Multi-Sector Bond Fund Commentary - December 2022

Macroeconomic Update

November was another positive month for risk assets as volatility tapered off and the yield curve continued to invert. There was a healthy bid for both stocks and bonds as investors began gearing up for year-end. Once again, the events driving much of the sentiment were a Federal Reserve meeting and a U.S. inflation report. 

The statement from the early-month Fed meeting struck a dovish tone while emphasizing that jobs data has been yet to cooperate with the Fed’s tightening efforts. The funds rate was increased 75 basis (bps) per expectation and the central bank acknowledged the natural lag between their actions and inflation data. However, Powell’s press conference felt more hawkish, and the market reaction reversed. He suggested a higher terminal rate and stated that the FOMC has not over-tightened. He added “it is very premature to think about pausing,” believing that the overheated labor market hasn’t yet shown the gradual softening they want, and that rates will need to be held at restrictive levels for some time. Meanwhile, there were no changes suggested for the balance sheet unwind.

A week later, good news followed, creating market hope that the Fed may yet pivot. The monthly CPI report came in at 7.7%, below the 7.9% expectation, as Treasury rates immediately rallied 20+ bps.  Investors were pleased to see a broad slowdown across the sectors of the CPI Index. Areas showing improvement included medical care, apparel, furnishings, airfares, and education, while the index of shelter costs remained elevated. With the CPI surprise tailwind, IG credit tightened 25 bps over the course of the month, and agency MBS turned in a fantastic performance with a 29 bp rally.  In Treasuries, 5s, 10s, and 30s rallied by 49, 44, and 43 bps, respectively. The 2Y, however, was less willing to capitulate, finishing at 4.31% after a move of 17 bps. Powell himself even emboldened this rally with a bullish speech on the last day of the month. It featured more friendly stances on the pace of rate hikes going forward (post-December moderation) and on the hope for a soft landing.  

Furthermore, inflation reports abroad showed slowdowns as well, as international risk assets outpaced the gains in the U.S. All eyes turn toward the next CPI reading on December 13th in hopes of continued momentum which could result in a less aggressive Fed.    

Portfolio Review

We have begun reaching the holiday months in the calendar. Market activity tends to get a little disjointed at this point in the year, with stop-start feel to it, and constant interruption of any momentum. With Thanksgiving at the end of the month, market participants at least had some excuses to pull back from being too active as they’d simply point to a turkey and shrug. The month itself started off with some optimism that new issuance would at least have a few days of activity and lift the market out of its doldrums, but those feelings were quickly dashed by inflation and rate fears, quickly dampening any year-end market activity hope. Although there certainly were a number of deals, especially in the early days of the month, momentum would cease by Fed speak, followed by Fed fears, or simply a recession headline. The bulk of new issuance was mostly concentrated in high grade, with high yield momentum sporadic and then extinguished by negative fund flows or a concern that an economic slowdown would prove damaging to credit sensitive issuers. This hasn’t been unusual since the rate hikes began, and the market seems comfortable in this new pattern. 

As expected, the Fed delivered the 75-bps hike in early November. Since then, anecdotal evidence and government reports continues to show some indication that inflation is ebbing somewhat. Nevertheless, jobs, employment and job openings, continue to surprise somewhat to the upside, keeping pressure on the Fed to continue on its course on rate hikes. During the month there were a few moments where it seemed the market was hoping for some indication of at least a slowdown. However, the Fed seems eager to push back on that through various speeches and insist it has much work to do. The market is starting to feel a little less on-edge with the Fed and expectations have now transitioned away from the 5.25% terminal rate the Fed seemed to indicate as a proxy for ending the cycle and is now slightly under 5.0%. 

Noted asset sector target or bias this month includes:

• Commercial and residential real estate is back in the news again. The latest focus has been Blackstone dropping the gate on redemptions from its mammoth Blackstone REIT (BREIT) fund. The fund typically has a quarterly maximum number of allowable redemptions but in the past, it typically hasn’t approached that amount and it has rarely been enforced. However, over the past quarter, the fund did hit its maximum allowed, and they ceased allowing redemptions for that quarter. The headlines were ominous, but the firm was aggressive about dispelling any negative connotations, simply indicating the move is allowed and merely prudent, given the relative illiquidity of the holdings. Both are true enough. However, the fund did sell some notable exposures, including interests in two Las Vegas hotels to raise cash. The news continues to be a bit worrisome around real estate. News like this feed concerns and with mortgage rates (well off highs, but still at levels not seen in years) at levels not seen in a while, there is still some fallout to expect. Certainly no one necessarily saw this type of response from what is considered a flagship fund for Blackstone as well as an industry one. We have had commercial real estate as a neutral sector, and continue to treat it as such, but we remain wary about being too aggressive in the sector in the near term.
  
  
• Bank paper overall has been a solid value, with the overall health of the sector strong. However, sub-segments have shown some cracks. Yankee banks have fallen somewhat out of favor, with Credit Suisse leading the negative headlines. The firm has been able to muddle through a right offering and while still considered a less than healthy competitor looks to have shorn up its capital. Nevertheless, the headlines have meant some contagion risk for other foreign competitors. We find value in some of the names, as there is typically a rush to lump all Yankee banks together when each has its own geographic strengths including foreign market liquidity. Thus, truly an issuer-by-issuer basis, but a place to find value. Community bank paper, another sub-segment, however, is one currently on our avoid list. The small deals the paper usually comes in is currently out of favor, and liquidity for secondary trading purposes has slowed. With the bigger investors in the sector, such as insurance companies, stepping back there are limited additional buyers. Thus, the liquidity premium continues to widen. Furthermore, the large exposures to commercial lending the banks focus on, while typically a strength, due to their familiarity with their own markets, needs additional due diligence as fallout from rates can mean a potential negative credit impact is on the horizon for some names. We currently like the banking sector overall, are positive on some Yankee banks but negative on the community bank sub-sector
  
  
• Treasuries continue to be a favored sector. Yields remain attractive, given the rate hikes. Furthermore, some notable pick-up is available in low coupon secondary paper, where there is some slight over-performance to be had as rate hikes continue. Overall, we remain more comfortable with certain parts of the curve, with the short end seemingly offering more upside from a performance standpoint. We remain constructive on the short end of the curve, 1-to-3-year notes which have rolled down the curve at heavy discounts, with additional interest in 20-year notes when looking further out the curve.  
  
  
• Corporate credit remains attractive, with a preference for defensive sectors as we ponder a slowdown in the economy once the calendar turns over. As such, we prefer consumer nondiscretionary and typical defensive sectors such as packaging. Other attractive value plays are found in Corporate Paper (CP). With the rise in rates, short paper, such as CP is once again solid value and provides an ability to ladder out the front end of maturities. Even better, because the chief competitor in the space is typically money market funds, significant upside and yield pickup can be found in tier 2 and tier 3 investment grade issuers, which money market funds cannot purchase due to SEC restrictions on credit quality. These investment grade issuers are well known names and brands, who have a desire to avoid issuing long paper in the higher rate environment which has also depressed supply due to end of year investor interest in new issue and incurring additional financing costs of that longer paper.
  
  
• Asset-backed securities (ABS) continue to offer value in certain segments. ABS spreads continue to be wide to historical levels, making them attractive, especially as some investor demand returns to corporates. The wider spreads make it appealing to buy up in the credit stack, finding more relative value in the A, AA rated area of the deal stack. As usual, we find auto ABS the more compelling sub-segment. Even with used car prices coming off their highs, levels are still historically strong and serious delinquencies remain muted, albeit starting to rise. One sector we continue to avoid in ABS, however, is personal loans and loan consolidation deals. The collateral is more personal loans, and thus uncollateralized. Furthermore, these deals have limited history and thus far have not gone through a period of time where the borrower has managed through an economic slowdown, meaning these types of deals have limited performance history in rougher economic times. We feel there will be some immediate hits to performance, once the economy slows and prefer to stay on the sideline as the market sorts itself out in those deals.  
  
  
• We remain constructive on Agency MBS at the current levels of rates and spreads, despite existing uncertainty surrounding the future path of rate volatility. The mortgage basis, defined as the spread between current coupon MBS and a blend of 5Y and 10Y UST, tightened substantially in November but still sits at a long-term wide. We believe the yield offered in Agency MBS more than compensates the bondholder for the product’s inherent risk of cash flow timing. Lower coupon, discount bonds offering characteristics that limit additional extension are among our top preferences from a total return standpoint. As an example, we like out of the money pools with geographic concentrations in states with high mobility and easy access to cash-out and refinancing.  We also see attractive carry in higher yielding, new products with spreads being wide, even though they are at risk to speed up in prepayment if the Fed pivots or Treasuries rally in an economic slowdown.
  
  
• Hybrids remain a neutral sector for us. We continue to like certain issuers, and while spreads have widened out, correlation to the equity market on pricing for these securities remains seemingly higher than normal. On a positive note, issuers are becoming more aggressive about exercising calls on the paper, as they contemplate the higher interest rate resets for those deals that have transitioned from fixed to floating rate. This type of response from issuers has investors revisiting the deeply discounted deals, anticipating at worst, attractive tenders for those deals that can’t be called yet. 

Positioning & Outlook

End of year activity can be a little sloppy. With another rate hike still on tap prior to year-end and the market settling into an expectation of 50 bps, there is still plenty of angst about rates to keep the market in a bah humbug mood. We also continue to watch credit conditions to see if big noise is on the horizon. There certainly have been headlines enough to expect some turbulence there. We continue to see more upside in high grade than high yield. However, we are also approaching the moment in the calendar where liquidity becomes a little tight, and those with dry powder providing liquidity can potentially target some issuers that produce over-performance as liquidity returns in the first quarter once the calendar turns over. As such, we prefer to hoard cash, ride out the turbulence and remain patient to take advantage if liquidity trades appear to our liking.  

With the market now expecting the Fed to step back or at least slow its hiking, there seems to be less angst in the market. However, the Fed continues to try and apply pressure through speeches. Nevertheless, we expect less angst in the market with regards to rates as we approach the end of the cycle and once the calendar turns over, a return to more normal markets. As we approach the year-end however, we remain conservative on new issuance, preferring to keep powder dry for opportunity trades and keeping risk shorter. We continue to prefer highly liquid and high credit quality at wider spreads names. We expect a 50 bps hike in December, followed by some indication of a slowing from the Fed. Maturities remain on the shorter side, but we like the 2–3-year corporate tenor in terms of value. We would expect duration to remain near current levels over the near term. 

Learn more about the Yorktown Multi-Sector Bond Fund:

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. 

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. 

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. 

Perpetual Preferreds (Perps) - Perpetual preferred stock is a type of preferred stock that pays a fixed dividend to investors for as long as the company remains in business. It does not have a maturity, nor a specific buyback date but does typically have redemption features. 

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.