Skip to content

Structured Credit Value Fund Q4 Commentary

Download PDF

Macro:  Resolution of political uncertainty and good news on vaccine breakthroughs, against a backdrop of additional fiscal stimulus and unprecedented monetary stimulus catapulted risk assets higher with the credit curve undergoing significant flattening as riskier profiles recovered most of their price losses from March.  Despite massive COVID-19 related disruptions that claimed over 350K lives and are likely to cause 3.5% decline in US 2020 GDP along with 6.7% unemployment rate, both IG Corporate and High Yield absolute yields reached the lowest levels on record at 1.74% and 4.18%.

The Russell 2000 index of small cap stocks posted a record quarter at +31.35%, more than double the return of the broad large cap S&P 500 index of +12.14%.  Bond markets priced in higher inflationary pressures in the 4th quarter with the treasury curve undergoing 24bp of bear steepening between 2s and 10s as 10-year Treasury note reached 0.91%. In spite of that move, interest rate volatility metrics continued to trudge along historical lows given investors’ perceived commitment by the Fed to keep low rates across the curve for the foreseeable future.  IG Corporate spreads tightened by 40bp with the Barclays Corporate index posting 3.04% return. High Yield outperformed on the back of a strong rally driven by COVID-19 vaccine news with the index spread tightening by 157bp and helping Barclays High Yield index post 6.45% return for the 4th quarter. The Fund posted 2.74% return in the 4th quarter outperforming Barclays Aggregate index by 2.07%.

RMBS: RMBS sectors continued to see similar trends observed in corporate credit with credit curve flattening and retracement of COVID related spread widening.  All RMBS credit sectors continue to be underpinned by very strong housing fundamentals with October S&P Case-Schiller national index posting an impressive 8.4% YOY gain in October.  About half of non-agency borrowers who turned delinquent between April and July due to pandemic related issues were able to return to the current status by the end of year. A large percentage of credit curing is due to payment deferral plans implemented by mortgage servicers. Legacy RMBS performed well but were outperformed by more credit-sensitive new issue sectors due to credit curve flattening in the quarter.  2020 RMBS gross issuance came to ~91bn based on JP Morgan research numbers with net issuance for RMBS running at -17bn versus +22bn in 2019. Relative lack of new issue supply helped further support RMBS spreads. RMBS once again delivered solid returns in the 4th quarter. With roughly 75% of RMBS exposure in Legacy securities, these bonds continue to benefit from strong carry and gradual spread tightening.  Outside of the Legacy holdings, we sold a small CRT M2 position at significant price gain.

CMBS: CMBS sector performance mirrored that of the High Yield market with spreads tightening across the credit stack and credit curve flattening following news of the vaccine breakthroughs.  AAA Last Cash Flow (LCF) spreads dipped to low 70s, inside the Pre-COVID LCF AAA levels while on-the-run BBB Conduit spreads tightened to high 300s/low 400s as yield hungry cross-asset investors took advantage of some of the widest available spreads in fixed income credit markets. Delinquency rates have mostly trended downwards since reaching their peak in June.  30+ day delinquency rates have fallen by 0.8% and 3.0% for the conduit and SASB universes, respectively.  Lodging and Retail remain the two most problematic CMBS sectors with 30+ day delinquencies at 19.66% and 14.21% at the end of November according to Trepp.  CMBS spreads were helped by a sharp decline in overall CMBS new issue supply, down 15% YOY, and robust demand from insurance companies who found CMBS yields attractive relative to other credit sectors.  We recorded some realized gains in SASB subordinate tranches and also saw significant price appreciation in Small Balance Commercial subordinate bonds off VCC and RCMT shelves.

ABS:  Continuing demand for incremental yield in short duration space along with solid credit fundamentals drove ABS spreads to tighter levels relative to Pre-COVID environment.  AAA Subprime auto spreads finished the year at +18 bp which is 18 bp tighter compared to the end of 2019 while BBB Subprime auto at 115 bp, roughly unchanged since 2019.  Prime Auto ABS annualized net losses are near their lowest level since 2015 while subprime auto ABS net loss rates were 4.4% in November 2020 compared to 9.1% in 2019.  Strong technical were driven by demand foe spread in short duration assets combined with declining supply as issuance was well below recent historical at $171bn, compared to ~$225bn average over the previous 3 years.

CLO:  S&P leveraged loan prices rallied 3 points in the 4th quarter, finishing 2020 at similar levels as they began 2019 – around 96h.  CLO credit curve flattened as in other sectors with BBs posting the best returns at 10% due to spreads tightening of 130-150bp in Q4.  BBBs rallied to 360 bp spread and posted an impressive 4.79% return for the quarter.  AAA spreads have tightened to 115 bp and are now at similar levels as Pre-COVID 2019 tights.  Loan default rates have declined from a 5 year high of 4.26% in September to 4% while CLO Overcollateralization (OC) test failures have improved as only 6% of deals were failing their junior OC triggers compared to 20% in June according to JP Morgan research.  CLOs contributed similar return to the portfolio as CMBS and RMBS as leveraged loan prices rallied, allowing the sale of AA and AAA positions at spreads inside of 200 bp.

Corporate Structured Notes: Structured notes benefited from a trifecta of positive tailwinds in the 4th quarter: 1) steeper yield curve 2) tighter corporate spreads and 3) rally in equity markets. Low multiple CMS floaters rallied 10-12% while higher multiple CMS floaters saw an additional 10% price appreciation in Q4.  The Corporate Structured Note sector, which comprised 14.3% of the portfolio, was the biggest contributor to performance in Q4. These CMS floaters benefited from a steepening in the yield curve, rally in equity and credit markets and insatiable demand for incremental yield among both institutional and retail investors.

 

Sector Quarter Return Allocation Attribution Price Yield Effective Duration Spread Duration
RMBS 1.82% 32.53% 0.63% $94.30 4.9% 3.2% 4.0%
CMBS 3.76% 14.65% 0.54% $93.00 7.3% 1.6% 2.8%
ABS 2.06% 4.88% 0.10% $63.10 4.5% 2.0% 4.0%
CLO/CDO 3.11% 16.81% 0.54% $77.30 5.6% 0.6% 5.9%
CORP 6.66% 16.04% 0.95% $93.40 4.6% 2.3% 9.7%
GOVT -0.21% 8.92% -0.01% $98.10 0.4% 4.2% 0.0%
Cash 0.0% 6.18% 0.00% $100.00 0.5% 0.0% 0.0%
Total/Average   100% 2.74% $89.20 4.6% 2.2% 4.5%

Portfolio Outlook:   After contracting 3.5% in 2020, US GDP is slated to expand by 3.5% to 5.0% in 2021 driven by more than $3 trillion in fiscal stimulus and the Fed’s various monetary liquidity programs.  With the Senate in the control of the Democrats, additional fiscal stimulus is expected.  Vaccine rollouts as well should lessen the need for additional lockdowns.  With the Fed firmly on hold, growth risks skewed to the upside due to vaccine efficacy, additional fiscal stimulus measures and more government spending in general, we think that the US Treasury curve is likely to continue its steepening trend.  Short term rates are not going anywhere with the Fed on hold, we also expect the Fed to limit the extent of steepening that occurs through various means they now have, with the 10 yr Treasury possibly reaching 1.5%.  With inflation expectations back at 1.5-2% after going to zero in March 2020, with 10 yr treasuries below 1.5%, real yields are now negative.  With nominal Treasury rates around 1% and Corporate bond spreads near all-time tights, nominal Corporate yields are near all-time lows, around 1.75%, while real Corporate yields are near zero.  Meanwhile, Corporate bond durations are near all-time highs, around 8.75 yrs.  Assuming a 35 bp sell-off in 10 yr Treasury rates to 1.5, with a near 9-year duration, Corporates would be down 3% in price.  With less than 2% yield, Corporates could easily have negative total return in 2021.

We believe Structured Credit looks more attractive than Treasuries or Corporates for 2021.  With home prices increasing by 8% in 2020 and mortgage rates at all-time lows, the housing market is in good shape fundamentally which should support non-agency RMBS returns.  CMBS sectors will continue to face fundamental headwinds into 2021 and additional stresses from pandemic related shutdowns and overall slowdown in consumer demand would likely cap any meaningful rally.  However, their yields are some of the widest in the fixed income markets and we believe that will attract demand.  ABS bonds remain fortified against the pandemic induced stress and are expected to hold up well in 2021.  After significant recovery in Q4 2020, higher rated CLO spreads do not look as attractive as earlier in the year.  However, like CMBS, some lower and below investment grade tranches still trade at significantly wider spreads and could provide excess returns, assuming riskier leveraged loan pools are avoided.  We still like Corporate Structured Notes such as CMS floaters with or without equity barriers found in secondary markets as they continue to offer incremental spread pick-up of 100-200 bp relative to Corporate bullets of the same credit.

 

As of 12/31/2020 1-Year 2-Year Since Inception 8/21/2018
I Share 14.05% 10.62% 9.69%
Morningstar Nontraditional Bond Category 3.01% 4.84% 3.48%
Barclays U.S. Aggregate 7.51% 8.10% 7.25%

 

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 31, 2021 for I Shares, A Shares, and C 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 2.01% for I Shares, 2.39% for A Shares, and 3.12% for C Shares; total annual operating expenses after the expense reduction/ reimbursement are 1.51% for I Shares, 1.75% for A Shares, and 2.50% for C Shares1. 5.75% 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

 

1The Fund’s investment adviser has contractually agreed to reduce and/or absorb expenses until at least March 31, 2021 for I, A, and C Shares, to ensure that net annual operating expenses of the fund will not exceed 1.49% for I Shares, 1.74% for A Shares, and 2.49% for C Shares, 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. 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. 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 Northern Lights 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 and should be read carefully before investing. The Saratoga Advantage Trust’s Funds, including all the James Alpha funds, are distributed by Northern Lights Distributors, LLC. 11/11 © Saratoga Capital Management, LLC; All Rights Reserved. Saratoga Capital Management LLC, James Alpha Advisors, LLC, Orange Investment Advisors, LLC, FDX Capital LLC, are not affiliated with Northern Lights Distributors LLC.

4250-NLD-2/4/2021