RISR Commentary for August 2022
Performance Summary
The FolioBeyond Rising Rates ETF (ticker: RISR) returned 0.47% based on the closing market price (2.18% based on net asset value or “NAV”) in August. In comparison, the ICET7IN Index (US Treasury 7 Year Bond Inversed Index) returned 3.82% while the Bloomberg Barclays U.S. Aggregate Bond Index ("AGG") returned -3.04% during the same period.
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%.
For most recent quarter-end and month-end standardized performance click here.
Markets entered August just days after the Federal Reserve announced its second 75 basis point (“bps”) rate hike in as many meetings. This took the Fed Funds target rate to 2.5%, back to where it stood prior to the Covid pandemic. Longer term interest rates, which had been falling since mid-June, reversed course. Between August 1 and August 31, the 10-year treasury rate bounced off the cyclical low of 2.58%, and ended the month at 3.20%. The was a rapid retracement of fully 2/3 of the mid-summer rally we have been describing for several months, as a “head-fake” rally.
More complicated movements in the overall shape of the yield curve added volatility and uncertainty to the market. If we focus on the 2s-10s spread[1], August saw extraordinary volatility in that measure. 2s-10s first became inverted in early July and plummeted to a spread of -49 bps in the first week of August. From there it recovered to -33 bps in mere days, only to reverse and fall back to -45 bps by mid-month. From there, the degree of inversion bounced around in a way that left many investors and strategists scratching their heads as to what it all meant.
[1] This is the yield of the 10-year treasury bond minus the yield of the 2-year treasury note. Normally this spread is positive, i.e. 10-year rates are higher than 2-year rates. This called an upward sloping yield curve. When the spread is negative, we are said to have an “inverted” yield curve. Many market observers believe an inverted yield curve is a signal of near-term financial market and economic distress.
We believe it meant markets were still confused about how firmly committed the Fed was to fighting inflation as its primary objective. This was finally made clear in a high-profile appearance by Fed Chair Jerome Powell at the Fed’s annual Jackson Hole conference. In a widely followed speech on August 26, Powell made it clear that the Fed was finally coming to grips with the inflation crisis. He spoke briefly (less than 10 minutes), and directly, taking no questions. He concluded by saying “We will keep at it (raising rates) until we are confident the job is done.” One wonders how much better our economic predicament would be if he had made that speech a year early. At last year’s conference, he blithely assured everyone that inflation was transitory and not a significant worry for the Fed or the economy.
RISR’s performance in August reflected the turmoil and uncertainty, although we did achieve meaningful appreciation in NAV[2]. It is worth noting that any fund can see a discrepancy between NAV and share prices. When the share price is below the NAV, the fund is said to be trading at a discount. When the reverse is true the fund is said to be trading at a premium. As portfolio managers, we have no control over the premium or discount in RISR’s shares. We manage the fund to attempt to increase NAV, and we trust that in an efficient market any premium or discount will be arbitraged away. When markets are highly volatile as they have been this summer, such premiums and/or discounts may be larger and persist longer than they would in more normalized market conditions. One reason the RISR’s price performance in August lagged the increase in NAV was that we closed July with a material price premium of more than 1.6% above NAV. Over time, such random noise tends to smooth itself out, but it can be concerning to investors. We are happy to discuss any concerns with investors or advisors directly.
[2] Net Asset Value, which reflects the value of the securities we own, as distinct from the RISR share price.
Another reason that RISR’s performance in August varied from what might have been expected given the positive changes in interest rates is that we use third-party pricing services to mark all our positions. From time-to-time pricing services can either (a) make mistakes or (b) make changes to their pricing algorithms that affect particular securities in unexcepted ways. For instance, the prices for the MBS IOs we own depend significantly on the prepayment assumptions one uses. These prepayment assumptions are not explicit, but are embedded in complex prepayment models provided by firms who specialize in building and maintaining these models[3]. When the vendors release updates to their models, this can affect calculated prices in unanticipated ways. We have been working with our pricing vendor to smooth out such large moves, but we felt some adverse impacts of these changes in August.
One encouraging indicator we saw after Powell’s Jackson Hole speech was the return of investor inflows. As noted previously we had to meet a series of redemptions in July and through mid-August as some investors—mistakenly we said at the time, now confirmed—concluded the inflation battle was over. Beginning in late August and into early September that reversed, and we saw fresh inflows of investor capital. We are hopeful we can quickly resume the fund-raising trajectory we had been on prior to the summer head-fake rally.
[3] The most widely used vendor of prepayment models is a product marketed as YieldBook. FolioBeyond’s pricing service uses YieldBook as a main reference point. In making our investment decisions we consider the outputs from several different prepayment models, including but not limited to YieldBook.
Outlook
Now that the Fed and the markets have largely agreed on the need to restrain inflation, the immediate question becomes how high will rates have to go? It is impossible to predict this precisely, of course, but we can look to history for some guidance. In every prior period of high inflation in modern US history, inflation has not abated until we have positive real rates. If nominal interest rates are below the rate of inflation, inflation tends to persist. It doesn’t take a Ph.D. in economics to see why this ought to be so: until there is a positive real rate of inflation, there is a strong disincentive to save for the future. And if households and businesses aren’t saving out of their income, they are spending it. This high rate of spending—aggerate demand is the economists’ term—fuels inflation.
Depending on the measure one looks at, inflation is running in the neighborhood of 8%. Long term nominal interest rates are around 3.5%, which produces a negative interest rate today of 4.5%. This is far below the level that will start to reduce aggregate demand, based on historical experience. This is does not necessarily mean that nominal rates need to go all the way to 8%, but it suggests they need to go quite a bit higher.
Of course, exogenous factors such as the war in Ukraine, Covid lockdowns in China and so on, might impact the rate of reported inflation independently of the Fed’s actions. But resolving some of those factors could actually put upward pressure on global inflationary pressures.
There is a wide range of opinions about how high and for how long rates will have to go before inflation begins to recede. We have a view that we have expressed for some time that the so-called “terminal rate” where the Fed stops hiking is considerably higher than today’s rate environment. A large contingent of market participants seems to think the terminal rate is something like 4% on Fed Funds, which currently stand at 2.5% as noted above. Since the Fed has all but guaranteed they will raise rates by an almost unprecedented third 75 bps hike when they meet on September 21, 3.25% is pretty well baked in. It doesn’t take much imagination to see the need for another 75 bps, in either one or two steps later this year.
For investors who share this view, we think RISR can still contribute importantly to your overall strategy. No matter if the Fed goes to 4% and pauses or is forced to go much higher as we believe, adding RISR can reduce the interest rate risk in your current portfolio by reducing duration and volatility, and adding a meaningful degree of current income from dividends. RISR currently pays a cash dividend yield of 5.77%, which is more than double the 2.5% yield of the AGG (RISR also has a 30 Day SEC Yield of 4.47% as of August 31, 2022).[4] If rates continue to rise, we will invest fresh capital in progressively higher mortgage coupon rates, which should increase our dividend accordingly.
As we have noted previously, our strategy aims to hold a negative 10-year duration. That is, the fund is managed to experience price movements of 10x the change in interest rates. Consequently, if rates were to rise 100bps, we would expect to see gains in NAV per share of around 10%. A 200 bps rise could see a 20% gain, and so on. Our firm belief is this trade has a long way to run. Even if it takes the Fed takes a break from hiking rates later in 2022, volatility seems to show no sign of abating. Under these circumstances, the benefits of holding RISR can be substantial for a broad class of investors. We would be pleased to discuss your particular situation to explore how best to incorporate RISR into your overall portfolio.
[4] AGG is an ETF that tracks the Bloomberg US Aggregate Bond Market Index, a broad measure of fixed income across all IG sectors.
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.
S&P 500 (Standard & Poors 500): The S&P 500 Index represents a market-capitalization weighted index of 500 leading publicly traded companies in the U.S, as defined by the Standard & Poors corporation.
Definitions
Alpha: a return achieved above and beyond the return of a benchmark or proxy with a similar risk level.
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.
GNMA: Government National Mortgage Association
FNMA: Federal National Mortgage Association
FHLMC: Federal Home Loan Mortgage Corporation
Producer Price Index (PPI) : is a family of indexes that measures the average change over time in selling prices received by domestic producers of goods and services. PPIs measure price change from the perspective of the seller. This contrasts with other measures, such as the Consumer Price Index (CPI), that measure price change from the purchaser's perspective. Sellers' and purchasers' prices may differ due to government subsidies, sales and excise taxes, and distribution costs.
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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