Multi-Sector Bond Fund Commentary - January 2024

Macroeconomic Update

Strong market performance continued in December following the historic November bull run. Investor confidence in a dovish pivot from the Fed reached a new high, as most believe the end of the hiking cycle has been realized. Debt and equity markets rallied from the month’s outset, with cooperative data paving the path as we closed out the year. Equities and credit spreads were among the star performers of 2023, while rates overall finished the year closer to unchanged, despite a wild ride. 

Treasury yields dropped across the curve to begin December as further slowdowns in labor markets reinforced expectations that the Fed will be able to cut rates in 2024 to stop a potential recession. Credit opened the month on a tear as well, with high yield spreads reaching their tightest levels since April of 2022. While the nonfarm payrolls number on the 8th was a bit stronger than expected, it brought downward revisions for the prior two months, and the print factored in UAW strikers rejoining the workforce. CPI was the next bellwether, as we’ve become accustomed to, and November core prices rose 0.3%, as expected. Year-over-year headline CPI fell from 3.2% to 3.1%, with core inflation standing still at 4.0%, with energy down and shelter up. All eyes, however, were ready and focused on the Fed meeting, which concluded on the 13th.

The Fed meeting signaled the long-awaited dovish pivot. Policymakers suggested more rate cuts could be in store for 2024 than they had envisioned back in September. An enormous rally ensued, with UST 2Y moving lower by nearly 30 bps. A less restrictive policy path became the base case as the Fed’s rate dot for the end of 2024 was lowered by 50 bps. This has been the most unambiguous indication yet that the hiking campaign, which began in early 2022, is finished, and investors celebrated the series of cuts being forecasted for next year. Based on the median estimate, this was the first time since March of 2021 that the central bankers wrote in no further hikes in their projections. 

Despite the 4.6% Fed Funds forecast for the end of 2024, there was a fair amount of variance in the individual voters’ expectations. Eight officials saw fewer than three quarter-point cuts next year, while five anticipated more. Meanwhile, in the press conference, Chair Powell did not push back on the market’s aggressive pricing of future cuts, providing even firmer ground for the rate rally. The committee acknowledged that inflation has eased but remains elevated, saying that they would monitor developments to see if any additional policy firming could be appropriate. The statement also said, "In determining the extent of any additional policy firming that may be appropriate to return inflation to 2 percent over time, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments."

Nonetheless, the rate futures market did not give much weight to any caveats from the Fed, as it now prices in over 150 bps of cuts (6+) by the end of 2024 – a reasonably significant divergence from the central bank’s median estimate. Lastly, on the 22nd, the Federal Reserve’s preferred gauge of underlying inflation was shown to have barely risen in November, adding another key data point to the dovish cause heading into the holidays. On a six-month annualized basis, the core metric rose 1.9%, just below the Fed’s target.

Portfolio Review

The end of the calendar year was more of the same as the previous month with regard to rates. More and more participants jumped on the rate cut bandwagon, and the 2-year rallied all month long, starting at 4.68% and ending the month at 4.25%. An impressive 43 bps move, which added to the previous month’s rally, meant the 2-year yield had dropped by almost 100 bps. Current expectations are forming around a rate cut as soon as the end of the first quarter and the beginning of the second quarter. We continue to focus on our internal expectations that a controlled but slowing economy will push credit spreads wider down in the credit stack and give support to lower rates. That doesn’t mean, of course, that we don’t expect Fed-speak early in the month and FOMC messaging to try and dampen or slow the rate rally. Thus far, data continues to support that position. As such, the portfolio reflects that thesis, and sector, issuer, and tenor allocations continue to be executed in the near term with that expectation in mind.

Noted asset sector targets or biases this month include:

• Corporate credit has seen a tightening of spreads to the point where overperformance will be difficult, given that, at worst, credit is priced tight and right at fair value. The credit in the upper tiers of the credit stack, investment grade, is strong and liquidity attractive enough that corporate credit in the right names is more of a liquidity bucket than a real opportunity for overperformance. As such, investment-grade corporate credit is a neutral sector for us: highly liquid and properly priced. On the less-than-desirable side is the re-emergence of higher coupon quasi-corporate credit such as BDCs. With the rate rally, the higher coupon sector has found a bid, and there seems to be interest in adding the sector to other investors in the market. BDCs remain an avoid sector for us, given the reach for yield in a sector such as this, which seems prime for some credit issues in the near term and has real competitive issues with the preponderance of private equity/private debt funds that have launched.
  
  
• Agency MBS had a second consecutive strong monthly showing. The mortgage basis tightened 10+ bps, and, paired with the Treasury rally, newer issue To Be Announced (TBA) collateral was generally driven between 1 and 3 points higher in dollar price. Prepays remained muted due to the level of rates keeping refi and turnover activity low, along with the usual seasonal effects from the winter. So while discount vintage pools have extended, more immediate value can be found in recent production MBS due to strong carry profiles, even with spreads now at their 10-month tights.  Although technical factors are unlikely to produce meaningful spread tightening in the near term, the current level of interest rates offers long-term performance potential for rate-driven products, making 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 market volatility in MBS, and, as an unlevered buyer, we also see good longer-term total return profiles in some discounted areas of the 30Y and 15Y coupon stacks.
  
  
• Agency paper remains an attractive sector. Newer issuance is composed of higher coupon and liquid paper, with the downside of a high likelihood of being called in a one-year horizon. However, the benefits of the paper are that high liquidity, no credit risk, and higher short-term yield present value when building out certain maturity ladders and matching expected future liquidity needs going out a bit. Market conditions and future expected economic conditions make this sector a favorable place to invest in our view, and we expect it will provide short-term performance boosts as well. 
  
  
• ABS remains an attractive sector, but a rate movement like the one just witnessed can skew appetites. With a drop in rates overall, we are seeing not only spreads tighten in plain vanilla ABS but also once again a resurgence of interest in higher yield, more esoteric deals. Data Center ABS and Whole Business ABS have once again re-appeared in the secondary market. Those deals tend not to perform when things turn harder economic-wise and worse; liquidity is sparse at best during the best of times. Those are the types of deals we continue to avoid. One area of ABS that has become more attractive in our view has been the senior AAA tranches of CLO paper. With a softening in economic activity expected, one would assume lower-rated tranches to be under some stress; however, the senior, over-enhanced AAA classes tend to provide overperformance and value in such moments. Better yet, given the lack of issuance over the past two years, older vintage deals will soon be paying down out of their reinvestment periods, representing a strong overperformance profile in the near term. Those deals were supportive as the liabilities boasted of variable rate structures, helping the coupons reset on a monthly or quarterly basis, providing a stable pricing aspect while capturing higher yields in their reset coupons. Now, with rates rallying, the vintages lend themselves to orderly paydowns and the opportunity to take principal paydowns and reinvest still at higher rates. 
  
  
• Preferreds ended the year rallying. Rates aided their attractiveness for those who were looking to suddenly lock in bigger coupons prior to future expected rate cuts. The most active was bank paper, which has spent the last 9 months rebuilding its investor base after the March collapse of a few community banks in the US and Credit Suisse. The paper remains attractive, in our view, with newer issuance with a deeper investor base and more liquidity and more interest than the aged paper that should have been called. We do expect calls to pick up once the calendar turns, however, and that makes certain issuances, depending on the discount, better targets for near-term overperformance. In contrast, the newer issuance represents overperformance possibilities in the future. When selected targets do become available, we are eager to add at the right price for those reasons. 

Positioning & Outlook

Liquidity during December was strong, but as per the calendar and the eagerness for a holiday celebrating, trading was subdued in the secondary market, and primary issuance was virtually non-existent. Most participants were happy to lock in performance and ride the rate rally wave as an end-of-year treat. As such, there was limited activity to fully grasp how liquid the market was. However, given the rate movement, what trading was needed certainly found plenty of liquidity available with negligible liquidity premium required to accomplish the end-of-year pruning. As part of the rate benefits, credit certainly was stronger, with credit spreads tightening across the board, including lower levels in high yield and ABS stacks. We used the calendar's timing and liquidity available to continue pushing up the credit quality in the portfolio, as we focus on what we expect come the new year. It was an opportune time to sell selected credits we felt had reached their full and fair performance levels and to transition further into higher credit quality, more liquid names.

The market continues to ride the momentum from November to the end of the year. The only thing slowing it was the holiday season. The mood in the market would seem to lend itself to one of optimism that this momentum will carry into the new year. We expect, as stated above, some pushback from the Fed in messaging and some “higher for longer” verbiage. That could lead to a few days where rates sell off, aided by the stray data release that is overall dovish but supportive enough in certain aspects to lead to some rate stagnation. Nevertheless, we expect an overall move in a manner that supports our investment focus: higher credit quality, liquidity, and diversity. Once a slowdown does commence, we would then expect spread widening enough in corporates to find some attractive targets later in the calendar year. Right now, however, we remain constructive on remaining on the current path and finding more value in the stronger, more liquid credits. 

As we end the year and look forward to the coming one, we continue to focus on the investment thesis of the previous months: taking a conservative approach to credit and remaining positioned for a slower economy. The past year was one spent trying to manage the rate volatility and uneasiness that the market felt over the Fed’s aggressive rate hiking schedule. The coming year, we expect, will be one that will feature rates rallying but with a softer credit environment as we deal with the tail risk of the higher rates on lower credits and the ripples that create a weaker economic environment. 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 1-3-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.