Macro Update
July was a strong month for rates markets as the Treasury curve rallied substantially. The front end and belly moved the most with 2-year US Treasury yield lower by 50 basis points (bps) and 5-year US Treasury yield 46 bps better, as the 2Y-10Y and 5Y-30Y curvatures underwent significant bull steepening. Given the move lower in rates, wider bond spreads would often be expected to follow due to investor selling into the large rallies, but that did not happen this month as risk remained well bid and credit spreads stayed tight. Corporate credit fared steadily overall in both investment grade (IG) and high yield (HY), while asset-backed securities (ABS) spreads inched in and agency mortgage-backed securities (MBS) had a nice month with the mortgage basis tighter by 7 bps.
The big move in yields was driven by the impact of quality economic data on Fed expectations. The numbers were just what the Fed needed to firmly earmark September for its first rate cut, and the good news began the very first week of the month. To start, the Institute of Supply Management (ISM) Services Index declined much below expectations, factory orders from May decreased, and the June Fed Minutes were published which featured encouraging language on the progress of inflation. Two days later, nonfarm payrolls ignited a massive move in Treasury rates. The overall payrolls number for June rose by 206k, slightly over the forecast, but it brought net downward revisions of 111k from the previous two reports. Looking further into the data, the figure was supported by government jobs rather than private sector jobs, which fell off a good bit. The unemployment rate from the household survey rose to 4.1% while the change in average hourly earnings was as expected. With the pace of job creation slowing, September became nearly everyone’s baseline for a Fed Funds cut, barring any surprises in the following week’s Consumer Price Index (CPI).
On July 11th, CPI delivered and September became fully priced in for easing. June Core CPI rose 0.1% month over month against a projected 0.2% and year over year rose 3.0% vs. its 3.1% estimate. The report was better than expected and was what the Federal Open Market Committee (FOMC) had been hoping for. Markets celebrated, despite two more CPI readings still to come before the September meeting, as 2.5+ total cuts had become priced in as the expectation between now and year end. As the month wore on, other data and news supported these hopes. While gross domestic product (GDP) growth was on the strong side, the case for lower yields was made greater by disappointing corporate earnings, weaker consumer data, and an equity market tech rout. Meanwhile, the Fed’s preferred inflation gauge, the Personal Consumption Expenditures Price Index (Core PCE), arrived in-line and failed to cause any disturbance. July ended with the Fed’s mostly uneventful meeting on the 31st at which it held rates unchanged for an 8th consecutive meeting. The market rallied on some encouraging changes in the statement’s language and a benign press conference from Chair Powell. Demand has remained strong in spite of cooling labor markets and inflation, so the Fed plans to closely watch both sides of its dual mandate from here.
Yorktown Funds Fixed Income Focus – Stay the Course
"The true mystery of the world is the visible, not the invisible."
-Oscar Wilde
Driving on the highway, especially the crowded ones around the New York tri-state area, is a skill. Knowing when to exit a lane, when to move over and which lane to get into in slowing traffic requires skill, guile and a sixth sense. Years ago we relied on the traffic report on the radio to warn us of impending doom. But I had a co-worker who routinely ignored those warnings. His thought process was simple: by the time it is on the radio it is stale information and the more they repeat that advice, the likelihood that whatever was causing the traffic mess is cleared up and the report is now diverting traffic from what is now likely a clear road. So instead of avoiding the reported area of trouble, he’d drive deliberately into it. His instincts were usually right. Today, we have up-to-the-second GPS apps on our phone and so the information being given isn’t necessarily stale. I do feel my old co-worker’s rule is still valid though. Now we’re urged immediately to take detours to avoid a traffic mess. It’s far more timely, and yet, given to all of us at the same moment. And we all do as we are told, quickly exiting the highway onto a residential area street. The result? Hundreds of cars, inching through residential streets meant to hold a fraction of that type of traffic, and all of us crawling through a maze of four way stops, pedestrian crosswalks, and speed bumps. The problem thus isn’t necessarily the technology, in this case. No, it’s our willingness to be led by that technology. A reaction to our circumstances. A capitulation to the moment. A willingness to trust a faceless voice. So my co-worker’s assessment remains valid. The timeline simply is sped up. Perhaps if we had just stayed on our previous path, fraught as that technology had warned it would be, in the end most would’ve gotten out of our way, and our trip most likely easier. Sometimes the old ways are the better way.
It's been but a few months of sun, but we are now deep into summer and dangerously close to the moment when markets come to a crawl as a vacation exodus occurs. Or at least that’s what one would expect. This year seems to be a bit different, as there is heavy activity across the markets, and at a time which historically has been pretty dead in the markets, we are seeing daily volatility in rates and credit spreads. The markets are eager for more clarity on timing of the rate cuts. We have a daily battle on no cuts for September, one cut, and maybe, if the economic data is off a bit, a sudden thought that we might see one large, sooner than expected cut. All of this with the occasional spiking of credit spreads. So chaos, overreactions, and then, nothing. The next day, forgetting everything that happened even 12 hours earlier, we feel a soothing in the market. A gentle, guiding invisible hand, led by the dealers, indicating all is well, and the water is just fine. And everyone runs back into the water, and we see a sharp return to tighter credit spreads and even rates steadily selling off, resulting in treasury yields climbing. We believe there seems to be a lack of conviction in investor minds these days. A willingness to let an invisible voice or message push them back into waters they were so desperate to exit mere days prior. But like traffic apps, sometimes it pays to not be in such a hurry to follow those voices and better yet, to stay with your convictions.
We continue to follow that, especially when considering credit. We pay close attention to the credit markets, and that of the lower end of the credit spectrum on the corporate credit ladder. As we pointed out several months ago, the love affair between investors and private credit has been nothing but amazing in terms of the speed of the demand being built and the acceptance of the space as an investment option. The amount of money being pushed into the space is for sure impressive, but as we have mentioned, very worrisome. Too much too fast. Events seemingly are being ignored. Events that should cause a pause. One example? A recent Bloomberg article pointed out that a small, lesser-known, firm in the private credit space, a business development company (BDC), Prospect Capital, is having issues. Without diving too deep into the weeds, the point of the article worth highlighting was the BDC’s use of market gymnastics to keep its dividend flowing but also, from a credit standpoint, acknowledging the BDC’s portfolio companies aren’t doing so great. Bloomberg reported Prospect Capital had losses of some 3% of its overall value and 13% of its loan exposure were being marked at 80 cents on the dollar. This on top of concerns that the overall marks on the portfolio weren’t being done correctly and might even be inflated. And while it might be easy to shrug it off as one company within a sector having issues, those issues being brought up, such as losses within the loan portfolio, are the types that most in the space would be dealing with if one makes the assumption that most in the sector adhere to sort of industry accepted underwriting and marking standards. If nothing else, it is a reminder that we just haven’t seen a full realization of what the higher for longer rates have done to the bottom rung of the corporate credit world. As firms pile into private credit, we just don’t know yet how much of a toll has been taken on the health of this area of credit. We suspect a longer tail risk than most are willing to accept. And as such, the true outcome won’t be known for a while, but issues at Prospect Capital are somewhat of a leading indicator, and we do have some other clues.
Below is a chart reporting on the effective yield of CCC credits. Overall, the effective yield on the CCC stack would seem to indicate that credit is holding pretty steady and the concerns about a weakening corporate world are overblown. But the whipping around of rates is masking a great deal of this. Indeed, with rates rallying overall, but especially on certain days of data that indicate a bigger cooling in the economy occurring than one expects, the movements of changes to effective yield are buried.
Source: Federal Reserve
A quick look at the difference between the 10-year treasury and the 2-year treasury we believe shows that we are pushing toward a normal looking yield curve. Some semblance of normalcy as we gradually crawl out of an inverted curve. We aren’t there yet, but the moves are solid enough to make it look like we aren’t that far away.
Source: Federal Reserve
That would be the point. As dealers push out new deals and amplify a “hey we’re all good here” guidance to the market, charts like those above seemingly mask what is actually happening in terms of credit. As illustrated below, the option adjusted spread (OAS), a barometer of measuring credit, of the CCC world paints a different story. For CCC rated issuers, credit spreads are spiking. Thus, while the rate movements, especially the anticipated rate cuts, are spurring on a rate rally, it is blurring our vision some. By simply stripping out that noise, one can see that the spreads for the weak part of the credit stack are climbing. Worse, because these are the moments that one can get caught off-sides, the steepness of the spike in these spreads can be especially damaging on the wrong days.
Source: Federal Reserve
All of which brings us back to BDCs, the private credit sector, and shareholders or investors in the space. The sector is facing headwinds in terms of credit and expectations should be it will soften even more. But for investors it is worse. They not only have to worry about seeing an uptick in credit concerns, as the higher for longer rates take their toll on the underlying credit, but at the same time, with the rate rally, they are facing lowering yields. That is, most of the debt in the loan universe tends to be variable rate, which means that as rates rally, loans already issued will reset at lower coupons so investors will be reaping less yield at a time that credit is getting worse. In other words, not nearly getting paid for the risk they are taking. As we see from a quick look at the Prospect Capital story, that is not only concerning, but devastating to those holding the exposures.
Source: Bloomberg
The above chart illustrates just what type of damage we are looking at it. The reset of rates on loans is relatively benign, given the securities are floating rate, and duration so little, but as can be seen we are witnessing a drop in the loan prices overall across the industry, which based on what we are seeing is due to the higher credit spreads and less interest in the loans themselves.
Below is a chart illustrating a more favored credit, as a contrast. The railroad company, Burlington Northern Santa Fe (BNSF)*, which we use a 30-year exposure to get the maximum maturity risk. With 30-year risk, we can see some movement in credit spreads. If one looks at the chart below, it would seem to illustrate an increase in spreads. BNSF is a strong single A rated credit. That spread movement for the month of July 2024, moved from 91 bps to 98 bps, or a change of some 7 bps during a moment in the market where credit concerns were heightened. In comparison, during the same period, the CCC OAS moved some 110 bps. A 14 times multiple of spread widening exhibited by the stronger investment grade credit, BNSF, and a relatively simple example of why in this particular moment, we prefer the more liquid, higher up in credit trade.
Source: Bloomberg
We continue to see a lack of conviction from investors. A willingness to be steered to certain streets and avenues in the market which is prevalent in the overall tone of the market and an eagerness to run away from credit or run to embrace it almost on a daily basis. A guiding by invisible hands if you will. But trends illustrated in the charts above and current anecdotal evidence of issues at the referenced BDC are further examples of a slippage in credit. The data and trends support a move to the higher spot of the credit ladder. With yields, even after the rate rallies, healthy in stronger credits, it makes little sense to be pushed into reaching for credit in this environment.
We continue to stay true to our investment thesis and prefer the higher part of the credit stack as we move through this part of the market environment and rate and credit cycle. As we have seen historically, the market data is indicating potential issues in a near-term time horizon, and as such, we prefer to be more liquid and in higher credit quality, keeping our powder dry future opportunities that will occur once this part of the cycle ends.
Funds Update
What started as a trickle is now a flowing current of momentum, as rate cuts seem a near-term event. The continued march toward meeting lower inflation targets, and a cooling jobs market has resulted in the Fed changing its language in its most recent statement. Markets are preparing for at least one, and some are calling for perhaps three rate cuts. In our opinion, that seems aggressive, but one to two certainly seems likely. Yields on treasuries have already started to move in anticipation, with the 10-year treasury rallying from 4.46% on July 1,2004 to 4.03% by July 31, 2024; an impressive 43 bps move. The 2- year treasury move in a similar direction, but even stronger than the 10-year, moving from 4.76% on July 1, 2024 to 4.26% by month end. The yield curve remains inverted between the 2-year and 10- year treasury, indicating there is still some sorting out to do in terms of rates, but the overall movement was promising. The change in the Fed’s message, slight as it may seem, was another important step and we remain focused on economic reports for indications that the higher rates for longer did more damage than most are giving credit for as a clue to how aggressive near-term rate cuts might be. We remain loyal to our previous rate expectations and continue to position ourselves in a manner that focuses on future rate cuts. As a result, the portfolio remains positioned in a manner that best reflects those expectations and to best take advantage of the opportunities for overperformance prior to and once a rate cut occurs.
The past month brought more headlines of impending and current corporate bankruptcies, including notable subprime and lower income retailers such as Conn’s, a home goods retailer with stores in 15 states; 99 Cents Only Stores, with 371 locations, filed for bankruptcy in April, and Big Lots, with almost 300 stores, announced they have doubt about their ability to continue. The higher for longer rates seem to have done their job in cooling the economy, but retailers filing for bankruptcy, especially those that serve the lower income demographic isn’t a healthy sign for credit. Multiple ripples occur from events such as these, as they are indicative of that segment of the work force suffering, which would lead us to believe higher delinquencies on credit cards, personal loans and auto loans are right around the corner. And at the very least, closing that many locations for these retailers means more stress on the commercial real estate market to name just two. We have argued credit was priced to perfection, and it seems that might have been true to the point where a reaction to stress such as this means days where risk-off sentiment might cause spiking in credit spreads, most notably those deep high yield firms. We continue to prefer the up in credit trade, which should seem some insulation from the credit stress most likely occurring in the below investment grade credit space.
Healthy new issuance remains the rule. Heavy ABS issuance continues, including as noted the CLO space, and high grade corporate issuance remains robust. Some slowing in the HY market is evident, but that initially could be written off to some firms still hoping for a rate reversal so as to get funding at lower levels and others are tapping the loan market, with an eye to the variable rate coupons that debt carries and a potential opportunity to see a reset coinciding with rate cuts in the future to help alleviate some of the debt costs. Overall liquidity remains strong, with secondary markets operating at full capacity and dealers seemingly eager to position paper. However, with the occasional risk-off days, it is a reminder that certain liquidity outlets might slow under the wrong credit environment for the wrong credits, especially “story” credits that even in the best of times have uncertain liquidity characteristics. With an expected slowing of the economy in our sights, moving to more liquid, household corporate names with solid IG ratings is more important. We covet the higher liquidity attributes for current mitigants against aggressive credit spread widening and for future ability to raise cash if opportunities to take advantage of credit fallouts surface.
We continue to find favorable market conditions in the fixed income space overall. Liquidity market depth remains adequate, allowing for execution and aiding flexibility when needed. The market still believes credit to be in a strong position, but we are wary and remain vigilant for slippage. A soft landing now feels more up in the air than it previously has, as a clear cooling in the economy is occurring. The market eagerly anticipates a near-term rate cut.
Noted asset sector target or bias this month includes:
The rate rally has legs. With jobs numbers cooling and other economic data indicating a step back, rate cuts seem right around the corner. With credit priced to perfection, recent missteps, including those mentioned in retail, lead us to think credit spreads will eventually widen and there is a scenario where the snapback is a spike rather than a gradual climb. As such, we do expect at least one rate cut and perhaps a bigger one than imagined even a few weeks ago, is in the near future. As a result, we continue to prefer to be defensive, strengthening credit, reducing risk and moving to more liquid exposures. The front end of the yield curve (the 1-3 year maturity area) is the place that we expect to see the most value, and the part of the curve most likely to overperform in the near-term. Longer duration is targeted in an effort to capture wider current yields in certain highly liquid names, which should overperform in most rate rallies and possibly certain credit events. Duration is relatively stable to the last few months, and we expect it to remain at current levels near-term.
*As of July 30, 2024, the Yorktown Multi Sector Bond Fund had approximately 1.2% of exposure to BNSF, and 0.30% exposure to BNSF 5.2 04/15/54.
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.