The Easterly Structured Credit Value strategy is a versatile choice for fixed income exposure in a portfolio. The strategy is designed to extract the risk-adjusted returns available in the structured credit market relative to the Bloomberg Aggregate Bond Index sectors, while targeting a risk profile lower than the Index. We do this through a value-based security selection strategy that seeks to capitalize on the complexity and diversity of the structured credit market to identify and acquire underpriced bonds while controlling interest rate risk, credit risk and liquidity risk to preserve excess returns.
Q1 2024 Market Summary and Results
| Category | Allocation | Contribution to Return |
|---|---|---|
| RMBS | 40.16% | 0.48% |
| CMBS | 26.91% | 1.09% |
| ABS | 6.13% | -0.02% |
| CLO/CDO | 4.69% | 0.32% |
| CORP | 12.21% | 0.17% |
| GOVT | 4.99% | -0.08% |
| Cash | 6.13% | 0.02% |
| Hedges | -1.22% | -0.65% |
| Total | 100.00% | 1.33% |
SOURCE: Orange Investment Advisors
Q1 2024 was marked by a continuation of a risk-on sentiment from 2023. Spreads tightened significantly and the credit curve flattened across structured credit sectors. CMBS was the primary beneficiary of spread tightening in Q1 2024 as money began to flow from high yield corporates to structured credit sectors that did not experience the same spread rally that other fixed income sectors saw in late 2023.
We reduced our allocation to some of the most levered, highest beta CMBS subordinate tranches that we acquired in 2023. We pared back our conduit CMBS exposure from 28.4% to 26.9%. At the same time, we slightly increased our RMBS allocation from 39.9% to 40.2% by adding attractively valued Legacy RMBS bonds. We also increased our corporate structured notes exposure from 11.6% to 12.2% to take advantage of relative value to bullets and benefit from potential yield curve steepening.
In terms of return attribution for the quarter, CMBS was the strategy’s biggest contributor with a 1.09% net return. The short CDX HY hedge was the biggest detractor, contributing to the -0.65% net return of hedges. We added some duration back using 10-year Treasury futures as the 10-year rate sold off from 3.80% to 4.25%.
We sold a BBB- rated conduit tranche with limited office exposure (22%) compared to the rest of the 2019 vintage. The deal had a weighted average Debt Service Coverage Ratio (DSCR) of 2.23x and a Loan to Value (LTV) Ratio of 57%. At the sale price, the yield to an extension scenario was 10.82% which represents a 652bp spread to the interpolated Treasury curve (assuming no credit losses). Given that 13% of the deal’s collateral was on our watchlist, we felt that most of the spread tightening had already occurred and that the capital could be better deployed elsewhere.
We also sold a 2023 vintage BBB- rated conduit tranche after purchasing it in Q3 2023. This tranche was issued at a 770bp spread to the interpolated Treasury curve in February 2023 and we purchased it at 975bp spread in Q3 2023 as serious concerns began to emerge regarding CRE refinancing risks. We liked the newly underwritten nature of the collateral that reflected higher financing costs with a Weighted Average Coupon (WAC) of 6.3%. The deal had a weighted average DSCR of 2.02x and a LTV of 51%. After significant spread tightening, we saw limited further upside amidst higher financing costs facing CRE sponsors and general volatility associated with long spread duration CMBS assets. Furthermore, we felt that given the upcoming CRE maturity wall, we would see additional spread volatility in the BBB- part of the CMBS credit curve allowing us to acquire more attractive securities from a relative value perspective.
We bought a de-levered 30%-45% attach/detach BBB- small balance commercial tranche that was initially a 9%-14% attach/detach at issuance and rated BBB-. This meant that credit enhancement increased from 9% to 30%, dramatically reducing the credit risk of the bond, yet this reduced credit risk had not been reflected in the rating. The collateral is mostly multifamily and mixed-use properties and only 1.7% of it is delinquent. We expect continuing de-levering from prepayments which should increase the likelihood that the tranche gets a rating upgrade. At the purchase price the bond yielded 10% which equates to a 561bp spread to the interpolated Treasury curve.
We also bought a senior Alt-A fixed-rate tranche with 0% credit enhancement that is a current loss-taker with 20% delinquent collateral. However, because we bought the bond at a deep discount to par, this tranche can withstand a significant write-down while still generating an attractive 9.4% loss-adjusted yield, representing a 543bp spread to the interpolated Treasury curve in our base case scenario. Given the senior nature of this cashflow, we see limited yield variability and believe that the bond has further upside should liquidation severities on the very seasoned loans come in lower than expected.
As mentioned above, the short CDX High Yield hedge had a negative impact on portfolio net return in Q1 2024. This hedge is designed 1) to reduce overall portfolio spread duration and 2) as a relative value play between Corporate Credit, which we see as much tighter than median levels on a historical basis, and Structured Credit, which we see as wider than median levels on a historical basis. With CDX High Yield spreads tightening from 356bp to 330bp over the quarter, this trade contributed to the portfolio’s -0.65% net return on hedges. In addition, the portfolio holds some of its duration in the form of 10-year Treasury futures, which are included in the hedges sector and also contributed to its negative return as rates sold off for the quarter.
Portfolio Outlook:
One potential benefit of structured credit versus corporate credit in the current market environment is illustrated in the table below.
| Category | YTW | Eff Dur | Spread Dur | 12mo CFR | Severity | LAY | LAY/Spread Dur |
|---|---|---|---|---|---|---|---|
| Easterly Structured Credit Value Composite | 8.66 | 2.98 | 3.59 | - | - | 8.66 | 2.41 |
| Bloomberg High Yield | 7.65 | 3.14 | 3.19 | 4.75% | 60% | 4.8 | 1.5 |
Source: Bloomberg and Orange Investment Advisors as of 3/31/2024. HY Default Rate (12mCDR): S&P Global base case as of 2/14/2024.
Easterly Structured Credit YTW Is already loss-adjusted. Easterly Structured Credit Net LAY assumes a 65bp management fee.
The Yield to Worst (YTW) of the Bloomberg High Yield Index is 7.66% with an effective duration of 3.09 and a spread duration of 3.68. However, according to S&P Global, the projected default rate will be 4.75% by the end of the year and when applying the average historical liquidation severity for the High Yield sector of 60%, the Loss-Adjusted Yield (“LAY”) of the High Yield index drops to 4.81%. When comparing the LAY for the Easterly Structured Credit Strategy vs. the Bloomberg High Yield Index, assuming a 65bp management fee, the strategy has the potential to provide 3.20% more yield over the next 12 months. Moreover, the average credit rating of the Easterly Structured Credit Strategy is Investment Grade (“Single-A” rated) while the average credit rating of the Bloomberg High Yield Index is well below Investment Grade (“Single-B” Rated).
Relative to High Yield, the Easterly CMBS position provides a 9.29% net LAY, 2.66-year effective duration, and 3.48-year spread duration, while having a BBB credit rating. The Easterly RMBS position has a 9.04% net LAY, 2.08-year effective duration, and 3.63-year spread duration, while having a BBB- credit rating. As a measure of risk-adjusted return, Net LAY / Spread Duration is significantly higher for the Easterly Structured Credit Strategy than for the Bloomberg High Yield Index.
In summary, the Easterly Structured Credit Value strategy utilizes an “All Weather” approach that seeks to exploit the risk-adjusted returns available in the structured credit market that emanate from its “non-indexed” properties. We believe structured credit can provide a strong source of fixed income excess returns relative to corporate credit. We believe our strategy’s risk-conscious approach to extracting excess returns from the structured credit market makes it an attractive core position within a fixed income portfolio, as well as a high yielding short duration alternative and a low volatility, investment grade high yield alternative. In the event the portfolio has an explicit allocation to structured credit, our risk-conscious approach may provide an avenue to extract the benefits of the structured credit market, while avoiding its particular risks (i.e., credit and liquidity risks), that have plagued structured credit during periods of market stress and dislocation.
| Composite Performance | Annualized 3-Year Standard Deviation | Total Assets (millions) | ||||||||
|---|---|---|---|---|---|---|---|---|---|---|
| Year End | Gross | Actual Net | Model Net | Benchmark | Composite | Benchmark | Internal Dispersion | Firm | Composite | Number of Accounts |
| 2023 | 7.48% | 5.91% | 6.79% | 5.53% | 2.73% | 7.24% | N/A | 541.83 | 316.24 | 1 |
| 2022 | -4.86% | -6.27% | -5.48% | -13.01% | 5.88% | 5.85% | N/A | 526.5 | 327.79 | 1 |
| 2021 | 6.35% | 4.79% | 5.66% | -1.54% | 5.37% | 3.40% | N/A | 422.61 | 294.19 | 1 |
| 2020 | 15.74% | 14.05% | 15.00% | 7.51% | N/A | N/A | N/A | 274.65 | 193.05 | 1 |
| 2019 | 8.92% | 7.31% | 8.21% | 8.72% | N/A | N/A | N/A | 39.74 | 39.74 | 1 |
| 2018 | 1.96% | 1.46% | 1.74% | 0.98% | N/A | N/A | N/A | 35.76 | 35.76 | 1 |
Firm Definition
Orange Investment Advisors, LLC is an independent registered investment advisor that provides primarily fixed income investment management services to institutional investors. The firm was founded in August 2018 and has claimed compliance with the GIPS standards since the firm’s inception.
Firm Verification Statement
Orange Investment Advisors claims compliance with the Global Investment Performance Standards (GIPS®) and has prepared and presented this report in compliance with the GIPS standards. Orange Investment Advisors’ performance has been independently verified from the firm’s inception, which includes the period from August 1, 2018 through December 31, 2021. The verification report is available upon request. A firm that claims compliance with the GIPS standards must establish policies and procedures for complying with all the applicable requirements of the GIPS standards. Verification provides assurance on whether the firm’s policies and procedures related to composite and pooled fund maintenance, as well as the calculation, presentation, and distribution of performance, have been designed in compliance with the GIPS standards and have been implemented on a firmwide basis. Verification does not provide assurance on the accuracy of any specific performance report.
Composite Description
The Structured Credit Value Strategy Composite includes all fee paying SMAs and Funds that invest in Structured Credit based on Orange’s Active Value Security Selection approach which is a bottom-up, value-based investment strategy. The strategy seeks to provide a high level of income and total return with low sensitivity to interest rates and credit spreads by taking advantage of opportunities in the inefficient and non-indexed structured credit market. Derivatives, including options, futures, and swaps, and short positions may be used, primarily for hedging or managing certain risks, including interest or credit spread risk. The account minimum for the composite is $1 million. The Structured Credit Value Strategy Composite invests in some index securities but primarily focuses on non-index securities, particularly structured credit securities, which offer exposure to underlying debt instruments. These securities can be investment grade, below investment grade, or non-rated and include asset-backed and mortgage-backed securities, and collateralized loan and debt obligations. The inclusion of both investment-grade and below investment-grade securities as well as index and non-index securities offers a broader set of candidates to the Strategy than the benchmark.
Benchmark Description
The benchmark for the composite the Barclays Bloomberg U.S. Aggregate Bond Total Return Index. Index returns reflect the reinvestment of income, but do not include any expenses, such as transaction costs and management fees. The benchmark measures the investment grade, US dollar-denominated, fixed-rate taxable bond market and includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate pass-throughs), ABS and CMBS (agency and non-agency).
Performance Calculation
Valuations are computed and performance is reported in US dollars.
Returns include the reinvestment of income and are presented gross and net of fees. Gross returns are net of transaction costs. Gross-of-fee returns for pooled funds are calculated by dividing the applicable total annual fund expense ratio by 12 and adding back that monthly prorated expense to each monthly net return to derive a monthly return gross of investment management and fund fees but net of transaction costs and interest and dividend expense. Actual net returns are net of actual transaction costs, management fees, as well as other fund operating fees and expenses. Model net returns are supplemental to actual net returns and are calculated by reducing the monthly composite gross return by a model fee of 0.05417%, which equates to an annual model fee of 0.65%, the highest fee charged to any SMA client. Actual fees may vary depending on, among other things, the applicable fee schedule and portfolio size. The firm’s fees are available upon request and also may be found in the firm’s Form ADV Brochure. The standard annual fee schedule is: 0.65% on the first $100 million, 0.55% on the next $150 million, and 0.45% on all assets above $250 million under management. Where mutual fund returns are included in a composite, the returns of the primary institutional share class are used. In the case of the Easterly Income Opportunities Fund, the returns and of the I Share class are used in the percomposite.
Investment Management Fee Schedule
The standard annual fee schedule is: 0.65% on the first $100 million, 0.55% on the next $150 million, and 0.45% on all assets above $250 million under management.
Composite Dispersion
Internal dispersion is calculated using the equal-weighted standard deviation of annual gross returns of those portfolios that were included in the composite for the entire year. It is not presented (“N/A”) when there are five or fewer portfolios in the composite for the entire year.
Standard Deviation
The three-year annualized standard deviation measures the variability of the composite gross returns and the benchmark returns over the preceding 36-month period.
Trademark
GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein.
Important Disclosures
Easterly Asset Management’s advisory affiliates (collectively, “EAM” or “the Firm”), including Easterly Investment Partners LLC, Easterly Funds LLC, and Easterly EAB Risk Solutions LLC (“Easterly EAB”) are registered with the SEC as investment advisers under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about the firm, including its investment strategies and objectives, can be found in each affiliate’s Form ADV Part 2 which is available on the www.sec.gov website. This information has been prepared solely for the use of the intended recipients; it may not be reproduced or disseminated, in whole or in part, without the prior written consent of EAM.
No funds or investment services described herein are offered or will be sold in any jurisdiction in which such an offer or sale would be unlawful under the laws of such jurisdiction. No such fund or service is offered or will be sold in any jurisdiction in which registration, licensing, qualification, filing or notification would be required unless such registration, license, qualification, filing, or notification has been affected.
The material contains information regarding the investment approach described herein and is not a complete description of the investment objectives, risks, policies, guidelines or portfolio management and research that supports this investment approach. Any decision to engage the Firm should be based upon a review of the terms of the prospectus, offering documents or investment management agreement, as applicable, and the specific investment objectives, policies and guidelines that apply under the terms of such agreement. There is no guarantee investment objectives will be met. The investment process may change over time. The characteristics set forth are intended as a general illustration of some of the criteria the strategy team considers in selecting securities for client portfolios. Client portfolios are managed according to mutually agreed upon investment guidelines. No investment strategy or risk management techniques can guarantee returns or eliminate risk in any market environment. All information in this communication has been obtained from sources believed to be reliable but cannot be guaranteed. Investment products are not FDIC insured and may lose value.
Investments are subject to market risk, including the loss of principal. Nothing in this material constitutes investment, legal, accounting or tax advice, or a representation that any investment or strategy is suitable or appropriate. The information contained herein does not consider any investor’s investment objectives, particular needs, or financial situation and the investment strategies described may not be suitable for all investors. Individual investment decisions should be discussed with a personal financial advisor.
Any opinions, projections and estimates constitute the judgment of the portfolio managers as of the date of this material, may not align with the Firm’s opinion or trading strategies, and may differ from other research analysts’ opinions and investment outlook. The information herein is subject to change without notice and may be superseded by subsequent market events or for other reasons. EAM assumes no obligation to update the information herein.
References to securities, transactions or holdings should not be considered a recommendation to purchase or sell a particular security and there is no assurance that, as of the date of publication, the securities remain in the portfolio. Additionally, it is noted that the securities or transactions referenced do not represent all of the securities purchased, sold or recommended during the period referenced and there is no guarantee as to the future profitability of the securities identified and discussed herein. As a reminder, investment return and principal value will fluctuate.
The indices cited are, generally, widely accepted benchmarks for investment performance within their relevant regions, sectors or asset classes, and represent non managed investment portfolio. It is not possible to invest directly in an index.
This communication may contain forward-looking statements, which reflect the views of EAM and/or its affiliates. These forward-looking statements can be identified by reference to words such as “believe”, “expect”, “potential”, “continue”, “may”, “will”, “should”, “seek”, “approximately”, “predict”, “intend”, “plan”, “estimate”, “anticipate” or other comparable words. These forward-looking statements or other predications or assumptions are subject to various risks, uncertainties, and assumptions. Accordingly, there are or will be important factors that could cause actual outcomes or results to differ materially from those indicated in these statements. Should any assumptions underlying the forward-looking statements contained herein prove to be incorrect, the actual outcome or results may differ materially from outcomes or results projected in these statements. EAM does not undertake any obligation to update or review any forward-looking statement, whether as a result of new information, future developments or otherwise, except as required by applicable law or regulation.
Past performance is not indicative of future results.
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