Multi-Sector Bond Fund Commentary - November 2023

Macroeconomic Update

The bear market carried on in October with higher rates and wider spreads. Volatility measures rose as the Treasury curve bear steepened and corporate bond spreads moved out across the rating spectrum.  The 10Y UST yield touched its highest point since 2007.

Investors have continued to express their belief that the Fed will remain higher for longer. In addition, quantitative tightening is increasingly impacting conditions, and the Fed’s balance sheet has now been reduced by $1 trillion since early 2022. Meanwhile, the recently extended elevation in bond yields likely helps the Fed do some of its work, as do the challenges from worker strikes in critical sectors and the resumption of student loan payments.

Price action in fixed-income assets this month was bearish from the get-go. The Treasury market experienced a sizeable two-day selloff on October 2nd and 3rd, following hawkish words from central bankers, a hot JOLTS number, worries about U.S. budget deficits, and technical factors relating to Treasury supply and declining foreign investor demand. Next, on the 6th, we received a blowout nonfarm payroll number, 336k against a 170k forecast, and the prior month was revised from 187k to 227k. Treasuries immediately reacted by selling off 12 bps across the curve. It was undoubtedly a stronger-than-expected report, while the unemployment rate and labor participation held unchanged, and average hourly earnings rose only slightly (0.2%). Meanwhile, the household survey showed a softer snapshot of job growth.

Although the NFP print would seem to support a November or December hike, the rate futures market didn’t alter its expectations for a pause. While the report indicated the economy still has much momentum and the Fed knows this raises inflation risks, there’s still enough belief in the lagged effects of rate hikes and the ability of higher yields to curtail growth and consumption.

The other major economic numbers for October came in reasonably robust as well: headline core CPI was a touch higher than expected;  retail sales beat expectations and also brought an upward revision; Q3 GDP came in at its highest since 2021; and core Personal Consumption Expenditures (PCE) (which strips out the volatile food and energy components) and inflation-adjusted consumer spending each jumped. All of these fed the narrative of higher for longer, and the curve got crushed along the way, even despite some rallies brought on by the Middle East conflict. Yet, as mentioned, rate hike bets for November and December did not materially shift.  Nonetheless, recurrent strong consumer and household demand figures still leave some potential for further tightening, as the Fed has stated.

Portfolio Review

More of the same for the month of October. The tone remained decidedly hawkish in terms of rates. There were many data points to change anyone’s mind, and the collective feeling in the market was just a sit back; it’ll be over soon. The end is near. There seems to be little doubt about that in terms of ending the rate hike cycle. And in terms of what is left yet to be spent, it is all being done verbally, with Fed officials hitting the banquet circuit, it would seem, insisting on playing all their golden oldies. But the audience seems to be becoming numb to it. The overall sense of the market remains on the side of the continued pause of the hiking. The idea of one more hike before the end of the year seems to be losing steam. Despite their continued insistence that we are in a higher-for-longer moment, there are signs the market is maybe not so sold on that. Rates remain elevated, but at this point, there is still a chance we could see a rate cut come the second quarter of 2024. Our view on the near-term credit and economic outlook remains consistent with the past few months. We continue to feel a slowdown is entirely possible. As a result, we remain positioned to express that outlook, intending to continue to be closer to neutral concerning rates and with a focus on credit and liquidity.

The rate pressures on the market continued to weigh credit down. Concerns about how the higher overall rates are impacting companies not only directly in terms of borrowing costs but also indirectly, such as consumers’ performance on loans, the housing market and costs of borrowing, and willingness of banks to continue to offer credit, have caused some uneasiness with where credit spreads are. That has led on certain days to a leakage in credit spreads and, with that, a secondary impact on liquidity. Names appearing in headlines are punished, and holders who wish to move on from those names find it challenging to do so. This continues to be a theme for us, as we remain wary of liquidity remaining tight and credit spreads moving wider faster at the first hint of weakness. As we head into year-end with the holiday schedule, we remain alert to credit moving in the wrong direction. Our theme regarding credit, especially with higher yields, remains to be content to move up in credit and accept what the market is providing. We prefer the higher credit quality and compensatory levels of yields that seem wide to where we would expect and thus, especially in this market, are attractive. Our approach remains to be patient with credit and to prefer to be up in credit, favoring specific, more defensive sectors.

Noted asset sector target or bias this month includes:

• We continue to focus on Agency MBS as a targeted sector. MBS were hit again in October and have been hurt substantially by the bear steepening in yields since midsummer. In tandem with the rate move, spreads have widened as mortgages have underperformed on a hedge-adjusted basis. Our view, however, remains that the longer-term investment profile for MBS is still attractive and that the asset class is somewhat cheap to corporate debt and Treasuries. Spreads are still wide from relative value and historical standpoints, and we believe the current level of interest rates offers substantial long-term performance potential for rate-driven products.  Higher coupon securities at attractive valuations offer sufficient carry to weather the current market volatility in MBS, and, as an unlevered buyer, we also see good total return profiles in a few other spots across the coupon stack.
  
  
• Private credit remains a hot topic in the marketplace, with more and more private equity firms raising money for the sector, creating further competition to what we would already deem a crowded field. We expect pressure as a result in the CLO sector, as finding collateral overall will be more difficult. Loans and direct lending are an avoid sector for us in totality. We remain concerned at the covenant-lite aspect of the market becoming a market norm and are cognizant of the pressures being pushed in various ways around the market as ripples to this hefty demand as a result. We prefer secondary offerings in the CLO space, mainly those deals well past their reinvestment period and looking at near-term deleveraging. The rate hikes have also resulted in solid coupons and performance offered at the higher end of the credit stacks, which we prefer over any sub-tranches. We continue to avoid the BDC sector, a sub-sector of the private debt market, and direct lending efforts, which we expect to see further under pressure as losses mount in the underlying collateral, given our view that credit at the lower end of the corporate debt rating scale is under pressure due to the higher financing costs.   
  
  
• As mentioned above, post-conference ABS issuance was heavy and caused some spreads to widen. Furthermore, there have been indications that delinquencies across the board in sectors such as unsecured consumer credit, auto, and credit card deals are rising. Nevertheless, those delinquencies are within historical expectations. As such, while undoubtedly worth monitoring, especially as it provides a window into the overall health of the consumer across the economy, we still find value in the ABS market. However, as in the past few months, we continue to feel more value is available in secondary offerings than new issuance. The vintage issuances were structured with slightly different underwriting and we benefit from the recorded performance those deals provide as we look to future performance down the road. Newer issuance has seemed to suffer more losses and there is a concern that the newer deals will see higher spikes in losses than older or more seasoned trusts.
  
  
• Preferreds are a more neutral sector for us, but specific names, once again, do represent individual value. They continue offering value in the bank and utility names, but corporates and insurance seem to lag in performance. More of interest are those names that have not been called as of yet, despite turning from fixed coupons to floaters. Those are of value in the current environment as their coupons have been reset a few times and carry large coupons on solid names. This overperformance seems to revolve around a few noteworthy names but indicates that there is certainly the potential for yield pick-up in the near term. Even if rates are cut, the coupon resets are typically a quarter behind, and thus, one can continue to carry the higher coupon even past the point of rate cuts due to this structural lag. 
  
  
• Agency paper is an attractive sector in our view. The pick-up in terms of yield and performance, especially if we see a slowing economy and some pullback in credit, remains a near-term possibility. We prefer callable paper as we expect a shorter maturity and, as a result, short and near-term overperformance.

Positioning & Outlook

Primary liquidity remains strong, with corporations jumping into the market despite the higher rates, as issuance needs to trump costs. The ABS market had its semi-annual conference, and post-conference primary issuance was historic in size. Concessions for corporations did not seem punitive, but the ABS market saw widening in some cases as the large issuance, while met with strong enough demand, seemed to be pushing the upper bounds of that bucket. The impact on secondary trading in the corporate world was less noticeable, as secondary activity seems to be done only at moments when the need to raise cash occurs. On a positive note, dealers seem eager to bid paper, and there seems to be little reluctance in desks, whether big or small, to make a market. This is one promising aspect of the current market, as many investors seem less active in this case. Still, the dealer bid has been noticeably positive regarding offering liquidity. Nevertheless, similar to last month, because a great deal of the activity in secondary liquidity seems to be dealer-led, while the bid side is strong, the liquidity premium can be a bit more punitive. The good news is that liquidity remains strong; the bad news is that it is going to cost you. 

We have entered the last quarter, one known more for its holidays than market activity. October is typically the last of the more active months in terms of issuance activity. As we enter the end of the Fall and beginning of the Winter, we do expect market activity to slow. However, if headlines persist regarding credit fallout from the rate hike cycle or economic data does indeed catch up to our expectations, we would expect the next month to be of more consequence in setting the tone for the first quarter of the following calendar year. This is the point in the calendar where one can prepare for the next six months, and repositioning can be vastly important when considering near-term performance. With rate volatility slowly winding down and only the shadows of what has occurred still skewing the market some, we remain focused on our targets. We remain committed to a near-term viewpoint consistent with our previous outlooks over the past few months. We continue to expect some bumps and expect to ride out the bumps. At the same time, these bumps help us identify targets and create future opportunities that will ultimately lead to an environment for potential overperformance.

We continue to take a conservative approach to credit and remain positioned for a slower economy. We prefer avoiding any sharp downside risk as we enter and march through the fourth quarter. We see more probability of a downturn and, as such, remain focused on liquidity, credit, and diversification. Until we see a shift in terms of the Fed outlook and some of the credit expectations play out, we will remain in this conservative crouch. 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 has moved out a little bit, but it is still near the most recent levels, 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.