Multi-Sector Bond Fund Commentary - March 2024

Macroeconomic Update

February brought about strong returns for the riskier asset classes, while safer securities largely underperformed. Among those were booming equity markets in North America, Asia, and Europe, which were led by tech stocks. Spreads on the lowest-rated corporate debt pulled sharply tighter, with the US HY index in by 32 bps, compared to an unchanged IG index. Commodities also had a strong month, and Bitcoin made headlines with a 44% move. As mentioned, however, higher-quality assets didn’t share in the good times. U.S. Treasuries sold off in magnitude, with the 2Y and 5Y each higher in yield by 41 bps.  AAA corporate debt widened by 4 bps and agency MBS spreads were off by about 8 bps.

The theme of the month was the reckoning that rate markets had been overly optimistic in their expectations for the path of projected Fed Funds cuts. Although this adjustment naturally hurt rate-driven products, the incoming economic data was still good enough to allow risk assets to shrug off any miscalculations and continue to perform, as written above.

Going into the month, a rate cut was being priced for the March 20th Fed meeting. This hope was quickly extinguished on February 2nd by a January jobs report that was stronger than expected (both payrolls and wages) and included upward prior month revisions. Two days later, Jerome Powell told 60 Minutes that the Fed was wary of cutting rates too soon. This one-two punch fueled a 27 bps selloff in the 2Y UST.  

Inflation data wasn’t cooperative either. Both yearly and monthly figures for CPI and core CPI were more elevated than expected, driving another rate selloff. The CPI data produced a further readjustment of the expected timing of an initial rate cut, this time suddenly pushing it from May to June. Producer Price Index (PPI) and core Personal Consumption Expenditures Price Index (PCE) were also higher than expected, despite the current overall positive trendline for the path of inflation.  In short, economic data has remained fairly resilient across the board.

As of the end of February, three 2024 Fed rate cuts are being priced in by the futures markets. This is down from six going into the new year, so we’ve undergone a meaningful recalibration of expectations.  Yet, interestingly, the market’s assumptions are now finally aligned with the Fed’s dot plot. It’s been a strange path getting here, but investors know that things can always change in a hurry, whether through friendlier data (such as the recently softening retail sales figures) or things more sudden and threatening (like issues with commercial real estate loans held by smaller banks).    

Portfolio Review

• The semi-annual ABS conference took place at the end of the month. Typically, that means a slowdown in issuance prior to the conference and exuberance post-conference as attendees run home eager to put their refreshed attraction to the space to work. Issuance has remained heavy over the past month, with a significant number of deals across the class and sector landscape. That primary issuance has been greeted with strong oversubscription in well-established trusts and the dealers’ efforts to try and tighten spreads. However, that has been less successful in more off-the-run name trusts. We have also witnessed a renewed interest in esoteric asset types, with even a rate music royalty deal as well as litigation receivables. Those are typically signs that over-eagerness has re-entered the market and a warning sign not to get swept up in the enthusiasm of others. We continue to like secondary, well-seasoned auto paper over new issue, and new issue equipment leasing deals. Liquidity remains strong in the more established asset types, and spreads, in our view, are still attractive at the top of the capital stack.
  
  
• Banks were back in the news again, courtesy of another New York Community Bank headline. The month started for the bank with a headline concerning their need to sell off their mortgage risk and ended the month with concerns about their internal risk controls. This time around, it is the smaller banks and regional banks most at risk, and on days such as this, bank paper can be quite volatile at that level of bank. We prefer exposures at this point to the larger global banks and, furthermore, prefer that paper in the form of preferreds. The shorter, senior paper of the more established, larger banks have spreads at the tights, leaving little room for upside. The preferred market is a means to establish longer duration yield, and during a rate rally impacting the back end of the curve, providing some large performance upside. At this point, it is more of a timing issue, as investor interest seems to really pick up when a rate rally occurs. We like the long-term performance upside of the space in this area and continue to avoid smaller bank exposures. 
  
  
• Agency debt, in our view, continues to be attractive. The optionality of the calls buried in the paper can make them unattractive to some, as they are almost a given to occur, especially given the rate outlook. Thus, it makes the paper a far better fit for shorter-duration needs than perhaps funds with longer-duration investment targets. Nevertheless, the low-credit risk, high coupon paper can be an effective front end of a maturity ladder and provide an effective hedge against any sort of short-term credit volatility that could pop up due to corporate issues, the previously mentioned banking concerns, or even any short-term geopolitical issues. 
  
  
• Corporate credit remains a neutral sector for us. The liquidity benefits seem to outweigh any performance upside, which continues to be focused more on the large, well-known corporate issuer rather than anything outside the norm or esoteric. The February calendar continues to be saturated with corporate issuance, reaching and sometimes breaking historical issuance records. Interestingly enough, according to Bloomberg, some 68% of the most recent issuance in the month underperformed and saw spreads widen in the secondary market once trading was allowed in the new issues. That would seem to vindicate our positioning in the space. Corporates, especially new issuance, have a healthy investor interest and are typically met with strong liquidity when the need arises. We believe it remains a strong place to be as spreads remain tight; however, the liquidity aspects, in our view, are the most beneficial in today’s market. We remain more interested in more defensive sub-sectors that have large, more stable investor bases, such as utility paper and rail. More specifically, 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 underperformed in February, following a great stretch to end the year.  The mortgage basis was wider and dollar prices were hit especially hard by the movements in Treasury markets. The down-in-coupon trade struggled the most, with longer duration suffering in the selloff, along with a large, lower coupon liquidation from Truist.  Mortgage bond 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 to us. 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. 

Positioning & Outlook

Issuance continues to be the story in the fixed-income market. Corporate issuance has continued at a historic pace. It seems every Monday, there are another ten to fourteen issuers lining up. With corporate spreads at tights and some sort of pause with rates, corporations are flocking to the table with bond offerings, which are being met with incredible demand. This type of demand is also prevalent in the ABS market, where new issue deals are routinely 5 times to 8 times oversubscribed, depending on how long the underwriters choose to keep in the market before closing the deal down and parceling out disappointed allocations to investors at tighter and tighter spreads. As a result, liquidity in the primary and secondary markets remains robust to the start of the year. Dealers are happy to position exposures, and eager to facilitate the secondary trades as investors shut out of the primary market offerings attempt to get fully invested. There is a feeling in the market that investors were getting concerned that they were missing out on locking in higher yields. As such, this is most likely contributing to the robust demand, especially by those investors who had been sitting on cash for the last six months of the previous calendar year. The happy byproduct is the increased liquidity in the market. The worry is that this surge in demand will cause credit spreads to tighten too much, potentially leading to some underperformance for those who rushed to feed at the trough of higher yields too quickly. 

Jobs data that was too robust and inflation numbers that didn’t quite meet expectations, mixed with a little prime-time Powell on a Sunday TV magazine show, meant that rates had a bumpy ride in February. There had been some thought that we might begin seeing some rate cuts in the first quarter of the new year, but that has all but evaporated. The 2-year treasury seemed to take the brunt of this volatility, ending January at a 4.21% yield and ending February at 4.62% yield. That type of selloff didn’t deter the new issuance market, as mentioned previously, but it did cause some havoc on a day-to-day basis in terms of investor sentiment and the performance of risk assets. Most importantly, it meant that instead of creating a ramp that investors could feel was fairly stable and headed in the right direction, it was instead an uneven road with an unsure destination. These are the type of days, of course, where opportunities present themselves, uneven as those days may be. We continue to use that type of volatility as prudently and advantageously as possible, selling at full value when the market is feeling aggressive and buying targeted issuers on days when investors seem forced to offer. We continue to use that type of environment to build a foundation for potential future overperformance. 

The market continues to hum along. The only misstep continues to be in community bank space, which seemingly cannot go a month without a headline. But the news of that type is welcome as it reminds the market not to embrace the rally too much and that the price of credit should not be ignored. There is strong liquidity, and rates do seem to have settled in by the end of the month. We remain focused, though, on the credit side as we continue to see small cracks in economic data and remain on alert for any shift in jobs data. It does feel like we are a big headline away from a major shift in economic tone, although we do remain hopeful for a softer landing. Nevertheless, our investment focus remains consistent over the past few months: higher credit quality, liquidity, and diversity.  

We continue to position the portfolio in a manner that anticipates a slight shift in the economic outlook and any volatility that might occur as a result. The heavy corporate issuance and the tightening spreads lead us to believe that things are being priced to perfection. We want to keep taking a conservative approach to credit and keep focusing on the liquidity and diversification benefits of our exposures. We anticipate upside in terms of performance by doing so, with the added benefit of mitigating any bumps that might occur in the near term due to spread widening from economic slowdown. This is a similar investment thesis we have previously espoused. We feel the most opportunistic area for investment targets is still in the front end of the curve, in the 1-3 year area. However, we do look to lock in duration when available in higher credit, liquid exposures when opportunities exist in targeted issuers. 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.