RISR Commentary for February, 2022
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Performance Summary
The FolioBeyond Rising Rates ETF (ticker: RISR) returned 2.82% based on closing market price (3.69% based on NAV) in February. In comparison, the ICET7IN Index (US Treasury 7 Year Bond Inverse Index) returned 0.34% while the Bloomberg Barclays U.S. Aggregate Bond Index ("AGG") returned -1.12% during the same time period.
It was a second month of bear flattener for the Treasury yield curve in February as the 10-year yield went up 5 basis points (“bps”) for the month while the 2-year yield spiked up 25 bps, taking the 2yr-10yr spread to 39 bps, from 60 bps at the end of January. RISR’s performance was primarily driven by a combination of correlation to rate increases, spread widening of Mortgage-Backed Securities (“MBS”), gains from security selection, and spread narrowing of MBS Interest Only Strips (“IOs).
The performance data quoted represents past performance. Past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than their original cost and current performance may be lower or higher than the performance quoted. Performance current to the most recent month-end can be obtained by calling 866-497-4963. Short term performance, in particular, is not a good indication of the fund’s future performance, and an investment should not be made based solely on returns. Returns beyond 1 year are annualized.
A fund's NAV is the sum of all its assets less any liabilities, divided by the number of shares outstanding. The market price is the most recent price at which the fund was traded. The fund intends to pay out income, if any, monthly. There is no guarantee these distributions will be made.
Total Expense Ratio is 1.01%.
February Market Turmoil
February ended nothing like it began, as the Russian military launched a significant armored invasion of neighboring Ukraine on February 24. This triggered an immediate flight-to-quality rally in Treasuries, that reversed a meaningful selloff prior to that point—one that had driven the 10-year briefly above 2%, a level not seen since mid-2019. By month’s end, the 10-year was back down below 1.83%, with a great deal of uncertainty about what would happen next.
Most significantly, Fed Chairman Jay Powell was set to testify before Congress just 2 days later, leaving investors to speculate about whether this geo-political crisis would derail what had seemed a settled view that the Fed would start raising rates at its next meeting on March 16. Spoiler alert—the answer was “no.” The Chairman said that, barring some dramatic development, the first rate hike of 25 bps would take place as planned. We will see if that holds.
Despite the market turmoil, the RISR ETF performed well in February. Part of that performance came from expectations of slower mortgage prepayment rates as medium- to long-term views around interest rates remained bearish. Recall, that our MBS IOs increase in value as expectations for slower future prepayments are priced into the market. This expectation has become so firmly embedded in the minds of most investors, that even the turmoil of the last few days of the month did not materially upset that market view.
Another contributing factor may be a developing consensus that housing prices are peaking. Housing affordability in many areas of the country is lower than it has been in many years. While most observers, including us, are not looking for a collapse in home prices, we agree that the froth one observes is not sustainable. That further supports a view that prepayments will slow down.
All of these factors are tied to the interest rate outlook, of course. We remain firmly convinced that rates will be headed meaningfully higher, and will do so soon. We think rates will be 50-100 bps above current levels by year-end 2022, and will be higher still by the end of 2023. While the situation in Ukraine is tragic and highly volatile, if anything it increases inflationary pressures that adds urgency to the Fed’s task to re-establish some measure of price stability.
Another component of returns came from security selection and the purchase of undervalued MBS IOs in the secondary market. While the MBS IO market size is estimated to be over $100 billion, each bond has its own profile with unique loan level characteristics underlying the mortgage pool. FolioBeyond’s analytical process filters the offerings in the secondary market to identify desirable MBS IO characteristics. These attributes include coupon, age, loan-to-value, geographics, investor loan concentration, etc. Additionally, value and risk measures tied to option adjusted spread (“OAS”), yield, duration and convexity are analyzed within a robust risk management framework. This fragmentation in the secondary market creates alpha generating opportunities for experienced MBS IO portfolio managers with advanced analytical tools. Unlike issuer-specific credit risks present in small issuers of municipal or high yield corporate bonds, the MBS IO market has the advantage of having quantifiable homogeneity in risk attributes: i.e. a loan pool with age of 24 months has certain attributes relative to a newer loan with 6 months of age, all else being equal. This allows for scalability of the strategy while avoiding significant security specific risks.
Portfolio Applications
We believe RISR provides an attractive, thematic strategy that provide strong correlation benefits for both fixed income and equity portfolios. It can be utilized as part of a core holding for diversified portfolios or as an overlay to manage the interest rate risk of fixed income portfolios. Alternatively, RISR can be used as a macro hedge against rising interest rates with less exposure to equity beta and negative correlation to fixed income beta. The underlying bonds are all U.S. agency credit that are guaranteed by FNMA, FHLMC or GNMA. There is no financing leverage or explicit short positions that relies on borrowed securities. Also, timing is on our side as the strategy generates current income if interest rates were to remain within a trading range.
Please contact us to explore how RISR can be utilized as a unique tool to adjust your portfolio allocations in the current inflationary environment.
| Yung Lim | Dean Smith | George Lucaci |
|---|---|---|
| Chief Executive Officer | Chief Strategist and Marketing Officer | Global Head of Distribution |
| Chief Investment Officer | RISR Portfolio Manager | |
| ylim@foliobeyond.com | dsmith@foliobeyond.com | glucaci@foliobeyond.com |
| 917-892-9075 | 914-523-2180 | 908-723-3372 |
Investors should consider the investment objectives, risks, charges and expenses carefully before investing. For a prospectus or summary prospectus with this and other information about the Fund, please call (866) 497-4963 or visit our website at www.etfs.foliobeyond.com. Read the prospectus or summary prospectus carefully before investing.
Investments involve risk. Principal loss is possible. Unlike mutual funds, ETFs may trade at a premium or discount to their net asset value. The fund is new and has limited operating history to judge fund risks. The value of MBS IOs is more volatile than other types of mortgage related securities. They are very sensitive not only to declining interest rates, but also to the rate of prepayments. MBS IOs involve the risk that borrowers may default on their mortgage obligations or the guarantees underlying the mortgage-backed securities will default or otherwise fail and that, during periods of falling interest rates, mortgage-backed securities will be called or prepaid, which may result in the Fund having to reinvest proceeds in other investments at a lower interest rate.
The Fund’s derivative investments have risks, including the imperfect correlation between the value of such instruments and the underlying assets or index; the loss of principal, including the potential loss of amounts greater than the initial amount invested in the derivative instrument. The value of the Fund’s investments in fixed income securities (not including MBS IOs) will fluctuate with changes in interest rates. Typically, a rise in interest rates causes a decline in the value of fixed income securities owned indirectly by the Fund. Please see the prospectus for a complete description of principal risks.
Diversification does not eliminate the risk of experiencing investment losses.
Index Definitions
Bloomberg Barclays US Aggregate Bond Index: A broad-based benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS and CMBS (agency and non-agency).
US Treasury 7-10 Yr Bond Inverse Index: ICE U.S. Treasury 7-10 Year Bond 1X Inverse Index is designed to provide the inverse of the daily return of the ICE U.S. Treasury 7-10 Year Bond Index (IDCOT7). ICE U.S. Treasury 7-10 Year Bond Index tracks the performance of US dollar denominated sovereign debt publicly issued by the US government in its domestic market. Qualifying securities of the underlying index must have greater than or equal to seven years and less than 10 years remaining term to final maturity as of the rebalancing date, a fixed coupon schedule and an adjusted amount outstanding of at least $300 million.
Definitions
Basis Points (bps): Is a unit of measure used in quoting yields, changes in yields or differences between yields. One basis point is equal to 0.01%, or one one-hundredth of a percent of yield and 100 basis points equals 1%.
Beta measures: the volatility of a security or portfolio relative to an index. Less than one means lower volatility than the index; more than one means greater volatility.
Coupon: is the annual interest rate paid on a bond, expressed as a percentage of the bond’s face value.
Convexity: A measure of how the duration of a bond changes in correlation to an interest rate change. The greater the convexity of a bond the greater the exposure of interest rate risk to the portfolio.
CUSIP: An identifier number that stands for the Committee on Uniform Securities Identification Procedures assigned to stocks and registered bonds in the United States and Canada.
Duration: measures a bond price’s sensitivity to changes in interest rates. The longer a bond’s duration, the higher its sensitivity to changes in interest rates and vice versa.
Put Option: (or “put”) is a contract giving the option buyer the right, but not the obligation, to sell—or sell short—a specified amount of an underlying security at a predetermined price within a specified time frame.
Short Investment (Shorting): is a position that has been sold with the expectation that it will decrease in value, the intention being to repurchase it later at a lower price.
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