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Structured Credit Value Fund Q3 2020 Market and Performance Commentary

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Macro Outlook

The rally across risk assets took some respite in September after 5 straight months of recovery from the sharp sell-off in March related to COVID-19.  A mixture of elevated valuations, escalation of COVID-19 cases across the European continent, uncertainties related to US elections and concerns regarding the passage of a new stimulus bill rattled some investors into reducing risk in their portfolios. While continuing jobless claims have declined from a peak of 25MM early May, they still hover at just below 9MM at quarter end.  While still positive, the rate of job creation has slowed with the unemployment rate still elevated at 7.9%, still far above the 3.5% pre-crisis level.  On the monetary front, the Federal Reserve re-confirmed its commitment to near zero short term rates for the foreseeable future at its latest September meeting and expressed its willingness to tolerate inflation rates above the 2% target if inflation has undershot this target in previous periods.

In the equity markets, the Nasdaq 100 finished 3rd quarter up an impressive 12.62% despite a decline of 5.67% in September, while the S&P 500 index returned 8.93% in Q3 while dropping 3.80% in September.  In fixed income, the Barclays High Yield (HY) Corporate index OAS widened by 40bp in September but still posted a return of 4.60% for the quarter on the back of 109bp of spread tightening as it retraced over 75% of March spread widening.  Barclays Investment Grade (IG) Corporate index was relatively flat in August and September, but still posted a 1.54% return for Q3.  Interest rate volatility reached record lows in September as 10-year Treasury yield declined 2bp with the 2-year Treasury remaining flat.  Overall, the yield curve was virtually unchanged in Q3, with the 2-year to 10-year spread steepening by a mere 5bp.

Sector Outlooks

RMBS (Residential Mortgage Backed Securities)

RMBS subsectors outperformed High Yield and IG Corporates in September as continuing favorable supply/demand technicals combined with solid fundamentals drove RMBS spreads tighter for the most part. Legacy RMBS performed well as delinquencies continue to decline while record low rates have generated prepayment increases on discount priced bonds.  New issue RMBS across most types and credit ratings continued to tighten during the quarter.  The 40% allocation to RMBS posted a sector return of 2.5% for the quarter, contributed 94bp of return to the portfolio.

CMBS (Commercial Mortgage Backed Securities)

Similar to RMBS, CMBS Conduit and Single Asset, Single Borrower (SASB) on-the-run tranches outperformed IG Corporates and High Yield in September despite negative headlines surrounding hospitality and retail segments of the market. For the 3rd quarter, new issue CMBS AAAs were about 27bp tighter while BBBs tightened by 135bp.  30+ day delinquencies have stabilized after reaching a June peak and now stand at 8.0% for Conduit and 7.1% for SASB deals, while delinquencies in Hotel and Retail property types continue to lead other sectors by a wide margin at 22% and 12% respectively at the end of September.  The 15% allocation to CMBS posted a sector return of 5.9% for the quarter, contributing 89bp of return to the portfolio.

ABS  (Asset Backed Securities)

September saw a deluge of new issue activity with $26 billion coming to the primary market and almost half of it out of auto sectors. Hence, secondary trading activity was quiet as investors were absorbing the new issue supply. For example, new issue subprime auto AAAs were placed at around a 30bp spread while BBBs spreads ranged from 140bp to low 200bp across issuers.  Strong demand for short duration paper continues to drive spreads tighter with most ABS sectors recovering most of March COVID-related losses.  JP Morgan ABS indices posted total returns of 3-5% across sectors for the 3rd quarter.  Credit performance of auto loans continues to exceed expectations with just 0.9% of prime loans and 6.2% of non-prime becoming delinquent or getting charged-off since April. The 5% allocation to ABS posted a sector return of 3.7% for the quarter, contributing 19bp of return to the portfolio.

CLO (Collateralized Loan Obligation)

CLOs outperformed HY Corporates in September on the back of another positive month for primary leveraged loan prices. Tighter CLO spreads finally made arbitrage conditions possible for CLO issuers who were able to place $11 billion in new CLO deals in September.  Over the course of the 3rd quarter AAA spreads tightened by 40bp, single As by 45bp, while BBBs exhibited about 75bp of spread tightening.  On the fundamental credit side, as the pace of loan defaults slowed in September while the leveraged loan prices continued to climb, median par build for most managers was positive for the first time since April.  Par build refers to an increase in value of the pool of loans collateralizing the CLO, which enhances the structural protection that CLO bondholders benefit from by increasing over-collateralization. The 18% allocation to CLOs posted a sector return of 3.7% for the quarter, contributing 66bp of return to the portfolio.

Corporate Structured Notes

Despite increasing macro related volatility and decline in major equity indices demand overwhelmed any limited supply with prices of capped CMS floaters from MS, CS, Lloyds, Barclays and other issuers rising by 1-3% in September. For the quarter, low multiple CMS floaters have appreciated by 5-7% while high multiple CMS floaters (10x and 20x) have seen similar price increases with most now trading well into the 90s. The 13% portfolio allocation to Corporate Structured Notes posted a sector return of 9.2% for the quarter, contributing 120bp of return to the portfolio.

Structured Credit Fund Asset Allocations

Portfolio Outlook

Given recent spread tightening across Structured Credit and fixed income sectors in general, we are comfortable holding a larger percentage of the portfolio in more liquid sectors such as short Treasuries and cash. We expect spread volatility to rise with election-related and other uncertainties and believe dry powder will position the portfolio for opportunities.  In terms of credit fundamentals, we expect home price appreciation (HPA) to moderate to around 3% for the remainder of 2020 and residential credit to continue to be supported by a strong real estate market and record low mortgage rates.  While commercial real estate (CRE) fundamentals continue to look precarious given turmoil in the hospitality and retail sectors, we believe credit dislocations will continue to offer opportunities as banks and primary dealers are not willing to provide liquidity due to a number of regulatory issues.  In CLO/CDO space we like post-reinvestment de-levered mezzanine tranches that seek to offer an upside of single digit yields, as well as some lower tier manager AA and A CLO mezzanine tranches as they seek to offer spread pick-up over better manager broadly syndicated loan (BSL) paper. We also like investment-grade, 2nd pay, well-enhanced Trups CDOs at a spreads above 300bp among CLO/CDO subsectors. Finally, we continue to aggregate Corporate Structured Notes that offer what we believe to be an attractive carry with further potential upside should the yield curve continue its steepening trend.

JSVIX Performance Chart as of 9/30/2020

Risks and Disclosures

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. Each tranche has an inverse risk-return relationship and varies in risk and yield. The Portfolio may engage in frequent trading of portfolio securities resulting in higher transaction costs, a lower return and increased tax liability. Basis risk refers to, among other things, the lack of the desired or expected correlation between a hedging instrument or strategy and the underlying assets being hedged. Certain derivative and “over-the-counter” (“OTC”) instruments in which the Portfolio may invest, such as OTC swaps and options, are subject to the risk that the other party to a contract will not fulfill its contractual obligations. Credit spread risk is the risk that credit spreads (i.e., the difference in yield between securities that is due to differences in their credit quality) may increase when the market believes that bonds generally have a greater risk of default. The dollar value of the Portfolio’s foreign investments will be affected by changes in the exchange rates between the dollar and the currencies in which those investments are traded. Derivatives may be volatile and some derivatives have the potential for loss that is greater than the Portfolio’s initial investment. OTC swap transactions are two-party transactions and are therefore often less liquid than other types of investments, and the Portfolio may be unable to sell or terminate its swap positions at a desired time or price. High yield, below investment grade and unrated high risk debt securities (which also may be known as “junk bonds”) may present additional risks because these securities may be less liquid, and therefore more difficult to value accurately and sell at an advantageous price or time, present more credit risk than investment grade bonds and may be subject to greater risk of default. 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.

James Alpha Advisors, LLC serves as the Advisor to the James Alpha family of mutual funds and related portfolios. James Alpha Advisors is a related entity to James Alpha Management, LLC, a New York based SEC-registered investment advisor which invests in emerging managers and their hedge fund and/or mutual funds. Their form ADV can be found at Please consider the charges, risks, expenses and investment objectives carefully before investing. Please see a private placement memorandum (PPM), 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 Northern Lights Distributors, LLC. Hedge Funds are distributed by FDX Capital LLC. Both are members of FINRA and SIPC.

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