Multi-Sector Bond Fund Commentary - October 2023

Macroeconomic Update

September was another challenging stretch for risk assets. While the month felt quieter and lighter on headlines, markets nonetheless moved as rates sold off across the entire Treasury curve. The economic data wasn’t strong enough to meaningfully alter expectations regarding the Fed’s plans for this fall. Still, it left many investors believing the Fed will need to hold rates high for an extended period of time. Notably, changes in the rates of futures markets showed a significant reduction in the pace of future rate cuts. By late September, the projections had trimmed the number of 2024 expected cuts by more than 1.5.

Non-farm payrolls led off the month, reinforcing the ongoing mixed employment situation.  Payrolls rose but included downward revisions for the prior two months. The unemployment rate rose mainly from an increase in labor participation. Meanwhile, average hourly earnings were higher, and in the aggregate, the data agreed with the notion the Fed would almost certainly hold the funds rate steady for September, with the likelihood of a final hike in late 2023 or early 2024 perceived as a coin flip. A few days later, a hot Institute of Supply Management (ISM) services reading (topping forecasts and registering a 6-month high) sharply increased Treasury rates. Bullard and Collins added fuel to the move by suggesting that another hike this year is a genuine possibility. A week later, core Consumer Price Index (CPI) came in less soft than hoped for, but it was still in line with the disinflationary process.

To no one’s surprise, the Fed left rates steady (with the median dot unchanged at 5.6%) at its meeting on the 20th. However, the central bank’s 2024 dot moved higher from 4.6% to 5.1%, driving home the higher-for-longer idea, with its 2025 median dot also up a half percentage point from June. Thus, the meeting was read as a hawkish pause, with an undeniable higher-for-longer messaging. The Fed repeated that they continue to take cumulative tightening and policy lags into account, while 12 officials see one more hike this year and seven do not. The year-end inflation forecasts were 3.3% for 2023, 2.5% for 2024, and 2.2% for 2025.

It was a busy month-end that featured more data and lawmakers avoiding a government shutdown, at least for another 45 days. On the data front, we received a decline in initial jobless claims. The figure reflected the lowest number of filings in 8 months, as the employment data does not seem to suggest that layoffs are picking up. Lastly, the third quarter ended with the monthly Personal Consumption Expenditure (PCE) from August coming in lower than expected, as investors welcomed the favorable inflation data point.

 

Portfolio Review

It’s the messaging, apparently. Or whistles only dogs can hear. There had been some hope that the signals from the Fed and economic data points would bring more stability to the rates environment. But that hasn’t occurred. The Fed has been a bit more hawkish in tone, and there seems to be a constant stream of speakers aggressively pushing the narrative that rates aren’t done yet. And enough market participants are reacting that treasuries continue to sell off. It had been hoped that rates would settle in and even the higher for the longer message would, if nothing else, create some calm. Instead, there is a growing assumption that we could see another rate hike before year-end, and then we would stop. More interesting is that the market seems to be acting in a manner that grasps the idea that higher rates are leading us into a more recessionary risk or harder landing. However, that doesn’t exactly translate into rate expectations shifting enough that future rate cuts would be a response. Currently, it appears that the market expects a potential rate cut in the second quarter 2024, which is a sizeable departure from pre-year-end expectations we saw just a few short months ago. We continue to try and keep the noise to a minimum, with our credit and economic assumptions slightly different than what the masses expect. As a result, we continue to maintain an approach with regard to rates consistent with what we have espoused previously. And to be as neutral to rates as possible, position ourselves similarly to where we have been over the past few months.

With volatility continuing in rates due to the need to dampen the economy, one would expect credit spreads to tighten. Still, we continue to see them widen, especially in the lower rung of credit. The soft landing pundits, who controlled some of the narrative of late, apparently have decided to take a coffee break because we have seen less of those headlines of late. Instead, the narrative is ever so slightly shifted toward a potential bumpier landing. This is what we have expected over the past few months, as we have seen far more evidence that there are some issues in the economy and, for some reason, haven’t seen them manifest themselves in jobs data, as a good example. We have been far more attuned to shifts in consumer health and corporations and banks hiring or announcing layoff data than things such as job openings. We continue to feel a shift is occurring and, as such, have been content to be more neutral and let potential worries play out. Our view is still to be patient with credit and continue to prefer to be up in credit and favor specific, more defensive sectors.    
Noted asset sector target or bias this month includes:

• MBS continued to weaken as they exhibited further volatility in September. The bear steepening in yields has hit the product hard since midsummer. In tandem with the rate move, spreads have widened as mortgages have underperformed on a hedge-adjusted basis, and the U.S. MBS Index lost 15+ bps of excess return this month. Our view remains that the longer-term investment profile for MBS is still attractive and that the asset class is 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 intermediate-term market volatility in MBS.
  
  
• Airline-related risk continues to offer strong value. The sector can be cyclical and was decimated in the beginning phases of the pandemic. Still, since then, with government support lending a helping hand, specific segments have shown to possess solid value. Unsecured airline risk is less palatable, but secured risk, such as EETC, depending on the collateral, represents solid value and overperformance with an amortizing structure benefit, given the sinking fund aspect for some of the securities. Recent upside headlines with pilot and employee contracts ironed out and bookings remaining solid means the sector, which has already recaptured much of the value lost during the pandemic, still has more upside available at the right bid. 
  
  
• ABS is still a solid preferred sector. Newer vintage auto ABS, especially those with a focus on used cars and low FICO score borrowers, is less of interest than seasoned secondary paper, which can be offered at better entry points in our estimation with a higher upside available given the pricing of new issue spreads but with the benefit of available track record in terms performance. On the primary side, we continue to see more upside in equipment leasing, which has seen more steady issuance of late. Less interest in the ABS sector would be in esoteric ABS or unsecured consumer credit, which has not been through a valley in terms of the economic environment just yet and remains, in our view, untested because of that.  
  
  
• We are moving floater exposures to a more neutral designation. As we approach the end of the hiking cycle, the benefit of owning them is dissipating. They still present a hedge against rising rates and, as such, are valued in terms of maintaining exposure to securities that typically do not see much in terms of price volatility. However, many are approaching what might be their last reset in coupon before rates stabilize, and while valued by some investors, they can find a smaller investor base and, as such, less demand than fixed paper. We continue to value them, but performance might be approaching full value now.  
  
  
• Bank paper also has been moved to a more neutral designation. We still find value in big bank domestic names and large yankee banks, but spreads seem to have reached a full tightening and we see little room for much more upside in this current environment. We appreciate the strong credit and there is ample liquidity in those names, but holdings are a full hold at this point while we wait for more insight into the next part of the economic cycle. 
  
  

Positioning & Outlook

Despite the rate jumpiness, primary liquidity had been relatively strong. We have seen a few ABS deals not have quite as much robust interest as we have seen previously. And daily, depending on the rate mood that morning, we have seen corporate deals pulled as they await a calmer market. But overall issuance has been robust, with more than a few deals announced seemingly daily, and certainly plenty of ABS deals available and being marketed into a deeper market than one would expect. Secondary liquidity has been adequate. There seem to be bids available for liquid instruments, but securities with some illiquid feel are not finding quite a substantial audience. The liquidity premium is much higher than before, and forced sells can carry a punitive level. This has led to some price volatility in specific names and sectors, where vulture bids can upset more tranquil markets with timing and lead to some trepidation. 

Summer is behind us. We are entering the last quarter sprint towards Thanksgiving. However, rate volatility continues to dampen the capital markets, and until there is some semblance of accepted expectations, one would expect the continuance of this type of market. And yet, markets such as this tend to produce the most opportunities for overperformance. 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, helping identify targets and create future opportunities that will ultimately help create an environment for potential overperformance. 

Like last month, we remain committed to a conservative approach to credit and are positioned for a slower economy. We prefer to be more conservative in our outlook and avoiding any sharp downside if economic data turns more negative and the market is suddenly overreacting to that noise. Similar to previous months, our focus is remaining as strong in credit as possible and focusing on liquidity and diversification as a means to mitigate whatever shift we might witness as we move into the fourth quarter. The front-end of the curve remains the most opportunistic area for investment targets, and we still 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.