RISR Commentary for March 2023
Performance Summary
The FolioBeyond Rising Rates ETF (ticker: RISR) returned -1.48% based on the closing market price (-0.23% based on net asset value or “NAV”) in March. In comparison, the ICET7IN Index (US Treasury 7-Year Bond Inversed Index) returned -3.72% while the Bloomberg Barclays U.S. Aggregate Bond Index ("AGG") returned 2.54 during the same period. This was a near complete reversal of the market move in February, which saw the 10-year Treasury yield rise 66 bps, only to return to near the prior low of 3.4%.
The immediate cause for the sharp decline in rates was a seemingly out-of-left-field run on a California based bank most Americans had probably never heard of--the Silicon Valley Bank (“SVB”). All commercial banks are subject to the potential risk of a run if depositors demand their cash back en masse. But SVB seems to have been especially vulnerable given its near exclusive focus on large deposits from venture capital-funded tech startups. Most of these accounts far exceeded the FDIC’s insurance limit of $250,000. In addition, SVB’s management seems to have taken little or no action to manage its duration risk. Its assets were heavily weighted toward long-term bond holdings that had seen a sharp decline in value as the Fed continued to raise interest rates throughout 2022.
When a handful of influential VCs noticed the problems at SVB, they urged their clients to move their funds out of SVB, in some cases using social media to communicate. It didn’t take long for panic to spread, and within days the FDIC, the Federal Reserve and the Treasury had to act aggressively to avoid a broader contagion to the rest of the banking system. Some have called it the first digital bank run, a description that seems apt. Among other actions, regulators effectively removed the cap on FDIC deposit insurance. This was an even greater accommodation than they had taken in 2008, when the cap was raised from $100,000 to $250,000.
The aggressive regulatory response, and the perceived need not to cause further mark-to-market losses for other bank’s assets, generated a sense among many market participants that the Fed would either pause its rate hike cycle, or even begin to cut rates. All eyes were on the previously scheduled Fed meeting for March 22. Despite the still simmering systemic bank problems, the Fed stuck to its plan and raised the Federal Funds target by 25 bps, to 5.0%. This was the highest Fed Funds rate since the prior hiking cycle that ended in 2006 after reaching 5.25%, a rate that held until the Great Financial Crisis of 2007-09.
In the immediate aftermath of the SVB panic and receivership, several other smaller banks failed, and had to be rescued. But, as of this writing, a broad-based bank panic seems to have been avoided. Questions about the underlying strength of regional banks, especially, remain. This has further complicated an already-exceedingly difficult decision tree for the Fed.
While there has been some softening in recent inflation statistics, the job market remains exceptionally strong. Moreover, a large share of the recent decline in official inflation numbers came from what appears now to have been a short-lived decline in oil prices. Indeed, Saudi Arabia recently announced a substantial reduction in its production targets that some analysts believe could lead to price increases back toward the highs seen last summer.
It is worth noting that RISR continues to exhibit positive asymmetric performance in response to broad moves in the bond markets. If we look at average of monthly returns since the beginning of 2022, the Fund’s share price decline when rates fall has been about half the size of the gain when rates rise by an equivalent amount. This beneficial asymmetry is attributable to some very specific prepayment characteristics for the securities we own.
As was the case in February, we maintained our stabilized dividend of $0.18/share in March. It is our intention to maintain this rate, although it cannot be guaranteed. As of now, the cash flow yield on our current portfolio is above the level needed to maintain that rate.
Outlook
The stresses in the banking system are not only being felt in the US, but internationally as well. Credit Suisse, one of the oldest and largest international investment banking firms, had to be rescued by the Swiss government in March. CS has been a troubled institution for a number of years, and never really made a complete recovery following the financial crisis of 2007-09. Still the rapidity of its final decline and absorption into UBS was surprising. It is clear that increases in interest rates by central banks in the US, UK and EU are having an impact on financial institutions.
As rates rise, and the value of bank’s long-term fixed rate assets declines, it is becoming ever-more clear that the risk management practices at many institutions are inadequate, and that regulators, ratings agencies and investors have not been looking closely enough at the risks these institutions are running. They are looking closely more closely now.
In response, banks have been tightening lending standards aggressively. According to a news story from Bloomberg:
US bank lending contracted by the most on record in the last two weeks of March, indicating a tightening of credit conditions in the wake of several high-profile bank collapses that risks damaging the economy.
Commercial bank lending dropped nearly $105 billion in the two weeks ended March 29, the most in Federal Reserve data back to 1973. The more than $45 billion decrease in the latest week was primarily due to a a drop in loans by small banks.
Some other signs of slowdown have begun slowly to emerge, but other indicators tell a different story. In particular, the persistently strong labor market has shown little signs of cooling. And, of course, inflation is still far above the Fed’s target of 2%. Forecasters are all over the map about whether a recession is likely this year or next, and if one comes how severe it is likely to be. The narrative in the market has ranged from “soft landing” to “hard landing” to “no landing,” sometimes in the space of a few weeks. Markets always exhibit a range of opinion and sentiment, but the current environment is notable for the diversity of outlooks.
It took them a while to get here, but in recent months the Fed and various officials have been fairly consistently “on message” about the need to maintain an inflation fighting posture until the job is done. Chair Jay Powell has made it abundantly clear he does not intend to repeat the mistakes of Authur Burns. Burns, who chaired the Fed from 1970-78 is widely, if perhaps unfairly, blamed for not having the conviction and fortitude needed to bring inflation down during his tenure. Instead, inflation roared higher after the Burns-led Fed eased its tightening posture prematurely. It was then left to Paul Volker to finish the job at the cost of a very severe recession.
The market is forgetting this lesson from history, and many are suggesting the Fed has already gone too far. Much of the chatter along these lines is, frankly, self-serving, coming as it does from folks whose business models rely heavily on cheap leverage. This includes real estate, venture capital and private equity, hedge funds and technology. As result, the tug-of-war in the market continues, and that means we are likely to see ongoing elevated volatility in bonds, stocks and in real estate.
We are taking the Fed at their word, and do not see any consensus within the Fed for reducing interest rates any time soon. Indeed, several Fed speakers have explicitly ruled it out for the remainder of 2023, at least. “Higher for longer” is the stance we have taken since we launched RISR, and we still think it is the right position for prudent investors and investment advisors. We think it still makes sense to maintain a short duration, and to be very cautious in adding credit risk. RISR can help in that task.
We designed RISR to have broad appeal to a range of investors, including those who have a more sanguine view, than ours, but who also agree with the wisdom of prudently managing risk. RISR can help in that effort, offering a low correlation to many key market sectors, together with a high current dividend.
Please contact us to explore how RISR might fit into your overall strategy, to help you manage risk while generating an attractive current yield.
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 0.99%.
For standardized performance click here
Portfolio Applications
We believe RISR provides an attractive, thematic strategy that provides 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 | 914-523-2180 |
This material must be preceded or accompanied by a prospectus. For a copy of the prospectus please click here.
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 Inversed 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 Index: The S&P 500 Index, or Standard & Poor's 500 Index, is a market-capitalization-weighted index of 500 leading publicly traded companies in the U.S.
IBOXHY Index: iBoxx USD Liquid High Yield Total Return Index measures the USD denominated, sub-investment grade, corporate bond market. The index includes bonds with minimum 1 years to maturity,
minimum amount outstanding of USD 400 mil. Bond type includes fixed-coupon, step-up, bonds with
sinking funds, medium term notes, callable and putable bonds.
Definitions
Alpha: a return achieved above and beyond the return of a benchmark or proxy with a similar risk level.
Annualized Equivalent Yield: represents the annualized yield based on the most recent month of income distribution : (income distribution x 12 months)/price per share.
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.
Cash flow yield: The projected interest cash flows net of principal amortization divided by the current market value
Coupon: is the annual interest rate paid on a bond, expressed as a percentage of the bond’s face value.
Correlation: a statistic that measures the degree to which two securities move in relation to each other.
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
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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