterested in battered credits. The bigger news this month was in the financial sector where B. Riley, a small broker dealer, which tapped the large retail market for funding, came under stress. The impact to the baby bonds market and retail was headline worry and caused some more damage. Furthermore, there seemed more stress in terms of movement in credit spreads in the lower end of the credit stack. Expect more stress in the credit market going forward, and a reason to move to higher ground in credit for more investors, further exacerbating the credit spread widening. Over the past year we have made a concerted effort to move up in credit, and we continue to find value in that thesis as we enter a new rate environment phase. We prefer higher ground here, and wait for more negative news in the high yield market which should lead later to more opportunities in credit as additional tiering is created in issuers.
The month of August was void of any real issuance. There was sporadic new issue at the beginning of the month followed by weeks of quiet. With vacation in full swing and the long Labor Day holiday weekend looming, that was to be expected. But right out of the gate in early September, the market was awash with new issue, threatening and breaking primary issuance records in terms of volume and number of deals. All of these were signs of a healthy fixed income market. There is plenty of demand for new issue and dealers are anxious to bid paper in the secondary market. Liquidity remains strong and ample. With rate cuts around the corner and demand such as this, stale deals and esoteric assets will find some reception as well. It is a good time to prune less desired holdings or those that have reached their return targets. We continue to use the opportunity to do so and add targeted issuers and sectors which we expect to help create overperformance in the near term.
A similar theme of the most recent months: favorable market conditions, including liquidity aiding our ability to continue adding to targeted opportunities. We stay wary of credit, expecting some fallout but more importantly widening corporate credit spreads. There remains far more value away from certain corporate credit sectors (see below) in our opinion. Rate cuts are around the corner as value and opportunities seem more prevalent in rate-based products and less so in chasing credit.
Noted asset sector target or bias this month includes:
Rates continue to rally. Employment data and other economic data releases point to a cooling economy. There seems less risk of a recession. Nevertheless, there remains concern in a few pockets from a credit standpoint in the data. We continue to expect further fallout in commercial real estate, with retail spaces joining office spaces as an area of concern as the softening economy hits that sector. Mezzanine financing in real estate also remains a point of worry as the capital structure of those loans takes a hit above the equity. Private credit also continues to be an area to worry about. There is some fallout in that on the horizon, we feel, and as such risk assets and high yield could potentially experience the ripple and cause further widening of credit spreads. All of this pushes us to take a more defensive approach. We remain focused on highly liquid, targeted defensive sectors and exposures, as well as seeking opportunities within rate movements with the potential for higher returns. The front end of the yield curve (the 1-3 year maturity area) still offers the most value, but there is some further value becoming more apparent as well out in long maturities, such as the 20-year locus. This provides benefit in longer duration targets, where higher yields in the more liquid names can still be found. Duration targets continue to be similar to the last few months, and we don’t expect that to change in the short-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).
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.