The worst year for bond investors in at least three quarters of a century trudged on. September’s selloff managed to eclipse even the pain of August as the U.S. Dollar strengthened and the Treasury curve continued to flatten. The 2Y United States Treasury (UST) finished an astounding 79 basis points (bps) higher in yield month over month. Major global equity indices sold off between 7% and 10% while credit spreads widened further (U.S. corporate high yield was off 68 bps). Agency Mortgage- Backed Securities (MBS) widened by around 31 bps after a 25 bps selloff in August. Volatility continued to climb while safe havens were exceptionally few and far between.
September began on a bullish pace until the monthly Consumer Price Index (CPI) print slammed markets. Inflation came in higher than expected, even following ninety days of declining gasoline prices. Shelter costs continued to surge, the expected change for food was doubled up, and new car prices and medical care costs rose. The Federal Reserve met the following week and expressed its commitment to fighting inflation. Following the expected 75 bps rate hike, Chair Powell offered these words: “We think that we’ll need to bring our funds rate to a restrictive level and keep it there for some time.” The Fed now projects the Fed Funds rate to reach 4.5% by early 2023 and for inflation to stay above 2% until 2025. Unsurprisingly, the dollar continued to rise.
Markets were hit hard in the aftermath of the meeting. Subsequent Fed speakers reinforced that rates will likely need to be held in restrictive territory for longer than investors had hoped, increasing recession risk. Geopolitically, eyes remained on the European-Russian energy conflict and the British Pound weakness in the face of sweeping tax cuts that risk sending inflation higher.
Opportunity usually follows difficult market periods and some highly visible investors have recently expressed positive sentiments and entered the market. We are seeing more commentators and pundits insist that valuations in corporate and government debt are widely beginning to present themselves as attractive. With a lot of cash still on the sideline right now, it will be interesting to see what the tipping point is that sparks reentry and changes the directionality of money flows.
September was a roller coaster with inflation data once again urging the Fed to react in a hawkish manner. The inflation print was expected to show inflation had started to abate, but the data skewed higher which not only had the market reacting in a hawkish manner, but the Fed coming out guns blazing. Following the Fed action, the Governors were out and about giving plenty of speeches about how they would be “acting aggressively to tame inflation,” no matter what. This led the rates market to sell off violently, causing havoc not only in treasury yields, but also pushing liquidity premiums and credit spreads wider. This ripple led investors to pull money from fixed income funds, leading to forced selling and the equity market falling deeper in the red. With the equity market and risk assets overall reacting unfavorably to the economic news, it is important to take a step back and realize that the market itself seems more in fear of the Fed than economic news as it would appear. That is, the market seems to be reacting favorably to bad news, or waiting on bad news, such as rising unemployment or lower job openings in that it would appear it might cause the Fed to pause. But that would seem to dismiss what that actually means, such as the economy slowing and most surely falling into a recession….which is good for the equity market? Seems like we have lost our compass some.
After the Fed action and post-meeting Powell press conference, there was some positive response as Powell seemed to indicate that perhaps the 75bps and 50 bps set at the last two meetings may not be set in stone. It is possible they might want to step back and see just how much work the previous rate hikes have accomplished, both of which seemed prudent and welcomed by the market. Just as important, Powell reiterated that he doesn’t expect the Fed to be selling any MBS off their balance sheet, and is content to let securities mature and roll-off to meet quantitative tightening targets. Also good news, as the Agency MBS market seemed concerned about getting in front of the Fed if it were to start selling, which had caused that market to seem a bit displaced. All eyes are now looking toward the next inflation data print and whether we might see 50bps or 75bps rate hike at the next meeting.
Noted asset sector target or bias this month includes:
- The asset-backed securities (ABS) primary market attempted to re-open once the summer ended but with the volatility of September overcoming markets, the primary ABS market was relatively quiet. There were a few deals that were able to get launched but when the worst of the market hit there were deals that were held back or postponed. Spreads widened in sympathy of other sectors. This however once again represented some opportunity. As such, we preferred the secondary market offerings over whatever new issue was offered, with seasoned legacy bonds representing significant upside versus primary offerings. The widening spreads also allowed us to capture value in the sub-tranches, who have performed well enough to expect rating upgrades in the near term, at spreads more reflective of current ratings. As such, we continue to focus on the liquid auto ABS sector for future over-performance possibilities in the near-term.
- Leveraged loans have come into focus in a negative manner. Banks are having a hard time selling the loans, especially for new, larger deals. The newer deals are especially problematic, given they are large, high-profile deals with one over $10 billion in size. This was expected as not only has credit become more of an issue in the risk-off tone of the market, but the floating rate liabilities of the loans have stopped being attractive to the “tourist investor,” or larger shops who only recently found the loans an attractive add in the run-up in rates. With the majority of those investors starting to step back from adding floaters as well as the risk-off tone, the overhang of new issuance and the drying up of bids has become an issue for the overall loan market. We long have had loans on our avoid list, anticipating the market turn. CLOs we have moved to a more neutral sector. Value is still available in the senior tranches of CLOs, but concerns about performance and as a result, risk at the lower end of the credit stack means the deep sub-tranches are to be avoided.
- Yankee banks have given off a mixed message of late. While there is opportunity in certain names, some domiciles and names have fallen out of favor. There has been a changing of government leadership in both the UK and Italy. The banking system in both are under the microscope. Furthermore, one of the largest banks in Europe, Credit Suisse, has fallen out of favor as hedge funds have attacked the name in the CDS market while the bank leadership at the same time has responded in head scratching manner. As a result, while the sector overall is attractive, given widening spreads, it is a name by name issue when determining exposure buy, hold and sell targets.
- Agency MBS is a favorable target. Over the past several months, the sector has severely underperformed. Some of that poor performance can be attributed to the Fed itself, which was decidedly murky in its messaging and leaving the investor base uncertain as to whether the Fed would be selling MBS to meet balance sheet reduction targets. That was recently cleared up some, when Chairman Powell indicated that the Fed would not be selling and relying mostly on maturing bonds to simply roll off. As a result, some small rally was witnessed. However, there still appears to be some solid value available in the sector, assuming preferred pool characteristics can be found.
- We continue to find liquid high grade corporates attractive. Spreads continued to leak in the space, and with the inversion of the curve at certain points on the yield curve, there are previously expensive names that are suddenly very attractive. We continue to favor corporate exposures in railroad, packaging, technology and life insurance in the 3-year tenor and railroad and utility names in the 20-year part of the curve.
- Esoteric ABS is an out of favor sub-sector. Liquidity continues to be desired, and the esoteric sub-sector which includes data center and whole business sectors are plagued by their illiquidity. Performance remains fine, but the spread widening in the space hasn’t justified the equal or greater liquidity premium being attached to these exposures.
Positioning & Outlook
We continue to move cautiously in the current environment, preferring to embrace liquidity and raise cash on days where risk seems to be embraced. Liquidity and diversification remain our focus. Furthermore, the additional liquidity we are able to set aside has proven valuable for picking up previously expensive names on the cheap, and not only increasing portfolio liquidity, but also capturing future over-performance for when the markets take a breather and catch its breath.
The market is frightened of the Fed at this point. Rates remain volatile with now an eye toward a 75 bps hike in November. And yet, still no real feel for what all the previous hikes have accomplished. This leads us to be a bit leery that there might now be over-correction in play and a more likely scenario of recession already occurring. We continue to move prudently into better credit quality/highly liquid names in response. Maturities remain on the shorter side, but like the 3-year corporate tenor in terms of value. We would expect duration to remain near current levels over the near term.
Learn more about the Yorktown Short Term 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.
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.
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).
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.
You should carefully consider the investment objectives, potential risks, management fees, charges and expenses of the fund before investing. The fund's prospectus contains this and other information about the fund and should be read carefully before investing. You may obtain a current copy of the fund's prospectus by calling 800-544-6060.
Per the most current prospectus, (1) Fund total operating expense ratios are: Class A, 0.87%; Class L, 1.52%; Institutional Class, 0.87% until at least May 31, 2023. (2) In addition, the Adviser has entered into contractual expense limitation agreement with the Trust so that the Fund’s ratio of total annual operating expenses are limited to 0.84% for Class A shares and Institutional Class shares and 1.49% for Class L Shares until at least May 31, 2023.
Fixed income investments are affected by a number of risks, including fluctuation in interest rates, credit risk, and prepayment risk. In general, as prevailing interest rates rise, fixed income securities prices will fall.
Past performance is no guarantee of future results. The investment return and principal value of an investment will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. There is no guarantee that this, or any, investing strategy will succeed.
Diversification does not ensure a profit or guarantee against loss.
There is no affiliation between Ultimus Fund Distributors, LLC and the other firms referenced in this material.