Multi-Sector Bond Fund Commentary - February 2024

Macroeconomic Update

January was a mixed-performance month that nonetheless featured its share of positive sentiment.  However, following nine weeks of market euphoria, things admittedly cooled off a bit, as the first several days of January brought higher rates and wider credit spreads. This felt like a product of self-reflection as investors paused to examine the intense dovish turn this winter as rate futures markets reduced their implied March rate cut odds from 86% to 71%. The December FOMC minutes released early in the month suggested that policymakers do believe that the funds rate is most likely at its peak and that cuts are coming. Still, they were intentional in stating that some uncertainty does remain. In short, no one at the Fed is willing yet to write off further tightening, but progress on the data is undoubtedly positive.

On the 5th, nonfarm payrolls for December arrived a touch stronger than expected, bringing good wage and earnings data, as well as two months of downward revisions to payroll growth figures from this fall.  The report was within the range of expectations, but the bond market seemed to react to the headline number and average hourly earnings, with yields moving higher and fewer cuts being priced in for 2024. Meanwhile, the Institute for Supply Management (ISM) services composite was softer than expected and represented the weakest report in three and a half years. 

Next was December CPI, and it was a little worse than expected, with core and headline higher by 0.3%.  The 6-month inflation rate was a bit at odds with the ongoing progress we’ve seen, but it was not enough to question the overall inflation trajectory. Rather, it was a data point that suggested we are less likely to see a first-quarter rate cut. Many Fed voices – Mester, Williams, Waller, etc. – have pushed back on the idea of a March cut, saying that there is still too much uncertainty in the path to 2% inflation. More disinflation may need to be seen before the Fed discusses a cut.

Later in the month, some stronger economic data had the market wondering if it had realistically gotten ahead of itself with its dovish bets. Strong retail sales and consumer sentiment pushed yields higher, reversing a previous rally around CPI. However, the ensuing Personal Consumption Expenditures (PCE) inflation numbers were pretty good, as were GDP and consumption, and these helped restore the message of moderating inflation that can coexist with economic growth.

Lastly, the January Fed meeting concluded on the 31st. As expected, the central bank held steady and said that it doesn’t likely see rate cuts until it’s more confident that inflation is nearing 2%.  With current March rate cut odds now less than 50%, the question will be whether February’s core PCE will be encouraging enough to give the Fed said confidence. In his presser, Powell stated that he does not expect the committee to have the confidence it needs by the March meeting, but the market still believes the decision is on the table and remains in tossup territory.  After all, the last six months have produced enough encouraging data to feel some degree of optimism when it comes to the landing.

Portfolio Review

The beginning of the new year started to feel like a rerun of last year; all encapsulated in one month. The month started off with some hope, with the 2-year treasury at a 4.25% yield. By mid-month, it had sold off. Then, after the Fed meeting at the end of the month, it rallied furiously, some 13 bps to close the month at 4.21%. Because of the inversion of the yield curve, the 2-year seems to be where one would expect the most movement that might provide a clue as to where we are headed. We continue to watch as the FOMC trots out speakers and interviews to get their message out in the market. And the Fed seems eager to push the market into believing that no rate cut is imminent and they certainly could raise rates again. In other words, don’t get too comfortable. The market has been predictably jumpy in terms of rates as a result, and each new economic report seems to whipsaw rates in either direction depending on the numbers and whether the Fed was expecting that or looking at it. The market is slowly losing faith in an end-of-first-quarter rate cut but still has faith in such a thing occurring in the second quarter. We continue to focus internally on an investment thesis built around a controlled but slowing economy that will be supportive of a rate cut. We have used the daily gyrations in rates as moments of opportunity to invest at certain points that we feel may produce overperformance once the volatility slows. Thus far, data and market reactions continue to be supportive of that position.

Overall the market was firing on all cylinders starting day one of the new year. Primary issuance on the corporate side, including investment grade and high yield, was robust. The new year started with a bang, with numerous deals that were seemingly pushed back at the end of last year all coming to the market at once. The heavy issuance was met with aggressive demand, with most deals being heavily oversubscribed and investors who had been quiet the last few months suddenly clamoring for new product. This was equally true in ABS, which seemed to have an insatiable demand for deals of all kinds, including subprime auto, point of sale and marketplace lending (MPL), and equipment leasing, which all seemed to be greeted by strong demand. The strong primary demand meant credit spreads, which were already tight in corporates, tightened a bit more, and ABS, which still had some prior slack, tightened considerably. Liquidity remains quite strong overall, and whatever investors paid in terms of a premium to sellers in the last two months of the previous year dissipated. We took advantage of the moment to sell into the demand, allowing us to move out of exposures that had reached targeted levels and add value opportunistically in exposures we felt had more upside still to capture.

Noted asset sector target or bias this month includes:

• Corporate credit spreads continue to tighten into heavy issuance, making overperformance difficult to capture in that type of environment. We like corporate paper for its liquidity and diversification benefits these days; thus, it is more of a neutral sector for us as a whole. Certain sub-sectors we feel are more attractive for that purpose include utility paper, rail, and packaging. All of these provide superior liquidity characteristics, in our opinion, than, say, BDC or even certain auto names in the current market. One sub-sector that is more negative is community bank and regional bank exposures. The sector came under stress when a community bank had to cut its dividend and take a charge on its commercial real estate loan book. This set in motion a few days of concern, revisiting some of the more volatile trading days in the sub-sector last seen at the peak of the Silicon Valley Bank debacle. There is some tail risk still to be had in the commercial real estate market, and it makes sense that the risk of loan fallout would manifest itself in these local lenders. We avoid that sub-sector for those reasons. We continue to lighten our risk in terms of exposures to sub-investment grade corporate credits and prefer the higher credit quality exposures in the space.
  
  
• Agency MBS performance moderated a bit this month after a good run to end the year. The mortgage basis was wider on the net, and dollar prices were volatile in a choppy Treasury market.  Prepays naturally remained benign, with turnover and refinance activity staying low due to the current level of interest rates and winter seasonal factors.  We continue to like the sector a good deal and see value in newer production MBS with good carry profiles. Even with the recent outperformance in the MBS market, spreads are still relatively wide as technical MBS demand did not return 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 attractive.  We believe the asset class looks relatively cheap to corporate debt and fairly valued to Treasuries.  Higher coupon securities at reasonable valuations offer sufficient carry to weather some near-term market volatility in MBS, if needed.  Furthermore, as an unlevered buyer, we also see some good longer-term total return profiles in a few discounted areas of the 30Y, 20Y, and 15Y coupon stacks.
  
  
• CLO paper has found a strong bid over the past month. Spreads on the paper, especially higher up in the capital stack, have become in demand. Light primary issuance over the past year has investors searching for older deals that are fast approaching the end of their reinvestment periods. We prefer the senior tranches of the deals, as well as those that are out of their reinvestment periods. The sector is a solid area for overperformance, especially in older deals. New issue is less desirable due to the more recent loan issuance that populates the holdings of the CLO deals, and concerns about the newer loans resetting at higher and higher coupons and putting additional stress on underlying borrowers. 
  
  
• ABS continues to be an attractive add. Spreads continue to contract, and that pace has picked up come the new year. There has been a resurgence of issuance in vanilla asset classes, such as equipment leasing, which has caused this sub-sector to offer overperformance possibilities in the near term. Auto ABS continues to be a popular hold, and secondary liquidity remains strong for vintage paper. Credit issues that surfaced in 2022 vintages have mostly abated, and there is strong demand for new issuance paper. However, sub-sectors that are now unattractive are student loan paper and esoteric asset classes such as whole business ABS. There has been an increased demand noted in the more esoteric asset classes, and we see supply increasing. Still, we have noted such demand for that type of paper is typically short-lived and prone to widening out, becoming illiquid at the wrong moment. There is plenty of upside to be had in the more humdrum plain vanilla asset classes.
  
  
• Preferreds also continue to be a sector providing solid overperformance, continuing their end-of-the-year run. The newer issue paper, with high-profile domestic and global bank issuers, offers attractive coupons and enticing back-end resets that make them not only a solid place to find income but, as rate cuts commence, attractive total return profiles. The sector has enjoyed an overall lift, allowing for the repurposing of more seasoned, older exposures to benefit from the increased demand. We have used this occasion to sell those exposures we find less attractive either for credit or performance reasons and move into the more desirable newer issuances, which also have more preferred liquidity attributes. Bank paper has been the most in-demand, and thus, we avoid corporate or insurance adds in the space as they have not quite caught up to the higher-profile new issue from the large banks.

Positioning & Outlook

The year has started off strongly. There has been ample supply being met with strong demand. Spreads have continued to grind in. The optimism with regard to rates has been infectious, with most no longer put off by the days when rates sell off. This is as the Fed tries to blanket the markets with a message meant to tamp down the overenthusiastic rate expectations. We do feel the market might be too aggressive and not appreciating enough the Fed’s desire to slow-walk this. We continue to feel there will be days or even a string of days where rates will be uncooperative and sell-off. The aggressive stance many investors have taken come the new year seems to be ripe for producing a moment where there will be a step back, and we continue to feel corporate credit spreads remain tight. We also continue to focus on what our investment focus has been over the past few months: higher credit quality, liquidity, and diversity.

We begin the new year in a similar manner as we ended the last. Our investment thesis remains centered on: taking a conservative approach to credit and remaining positioned for a slower economy. Last year was spent managing around the rate volatility and the Fed. This year there has been some overenthusiastic approach to the Fed, but we do feel a step back is possible. As such, we like to add to rate exposures when the entry point becomes more attractive and continue to approach credit by simply stepping up to higher ground and more stable, higher credit quality. The front end of the curve remains the most opportunistic area for investment targets, and we still feel we find the most value in the 1 to 3-year area. Duration remains similar to the last few months, and we expect it to stay in that area for 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.

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.