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Structured Credit Value Fund Q3 2021 Fund and Market Commentary

Macro: The performance of most risk assets moderated during the third quarter. Entering the fourth quarter, stretched valuations, stagflation concerns, the Fed’s impending tapering of Treasury and Agency MBS purchases and potential Evergrande spillover effects have dampened what has otherwise been a continuous equity rally since last year’s presidential election.  Corporate credit posted a positive quarter with the Bloomberg Investment Grade Corporate index up 0.96% and the Bloomberg High Yield index up 0.78%.  Both the absolute yield and spread levels of the High Yield index reached historical lows of 3.53% and 258 bp during the quarter, while IG Corporate spread levels approached January 2018 lows with a plunge to 84bp in early July.  However, both IG and HY spreads widened marginally in September on the back of the equity sell-off.  Credit fundamentals remain favorable due to plentiful funding options available to IG and High Yield issuers.  The trailing 12 month CCC default rate has reached the lowest level in 14 years on a par-weighted basis, at 3%, while the projected default rate for broad High Yield index over the next 12 months is 1.8%, according to Bank of America research.

In spite of a mid-quarter rally, Treasury rates finished Q3 2021 just a few bp higher across the curve.  Federal Reserve chairman Powell strongly suggested at the September FOMC meeting that the Fed would begin tapering Treasury and MBS purchases by the end of the year, with the consensus for the Fed’s tapering announcement being the November meeting, with the start of tapering in December.

Headline CPI YOY% was 5.3% in August while a PPI YOY% August reading of 10.5% resembled inflationary data from early 1980s.  Average wages have been growing at around 5% YOY as employees continue to command higher wages amidst record job openings.  The S&P Case Shiller National Home Price index recorded its highest ever annual increase at 19.7% in July. The Manheim Used Vehicle Value Index was up 27% YOY in September, after moderating a bit this Summer, as persistent supply bottlenecks continue to plague the auto industry. Despite this evidence, headline inflationary statistics are being characterized as transitory and expected to abate soon.

 

RMBS: Supported by record-setting fundamentals including home price appreciation and rent increases, RMBS credit had another positive quarter.  However, with spread levels already close to post-GFC tights, price increases were muted with most of the return derived from carry and gains. The credit curve continued its flattening trend as investors were forced to look to more credit-levered subordinate tranches to find yield.  RMBS credit fundamentals remained robust with aggregate delinquency rates declining for all sectors by 1-3%.

The RMBS allocation, currently at 36% of the portfolio contributed 27bp of return for the quarter.  We continue to find interesting opportunities in the RMBS space, including in slightly seasoned Prime 2.0 subordinate tranches. We believe this prime subordinate tranche carries minimal credit risk given its massive amount of subordination and benefits from optional call extension scenarios where the issuer doesn’t exercise the call right away.

 

CMBS: CMBS spreads were mostly unchanged and correlated with the moves in 10-year Treasury yields during the third quarter. The CMBS market has seen a record amount of supply, with YTD issuance at $101 billion for private label CMBS securities through Q3 2021. The majority of the supply came from Single Asset Single Borrower and CRE CLO segments of the market. Despite some notable outliers, the CRE market has remained quite healthy with national property prices increasing by 13.5% YoY, according to Real Analytics’ August CPPI report.  The gains were once again led by the multifamily sector. The Trepp CMBS delinquency rate has declined for 15 consecutive months. Lodging and Retail continue to lead other CMBS sectors in terms of delinquency percentages with 11.45% and 9.75% of loans, respectively, in 30+ day delinquency bucket. The Lodging sector’s delinquency has dropped by 50% from 12 months ago as the economy has continued to reopen. Higher-rated Small Balance Commercial new issue spreads continue to grind tighter.

 

At a 15% allocation, CMBS delivered 16bp for the third quarter. We added a significant 3.5% to the CMBS sector allocation, primarily in investment grade subordinate tranches off small balance commercial collateral.

 

ABS: The ABS market continues to see record supply along with very strong credit performance. YTD ABS issuance reached $217 billion through the end of Q3, according to Bank of America, up 48% relative to 2020 issuance. Assuming that issuance trends continue across ABS sectors, 2021 will surpass 2018 as having the most issuance since the GFC. ABS issuance has been led by Auto ($105b), Student Loans ($26b) and Consumer lending ($16b).  Delinquency and loss rates have trended lower this year despite somewhat elevated unemployment numbers, as numerous rounds of fiscal stimulus, generous forbearance, and payment deferral plans have helped keep consumer delinquencies and losses in check.  ABS spreads held in a tight range, as strong demand for short duration paper combined with robust credit fundamentals outweigh record primary issuance. Our 2.8% allocation to ABS contributed 2bp of portfolio return in the 3rd quarter.

 

CLO/CDO: Similar to other sectors, CLOs are likely to post record post-crisis issuance in 2021, with $127 billion issued through Q3, as CLO managers have taken advantage of tight spreads to refinance and reset many deals. Robust M&A and buyout activity has also contributed to $55 billion of net issuance.  BB CLOs were the best performers for the quarter with 1.6% return in Q3.  Both investment grade CLOs and TruPS CDOs continue to offer compelling relative value to IG Corporates and BB High Yield securities. The 15% allocation to CLO/CDO    contributed 20bp return this quarter.

 

Structured Notes: Investor demand continued to be healthy for most structures and liquidity remained strong with bid-offer spread inside a point on many seasoned secondary deals. Issuer call activity from Citigroup, Credit Agricole, Lloyds and Natixis has helped to keep prices from rising much above par. With a 16.7% portfolio allocation, Corporate Structured Notes contributed 13bp of return during the quarter.

 

 

Current Portfolio Positioning and Performance Attribution

 

Sector 3Q21 9/30/21
%Rtn %Port %Attrib Allocation Price Yield Eff Dur Sprd Dur
RMBS 0.76% 36.1% 0.27% 34.7% $97.40 3.9% 2.7 3.3
CMBS 1.05% 15.1% 0.16% 16.8% $96.00 5.2% 1.7 2.6
ABS 0.55% 2.8% 0.02% 3.3% $102.00 4.6% 1.8 2.9
CLO/CDO 1.34% 15.0% 0.20% 14.6% $79.30 5.3% 0.5 4.6
CORP 0.80% 16.7% 0.13% 16.3% $98.60 7.6% 2.2 6.8
GOVT 0.14% 7.3% 0.01% 7.0% $98.40 0.5% 3.8 0.0
Cash 0.00% 7.1% 0.00% 7.3% $100.00 0.5% 0.0 0.0
Total 100.0% 0.79% 100.0% $94.60 4.5% 2.0 3.5

 

 

JSVIX posted 0.79% return in Q3 2021 outperforming Barclays Aggregate Index by 0.74%.  All of the returns for the quarter came from carry and some active trading while price return was a slightly negative drag on portfolio performance.  Across sectors, the contribution to portfolio return was fairly evenly distributed.

 

Portfolio Outlook: While we expect some spread volatility in the coming months, we do not think that spreads will widen materially given the robust economic backdrop. Credit fundamentals for residential, consumer and corporate credit look benign, as excesses have not yet formed in these markets.  Long term rates could pose a risk if there is a sudden spike in interest rates as valuations are stretched across most sectors.

 

Within the RMBS sector, we prefer Seasoned Prime/Alt-A fixed-rates trading at or above, Seasoned Subprime fixed-rate (seniors or subordinates) trading at a premium, 2013-2019 vintage Prime 2.0/Non-QM fixed-rate subordinate tranches that have de-levered to warrant investment grade ratings, and select Mortgage Insurance CRT M1 tranches trading at 270-300 bp that can benefit from a rating upgrade.  In CMBS, we like seasoned de-levered Small Balance Commercial mezzanine and subordinate tranches, select A and BBB rated CMBS Conduit mezzanine tranches from 2011-2014. Within ABS, we believe that select delevered subordinate tranches of Equipment ABS deals, and off-the-run Private Student Loan ABS Senior and Subordinate tranches that trade 50-100bp wider relative to more generic shelves both offer relative value. In the CLO/CDO sector, we see value in downgraded BB tranches that have similar credit risk to BBB tranches (CE and MVOC) where credit performance has improved due to higher loan prices and collateral ratings upgrades. These below-IG tranches can provide 100-150bp of spread relative to BBBs.  We also like select CLO Mezzanine tranches from Middle Market CLO deals. We see relative value in 2nd and 3rd pay TruPS CDO investment grade bonds at spreads wider than 200 dm.

 

Finally, in the Corporate Structured Note sector, we like higher multiple Morgan Stanley and Credit Suisse structured notes (10x and 20x) where carry can offset any immediate price declines, as well as lower multiple structured notes in low 90s and below which offer cheap optionality on further curve steepening.

 

We enter 4Q 2021 with a 14% allocation to cash and Treasuries.  As through the history of the approach, we believe this will allow us to be nimble and opportunistic during any dislocation in the structured credit markets.

 

Looking forward, there are a few factors that may stir some volatility in credit markets: the early December debt ceiling negotiations, the Fed’s impending tapering announcement, inflationary pressures that go beyond “transitory”, putting pressure on the Fed to react sooner than expected and disappointing earnings reports. Given that spreads across structured credit sectors have tightened to post-GFC tights, we continue to apply a conservative portfolio management approach, maintaining sufficient liquidity and avoiding undue credit or interest rate risk.

 

9/30/2021 YTD 1-Year 3-Year Since Inception (8/21/2018)
I Share 4.79% 7.65% 8.96% 8.90%
Morningstar Multisector Bond Category 2.34% 6.52% 4.94% 3.20%
Bloomberg U.S. Aggregate Bond Index -1.55% -0.90% 5.35% 4.93%

Source: Morningstar Direct. Performance data quoted above is historical. 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.

The Fund’s management has contractually waived a portion of its management fees until March 19, 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 1.58%, 1.80%, 2.60% and 1.59% respectively; total annual operating expenses after the expense reduction/ reimbursement are 1.53%, 1.78%, 2.53% and 1.16% respectively1. 2.00% is the maximum sales charge on purchases of A Shares.

 

Glossary:

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.

CRT: 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.

CBO: A collateralized Bond Obligation is an investment-grade bond that is backed by a pool of junk bonds. Junk bonds are typically not investment grade, but because the pool includes several types of credit quality bonds together from multiple issuers, they offer enough diversification to be structured as “investment grade.”

CCC: A credit rating used by the S&P and Fitch credit agencies for long-term bonds and some other investments. It is equivalent to the CAA rating used by Moody’s. A CCC rating rep resents an extremely high-risk bond or investment. CCC bonds are junk bonds.

DM: A discount margin is the average expected return of a floating-rate security (typically a bond) that’s earned in addition to the index underlying, or reference rate of, the security. The size of the discount margin depends on the price of the floating- or variable-rate security.

LCF: Last cash flow is the AAA bond which is set up to receive principal repayment last among the AAA bonds.

Non-QM: A non-qualified mortgage is a home loan designed to help homebuyers who can’t meet the strict criteria of a qualifying mortgage.

OAS: Option-adjusted spread is 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.

RPL: A reperforming loan is a mortgage that became delinquent because the borrower was behind on payments by at least 90 days, but it is “performing” again because the borrower has resumed making payments.

TruPS: Trust Preferred securities are hybrid investments issued by large banks with the characteristics of both stocks and bonds. The shares issued are considered to be preferred stock.

 

Risks & Disclosures

  1. The Fund’s investment adviser has contractually agreed to reduce and/or absorb expenses until at least March 19, 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.

Easterly Funds, LLC serves as the Advisor to the Easterly family of mutual funds and related portfolios. Their form ADV can be found at www.adviserinfo.sec.gov. Please consider the charges, risks, expenses and investment objectives carefully before investing. Please see the prospectus, or if available, a summary prospectus containing this and other important information. Read it carefully before you invest or send money. Mutual Funds are distributed by Ultimus Fund Distributors, LLC. Both are members of FINRA and SIPC.

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. 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. Easterly Funds, LLC are distributed by Ultimus Fund Distributors, LLC. Easterly Funds, LLC, Orange Investment Advisors, LLC and FDX Capital LLC, are not affiliated with Ultimus Fund Distributors, LLC.

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.

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