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Structured Credit Value Fund Q1 2021 Commentary

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Macro:  The Democrats’ sweep of both Senate seats in Georgia’s run-off election gave them essentially a 51-50 majority in the Senate to go along with a reduced and thin majority in the House.  This set the stage for President Biden’s signing of the $1.9 trillion COVID-19 relief bill dubbed American Rescue Plan which Democrats passed unilaterally without any votes from Republicans.  The new stimulus bill increased direct payments to most Americans by $1,400, extended unemployment insurance benefits, and provided $350 billion to state and local governments, pushing the combined fiscal stimulus since last March to over $5 trillion and caused the U.S. deficit to reach an all-time high. The Federal Reserve continues to fund much of this deficit through QE purchases of Treasuries and MBS securities, increasing such purchases in Q1 2021 to $325 billion from $307 billion in Q4 despite unemployment declining to 6% in March 2021 from the peak of 14.8% in April 2020.  The Fed’s continuous liquidity injections have pushed the M2 YOY % increase to 27% in Q1 2021, also the highest on record.  While Fed’s preferred inflation gauge, PCE, along with CPI posted rather anemic rises of 1.4% and 1.7% in February 10-year break-evens spiked up in Q1 to 2.32% to reach the highest level since 2013. Inflationary concerns caused the long-end of the Treasury curve to sell off with the 10-year rate increasing 83bp while 2-10s steepened by 78bp.  The Fed’s dovish stance, as indicated by their desire to see sustained inflation above 2% and dismissal of high inflationary prints as transient, continue to anchor short term rates near zero with no Fed Funds increases expected until 2023.

Fears of higher inflation and higher long-term interest rates were counterbalanced by the expected economic boom stemming from the fiscal stimulus and reopening of the economy as a significant portion of the U.S. population has been vaccinated.  The Russell 2000 continued its staggering run begun in Q4 increasing 11.4% in Q1 2021 while the S&P 500 and Nasdaq 100 posted 6.7% and 1.1% returns, respectively.  In the credit markets, the Bloomberg Barclays Corporate Index posted a -4.71% return due to its long duration exposure while Corporate OAS tightened 7 bp to 91 bp, very close to pre-COVID-19 lows.  The Bloomberg Barclays High Yield Index managed a total return of 0.85% as its carry and spread tightening outweighed the negative impact of higher interest rates.  The Bloomberg Barclays High Yield OAS of 288 bp is approaching all-time low levels from 2018.  Structured credit outperformed Corporates as higher carry and continued spread tightening was not offset by rising rates due to its generally shorter effective duration.

RMBS:  A combination of record low mortgage rates, record low inventory, and excess liquidity propelled home prices higher by 11% YOY in January.  Existing home sales surged to 6.5 million per annum by year end, driving existing home inventory down to just 1.9 months’ supply, a record low.  Meanwhile, borrower credit performance continues to improve with between 53-74% of loans with COVID-19 related forbearance have cured, particularly for new issue Prime 2.0 mortgages.  In fact, prepayment risk posed by these premium-priced bonds now overshadows credit risk.  Across RMBS sectors, floating rate securities outperformed fixed-rate bonds on an absolute basis as rising rates pushed down prices of fixed-rate bonds in Prime 2.0, Non-QM, and RPL sectors. However, both floating and fixed-rate securities posted positive excess returns due to some mild spread tightening.

Within new issue sectors, lower rated subordinate Credit Risk Transfer (CRT) securities performed well benefitting from credit curve flattening with many CRT sectors approaching all-time tights at the end of January.  However, increases in interest rate volatility combined with liquidity pressures widened them back out somewhat into quarter end.  Non-QM senior and subordinate tranches priced at record tight levels in February but, like CRT, the rate back-up along with prepayment unpredictability pushed spreads 15-20bp wider into quarter end.  We feel that more seasoned 2015-2019 Non-QM/RPL subordinate tranches offer better relative value compared to the new issue, especially when considering any extension past the first call.  Legacy RMBS posted strong performance in Q1 2021 as spreads tightened for both floating and fixed-rate coupons.  Bank of America Legacy RMBS index was up 2.5% in Q1 with spreads on longer-duration non-investment grade subprime floaters tightening inside of 200 bp. Secondary market supply continues to be very light for Legacy RMBS securities with weekly BWIC volumes rarely exceeding $1 billion. Lack of supply combined with strong demand for low duration securities has pushed Legacy RMBS floaters close to post-crisis tights.

RMBS was the 2nd best performing sector in the portfolio for the quarter, contributing 71 bp. Roughly 65% of portfolio RMBS exposure is in Legacy RMBS securities and these bonds continue to benefit from strong carry and gradual spread tightening.  In the first quarter we have added several 2015-2019 Non-QM subordinate tranches that pick up 50-100bp over brand new issuance.  We also added exposure to 2019 RPL Seniors with attractive spread pick-up assuming extension past first call date.

CMBS:  As was the case for the RMBS sector, CMBS benefited from improving credit fundamentals as special servicing rate has declined for 6 consecutive months through March 2021 where it stood at 9.42%.  Credit weakness remains property type specific, with Lodging having 24.2% of its balance in special servicing while Retail had 16.2%.  Green Street Commercial Property Price Index increased 2.5% in Q1 2021 but still is approximately 5% below pre-COVID-19 levels. Industrial properties remain the best performing segment of the Commercial Real Estate (CRE) market with prices up 14% from pre-COVID-19 levels while malls are the worst performing segment down 20%. However, we believe all CRE prices will eventually be supported by the more than $75 billion of distressed real estate funds raised by private equity hoping to take advantage of COVID-19 related dislocations and by gradual reopening of the economy.

Credit curve flattening was at work in the CMBS market as CMBS conduit mezzanine tranches with on-the-run BBBs tightening by 60bp from 375 to 315bp while AAA LCF tranches were roughly unchanged in Q1 at 70bp.  However, the tightening of deeper credit tranches was not necessarily indiscriminate as several large CMBS sponsors including Simon Property Group and Brookfield have decided to hand in keys to several regional malls and the news had a negative impact on select mezzanine tranches from 2011-2015 deals. In SASB space we saw a continuing spread compression across most AAA tranches from low 100s to low 70s dm.  There was also renewed appetite for mezzanine tranches off hotel deals that had struggled from COVID-19 related effects. Hotels that are perceived to survive the pandemic have seen mezzanine prices approach par while more questionable properties continue to trade weaker. Small Balance Commercial (SBC) mezzanine floaters continued to see spread tightening in Q1 with some highly credit-enhanced non-Investment grade floaters trading well inside 200 discount margins (DM). The CMBS sector contributed 45 bp to the overall return for the quarter benefitting from the reach for yield and continued credit curve flattening.

ABS:  Consumer ABS sectors’ credit performance has been exceptionally strong through the pandemic buoyed by government assistance programs benefitting the consumer.  One clear example of this trend is the performance of unsecured consumer loans originated via different Marketplace Lenders (MPL).  According to Kroll’s research, their Tier 3 index comprised by loans originated through the Avant and LendingClub platforms with average FICO scores between 630 and 660 have seen their annualized loss rates decline from 20% in 2019 to below 10% in Q1 2021 while 30+ day delinquencies have dropped from 7% pre-COVID-19 to below 4% in Q1 2021.  As a result, MPL subordinate tranches have been the best performers among ABS subsectors with BBB tightening from 390 bp last summer to 270bp and BB spreads tightening from 700 bp to 425bp over that same period.  ABS issuance has picked up in Q1 2021 to 63.3 billion, up 25% YOY. New issue volumes were led by Auto ABS (54%), Student Loans (24%), and equipment ABS (10%).  ABS, which makes up less than 4% of portfolio assets, contributed 8 bp to overall portfolio return for the quarter.

CLO:  S&P Leveraged Loan prices rallied 1.4 points to 97.6 in Q1 2021, eclipsing the 2019 high and close to February 2018 levels when the loan index price rose above 98.  AAA CLO DMs tightened to 108 bp at the end of Q1 according to Palmer Square CLO indices. A-rated CLO DMs reached 205 bp while BBB spreads tightened to 340 bp as the credit curve continued to flatten. Tighter CLO spreads produced an avalanche of new issue volume with a record $98.7 billion in new deals, refinancing, and resets issued in Q1 2021.  Many deals with high CCC allocation saw significant credit improvement as around 16% of CCC loans have been upgraded according to Bank of America Research, and the average price of CCC loans has improved from mid 60s in the summer of 2020 to slightly above 90 as of the end of Q1.  As a result, the Market Value of Collateral (MVOC) ratios of BBB and BB tranches are now above pre-COVID-19 levels.  The CLO/CDOs sector contributed 51 bp to the overall portfolio return.

Corporate Structured Notes: Structured notes continued to benefit from a steeper yield curve and a rally across equity markets.  The 70bp increase in 30 – 2 yr. swap rates caused 5x levered Constant Maturity Swap (CMS) floaters’ coupons to approach cap levels of 10%. Meanwhile 4x Morgan Stanley (MS) non-callable CMS floaters have appreciated to around par, 35-40 points above Q1 2020 pre-COVID-19 levels. There has been a heavy call activity by other bank issuers including Citibank, Nomura, Lloyds, Credit Suisse, of callable 4x CMS floaters whose coupons are now 7%+, which has reduced the available secondary supply.  10x and 20x MS non-callable CMS floaters have been trading between 108 and 112 and continue to offer significant value relative to lower multiple CMS floaters.  This sector was the biggest contributor to portfolio performance, benefitting from significant steepening of the yield curve during Q1 2021, the rally in equity markets, and the insatiable demand for yield among both institutional and retail investors, adding 114 bp to portfolio total return in 1Q21.

Portfolio Outlook:   In spite of the Fed’s stated dovish stance and continued QE purchases, the long end of the yield curve sold off significantly in Q1 2021 as market participants expect inflationary pressures to materialize soon due to record money supply and fiscal stimulus programs in the U.S.  With home prices already higher by 11% YOY and commodity prices jumping 50% YOY, it will be interesting to see if the Fed’s preferred indicators continue to deny the existent of emerging inflation.  Any surprises to the upside should move long end of the curve higher and a rise in 10-year note to 2.25-2.5% cannot be ruled out in such a scenario.  Absent that, we should see limited rate volatility which should allow additional spread tightening at the riskier end of the credit spectrum (i.e., additional credit curve flattening).  However, given that most Structured Credit sectors are already tighter compared to the Pre-COVID-19 2019/2020 environment, we remain wary of reaching for yield.  Instead, in this environment we prefer a robust and relatively liquid portfolio, positioned to take advantage of volatility in credit markets opportunistically.

Within Structured Credit, we do still find many sub-sectors attractive, particularly relative to other fixed income sectors such as Corporates and Agency MBS.  In RMBS, for example, we like Legacy Callable Seasoned Fixed-rate Seniors/Subordinate tranches and 2017-2019 vintage Non-QM subordinate tranches.  In CMBS, we like moderately seasoned conduit subordinate tranches higher up in the capital structure.  In the CLO/CDO sectors, we see value in Single A rated CLO Mezzanine tranches off tier 3 or 4 managers as well as investment grade Trups CDOs backed by seasoned pre-2010 trust preferred issued by small to medium sized banks.  In the Corporate Structured Note sector, we prefer non-callable high multiple bank issued structured notes. As we enter Q2 with effective duration of 2.2 years, spread duration of 3.6 years, and portfolio yield of 4.6%, we still have dry powder of over 17% cash and Treasuries in the event those opportunities materialize.

 

3/31/2021 YTD 1-Year 2-Year Since Inception

8/21/2018

I Share 2.66% 22.47% 10.62% 9.84%
Morningstar Multisector Bond Category -0.22% 14.84% 7.16% 4.82%
Bloomberg Barclays U.S. Aggregate Bond Index -3.37% 0.71% 8.10% 5.15%

 

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. The Fund’s management has contractually waived a portion of its management fees until March 19, 2023 for I Shares, A Shares, C Shares, 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% for I Shares, 1.80% for A Shares, 2.60% for C Shares, 1.59% for R6 Shares; total annual operating expenses after the expense reduction/ reimbursement are 1.53% for I Shares, 1.78% for A Shares, 2.53% for C Shares, 1.16% for R6 Shares1. 2.00% is the maximum sales charge on purchases of A Shares. For performance information current to the most recent month-end, please call 888.814.8180.

 

Risks and 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.

James Alpha Advisors, LLC serves as the Advisor to the James Alpha 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. James Alpha Funds, LLC are distributed by Ultimus Fund Distributors, LLC. James Alpha Advisors, LLC, Orange Investment Advisors, LLC, FDX Capital LLC, are not affiliated with Ultimus Fund Distributors, LLC.

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