The Fed’s aggressive shift from dependable monetary accommodation to panicked tightening that aims to quell inflation has led to a combination of rapidly rising rates, flattening yield curve and wider credit spreads, which have pummeled bondholders. The Bloomberg Aggregate Bond Index finished Q1 2022 down -5.93%, while the Easterly Income Opportunities Fund returned -1.51%.
Much of the bear market in Q1 2022, that included a 160bp rise in the 2-year yield, an 83bp rise in the 10-year and a 54bp increase in the 30-year, has been related to a dramatic reversal in the Fed’s monetary policy. After spending most of Q4 2021 asserting that inflation would be “transient”, the Fed made a dramatic reversal from “too dovish to impact inflation” to “too hawkish to assure a soft landing”. It is notable that the Fed’s median dot plot in 2023 and 2024 moved above their neutral rate of 2.375%, which demonstrates its increasing resolve to hike aggressively to tame this inflationary cycle. We believe the urgency on the part of the Fed was brought on by the highest 10-year breakeven inflationary expectations on record at the time of the March meeting.
The RMBS sector faced challenging headwinds during the quarter, despite strong credit fundamentals, technicals drove spreads wider for most of the quarter. Fundamentals remain strong, with RMBS deals issued prior to 2020 having accumulated 33% of cumulative Home Price Appreciation (HPA) since the start of pandemic, with 19% coming in 2021. This unprecedented appreciation has pushed homeowner’s equity to a record high $9.9 trillion by the end of 2021. With the economy growing by 7% in 2021 and projected to post solid growth in 2022 (3% median real GDP forecast), unemployment plunging to 3.6% and the number of people employed surpassing pre-Covid levels, RMBS credit fundamentals appear to be on solid footing. However, investors were battered by another massive supply wave in Q1 2022. At the same time, rapidly rising interest rates have pushed 30-year mortgage rates higher by almost 175bp to 4.9%, sparking extension fears across most RMBS segments and expanding overall duration. The biggest casualty was new issue fixed-rate bonds with longer durations as investors priced in longer extension scenarios at lower prepayment speeds with most of the mortgage universe now lacking refinancing incentive.
CRT (CAS/STACR) saw a massive $9 billion of supply during the quarter compared to $14 billion for all of 2021. The supply wave combined with Fed-induced macro volatility and extension fears, pushed spreads across the CRT credit stack materially wider. More seasoned vintages outperformed new issue collateral as their lower LTV’s (Loan-to-Value) should make them eligible for at least cash-out refinancing to moderate average life extension due to the lack rate-driven refinancing. Low LTV is also a factor as a credit enhancement as you go lower in the credit stack.
Non-QM (Qualified Mortgage) was another sector that saw a significant uptick in new issuance during Q1 2022 with $13 billion issued YTD 2022 compared to $28 billion in all of 2021. This, combined with macro related volatility and extension fears, pushed spreads wider. Legacy RMBS sectors fared better than CRT and Non-QM new issue deals with spreads generally widening by 25bp to 50bp for passthroughs and locked-out mezzanine tranches. The hardest hit legacy RMBS cashflows were levered long-duration subprime mezzanine tranches that rely on excess spread to help protect them against collateral losses. With short rates expected to increase sharply, the excess spread will most likely dramatically shrink as collateral weighted average coupon (WAC), originally floating rate at issuance, is held down by a high percentage of fixed-rate collateral due to loan modifications. Prepayment speeds are also expected to decline and that should extend the average life of many of these locked-out mezzanine tranches. However, as holders were reluctant to sell, not many trades were printed in this sector.
While CMBS issuance in Q1 2022 was less than the record supply in Q4 2021, it was still higher by 75% compared to Q1 2021 as many sponsors tried to lock-in rates before a significant rate sell-off. Conduit and CRE CLO issuance was higher relative to Q4 2021 while Single-Asset Single-Borrower (SASB) sector issuance was hurt by increased risk premia and investor aversion to office exposure. For the quarter, private label CMBS issuance reached $44 billion while Agency CMBS issuance was $13 billion. CMBS conduit AAA LCF spreads widened from 70bp to 100bp, underperforming similar duration IG Corporates. In addition to macro-related volatility caused by aggressive repricing of the Fed’s rate hikes, CMBS AAA LCFs were impacted by a significant supply wave that was not met by a similar uptick in demand. Once the rate environment stabilizes and supply increases subside, we believe these AAA spreads will attract more fixed-income investors into the space. One area experiencing low demand were deals with elevated office exposure as the debate on the stabilized valuations of office property in the new “work-from-home” economy continued. SASB market participants were shocked by Blackstone’s turning over the keys to the special servicer on the “1740 Broadway” office loan that was securitized into the BWAY 2015-740 SASB deal.
The overall delinquency rate for both Conduit and SASB deals continued to decline over the quarter with the 30+ day delinquency rate falling to 3.9% and the special servicing rate to 2.3%. Hotel and retail performance continued to improve with 30+ day delinquencies declining to 7.9% and 7.5%, respectively, as robust economic activity normalized hotels’ RevPARs and occupancy rates.
ABS: ABS issuance reached almost $70 billion in Q1 2022, making it a record for Q1 volume since 2007. Auto ABS lead the new issue volumes once again with $35 billion issued in the quarter. All ABS sectors experienced some degree of spread widening and credit curve steepening as lower credits widened more than more senior classes. While overall consumer credit remains strong, the most vulnerable consumers faced numerous headwinds, including 40-year high inflation, record gas and food prices and double digit rent increases. Personal loan securitizations have experienced some of the most stress in ABS. Nevertheless, these metrics remain far below pre-Covid annualized loss rates and 30+ day delinquency rates. We expect inflationary pressures to continue to weigh on consumer balance sheets and cause further deterioration in credit metrics for the affected consumer ABS sectors.
CLOs fared better than other structured credit sectors during the first quarter, benefitting from strong investor demand as their floating coupons, minimal duration and attractive spreads made them attractive versus fixed-rate structured credit products. Inflows into bank loan floating-rate funds totaled tens of billions in Q1 and matched the highest level since 2013. CLO spreads held better than both IG Corporate and High Yield sectors. CLO spreads were also aided by a decline in new issue supply with new issuance down 19% compared to Q1 2021 (BofA Research). The ability of companies to pass along higher commodity-related expenses and higher LIBOR-related interest costs to their customers may be a crucial factor in driving credit performance in 2022. Managers’ ability to avoid distressed credits may be one of the key components of total return for CLOs in 2022, similar to the environment in 2019.
Structured Notes: CMS Linked Notes have suffered on three separate fronts in Q1 2022 and were some of the worst performers among structured credit sectors. They have been battered by unprecedented flattening of the yield curve. The U.S. swap curve flattened by 171bp since the end of Q3 2021 and by 110bp from the end of 2021, resulting in a curve inversion of -30bp between the 2yr and 30yr CMS rate at the end of Q1 2022, the lowest level on record. Since coupons on CMS Spread floaters reset to the difference between 30-year and 2-year CMS rates (or 10-2, 30-5), the current carry and projected coupons have declined significantly and for most of these structured notes, coupons are mostly likely going to reset to zero with an inverted swap curve. In addition to a rapid decline in coupons, higher rates are also pulling down current valuations as these bonds have longer effective duration than our portfolio average. Finally, credit spreads for bank issuers have widened in Q1 with MS corporate spreads wider by 25bp, which has also negatively affected the valuation. Shorter maturity bonds fared better than longer maturity securities because less of their valuation is based on coupon and more is based on price accretion to par.
Portfolio Attribution and Activity:
|Sector||Return||%Port||%Attrib||Allocation||Price||Yield||Eff Dur||Sprd Dur|
For the quarter, the Easterly Income Opportunities Fund posted -1.51% return, outperforming the Bloomberg Aggregate Bond Index by 4.04%. Q1 2022 was the worst quarter for most fixed income funds in decades as a Fed-triggered rate sell-off, along with a 100bp bear flattener, caused massive declines across bond funds. Most portfolio losses came from duration and curve exposure. Corporate Structured Notes was the worst performing sector in our portfolio with -0.75% contribution to return after rate hedges. These CMS Spread floaters have a significant negative sensitivity to a flatter yield curve and have taken a big price hit as the 2 30-year CMS curve inverted in Q1 2022. We did hedge some of flattening exposure during the quarter by entering into 2-year pay fixed swap, but the extent and pace of flattening was unprecedented, triggered by hawkish Fed speak before the March FOMC meetings. At that meeting, the new dot plot implied ten rate hikes by 2023, up from three previously. At the same time, the long end of the curve did not sell off as much due to perception that the US economy may not be able to avoid a recession.
We have marginally increased our allocation to CMBS through select investments in seasoned investment-grade conduit mezzanine tranches and investment-grade small balance commercial tranches. While there are a number of potential headwinds across the office and retail sectors, we believe the tranches we have acquired have sufficient amount of credit subordination to withstand losses in stressed market environments. In the ABS space we have added a seasoned ABS CDO backed by seasoned legacy subprime mezzanine tranches at a spread of 500dm and a subordinate tranche off a deal backed by residential and commercial PACE assets. Our CLO allocation has declined due to several deals getting refinanced by collateral managers.
Predicting the path of interest rates has become extremely challenging given extreme interest rate volatility, with the MOVE index reaching the highest level since March 2020. The Fed revealed its plan for Quantitative Tightening (QT) in Fed’s March meeting minutes with a proposed cap on Treasury and Agency MBS run-off at $95 billion. The process could start in May and involve $95 billion in run-off by July as T-Bills mature and MBS pools pay down. Some Fed members raised the prospect of direct MBS sales to cool down an extremely hot housing market, but the impact of QT on the rate market and curve remains difficult to predict. We do expect QT and continued uncertainty with its implementation to keep overall pressure on the long end of the curve. As such, we would not be surprised if 10-year rises above 3% at some point in 2022. If the Fed is serious about tackling inflation it would probably want to raise long-term interest rates to tame an overheated housing market and other consumer sectors. We do expect a slowdown in the second half of 2022 as run-away inflation with its high energy and food prices will heavily weigh on consumers’ spending on discretionary items. There is a chance that economy will decelerate enough for Fed to stop its hiking cycle. One would expect a rate rally and the curve to steepen in such a scenario.
With current uncertainty regarding the path of interest rates, we expect to maintain our current 2-year duration on the overall portfolio. Against the current backdrop, we expect to maintain ample liquidity in the form of cash instruments and Treasuries. We continue to focus on carry at the top of a credit stack in RMBS, CMBS and ABS sectors and will only go down in credit during periods of significant dislocation like we saw in mid-March 2022.
|3/31/2022||YTD||1-Year||3-Year||Since Inception (8/21/2018)|
|Morningstar Multisector Bond Category||-4.30%||-1.90%||2.59%||2.92%|
|Bloomberg U.S. Aggregate Bond Index||-5.93%||-4.15%||1.69%||2.49%|
Past performance does not guarantee future results and current performance may be lower or higher than the performance data quoted. The investment return and principal value of an investment will fluctuate, so that shares when redeemed may be worth more or less than their original cost. Investors cannot invest directly into an index. For performance information current to the most recent month-end, please call 888-814-8180.
Source: Morningstar Direct. Performance data quoted above is historical.
The Fund’s management has contractually waived a portion of its management fees until March 31, 2023 for I, A, C and R6 Shares. The performance shown reflects the waivers without which the performance would have been lower. Total annual operating expenses before the expense reduction/reimbursement are 1.61%, 1.86%, 2.61% and 1.63% respectively; total annual operating expenses after the expense reduction/reimbursement are 1.51%, 1.76%, 2.51% and 1.14% respectively.1 2.00% is the maximum sales charge on purchases of A Shares.
500dm: dm refers to discount margin and is the average expected return of a floating-rate security that is earned in addition to the index underlying, or reference rate of, the security.
AAA LCF: AAA Last Cash Flow are the AAA bonds setup to receive principal repayments last among AAA bonds.
ABS: Is a type of financial vehicle that is collateralized by an underlying pool of assets — usually ones that generate a cash flow from debt.
Bloomberg Aggregate Bond Index: A broad bond index covering most U.S. traded bonds and some foreign bonds traded in the U.S. The Index consists of approximately 17,000 bonds.
CLO: Collateralized Loan Obligation is a single security backed by a pool of debt.
CMBS: Commercial mortgage-backed securities (CMBS) are fixed-income investment products that are backed by mortgages on commercial properties rather than residential real estate.
CMS: Constant Maturity Swap is a type of interest rate swap where the floating portion of the swap is reset periodically against the rate of a fixed maturity instrument, such as a Treasury note, with a longer maturity than the length of the reset period. In a regular or vanilla swap, the floating portion is usually set against LIBOR, which is a short-term rate.
Conduit: Are commercial real estate loans that are pooled together with similar commercial mortgages.
CRE CLO: Commercial real estate collateralized loan obligations. These securitization vehicles purchase mortgage loans secured by commercial and multifamily properties that are typically undergoing some type of transition and are short term floating-rate.
CRT (CAS/STACR): Credit Risk Transfer securities are general obligations of the US Federal National Mortgage Association, commonly known as Fannie Mae, and the US Federal Home Loan Mortgage Corporation, commonly known as Freddie Mac. TCRT securities were created in 2013 to effectively transfer a portion of the risk associated with credit losses within pools of conventional residential mortgage loans from the GSEs to the private sector. Two CRT structures are STACR (Structured Agency Credit Risk) and CAS (Connecticut Avenue Securities).
MOVE Index: (Merrill Lynch Option Volatility Estimate) Index is a measure of bond market volatility similar to the VIX for equity markets.
Non-QM: A non-qualified mortgage is a home loan designed to help homebuyers who cannot meet the strict criteria of a qualifying mortgage.
RevPARs: Revenue per available room is a performance measurement in the hospitality industry and is calculated by multiplying a hotel’s average daily room rate by its occupancy rate.
RMBS: A type of bond secured by a pool of residential mortgages. Typically, there are 100’s of mortgages grouped together in one bond.
Investors should carefully consider the investment objectives, risks, charges and expenses of the Fund. This and other information is contained in the Fund’s prospectus, which can be obtained by calling 888-814-8180 and should be read carefully before investing. Additional Fund literature may be obtained by visiting www.EasterlyFunds.com.
Risks & Disclosures
Past performance is not a guarantee nor a reliable indicator of future results. As with any investment, there are risks. There is no assurance that any portfolio will achieve its investment objective. Mutual funds involve risk, including possible loss of principal. The Easterly Funds are distributed by Ultimus Fund Distributors, LLC. Easterly Funds, LLC and Orange Investment Advisors, LLC are not affiliated with Ultimus Fund Distributors, LLC, member FINRA/SIPC. Certain associates of Easterly Funds, LLC are registered with FDX Capital LLC, member FINRA/SIPC.
1 The Fund’s investment adviser has contractually agreed to reduce and/or absorb expenses until at least March 31, 2023 for I, A, C and R6 Shares, to ensure that net annual operating expenses of the fund will not exceed 1.48%, 1.73%, 2.48% and 1.11%, respectively, subject to possible recoupment from the Fund in future years.
There is no assurance that the portfolio will achieve its investment objective. A CLO is a trust typically collateralized by a pool of loans. A CBO is a trust which is often backed by a diversified pool of high risk, below investment grade fixed income securities. A CDO is a trust backed by other types of assets representing obligations of various parties. For CLOs, CBOs and other CDOs, the cash flows from the trust are split into two or more portions, called tranches. MBS and ABS have different risk characteristics than traditional debt securities. Although certain principals of the Sub-Adviser have managed U.S. registered mutual funds, the Sub-Adviser has not previously managed a U.S. registered mutual fund and has only recently registered as an investment adviser with the SEC.
MBS and ABS may be more sensitive to changes in interest rates and may result in prepayments which can include the possibility that securities with stated interest rates may have the principal prepaid earlier than expected, which may occur when interest rates decline. Rates of prepayment faster or slower than expected could reduce the Fund’s yield, increase the volatility of the Fund and/or cause a decline in NAV. With respect to the tranches, which are part of CLOs, CBOs, and CLOs, each tranche has an inverse risk-return relationship and varies in risk and yield that depending on economic factors such as changes interest rates can adversely affect the Fund.
Easterly Funds, LLC and Easterly Investment Partners, LLC both serve as the Advisors to the Easterly Fund family of mutual funds and related portfolios. Both Easterly Funds, LLC and Easterly Investment Partners, LLC are registered as investment advisers with the SEC. Mutual Funds are distributed by Ultimus Fund Distributors, LLC, member FINRA/SIPC. Although Easterly Funds, LLC and Easterly Investment Partners, LLC are registered investment advisers, registration itself does not imply and should not be interpreted to imply any particular level of skill or training.
THE OPINIONS STATED HEREIN ARE THAT OF THE AUTHOR AND ARE NOT REPRESENTATIVE OF THE COMPANY. NOTHING WRITTEN IN THIS COMMENTARY OR WHITE PAPER SHOULD BE CONSTRUED AS FACT, PREDICTION OF FUTURE PERFORMANCE OR RESULTS, OR A SOLICITATION TO INVEST IN ANY SECURITY.