RISR Commentary for February 2024
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Performance Summary
The FolioBeyond Alternative Income and Interest Rate Hedge ETF (ticker: RISR) returned 3.82% based on the closing market price (4.99% based on net asset value or “NAV”) in February. In comparison, the ICET7IN Index (US Treasury 7-Year Bond Inversed Index) returned 2.04% while the Bloomberg Barclays U.S. Aggregate Bond Index ("AGG") returned -1.41% during the same period.
The interest rate roller-coast ride continued last month. Over the last 12 months, usually in response to some mildly supportive news story or economic release, we have seen more than half-a-dozen frantic rallies during which the 10-year rate drops 20-30 basis points in just a few days. In most cases, those frenzied markets then reverse more gradually, until the next event. For those of us who have been market watchers for decades, this sort of action is highly atypical, and somewhat concerning, as it illustrates a huge gap in perspective between markets and policy makers.
February was another example of this pattern. The 26 basis point drop that occurred from January 24 to February 1, was almost fully reversed by February 5, and rates then steadily ground higher for the rest of the month, to close at 4.25%, more than 30 basis points higher than they started the month. RISR’s performance for the month was driven by that move, plus a continued tightening of option-adjusted spreads (OAS) for MBS IOs, generally. OAS, which represents a spread to the risk-free rate that accounts for potential prepayments in the underlying mortgages, is the primary return measure we focus on when managing the RISR. Most fixed income investors are probably more familiar with yield-to-maturity, which we also consider. But OAS is a better gauge of risk-adjusted return for MBS IOs.
RISR’s 12 month (TTM) performance of 13.52% places it among the top performing fixed income ETFs in the market. Bloomberg tracks 481 domestic fixed income ETFs. Through February 29, 2024, RISR produced among the top handful of return performances of all such ETFs for the last 12 months.
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%.
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The catalyst for the most recent rebound in rates that has been driving RISR’s performance is the growing recognition that the battle against inflation has not been won. Rather than approaching the Fed’s 2% target, there has been a clear leveling out on the underlying inflation trend as a bit above 3%. While that may not seem like a large difference, over time the cumulative effect on purchasing power of the dollar is significant, as illustrated in the table below.
This is the reason the Federal Reserve has been so adamant (if inconsistent in their communications) about the need to bring inflation down to its 2% long run target. Many economic sectors including commercial real estate investors, technology investors, and even home-buyers, became accustomed to near zero interest rates, and are longing for the return of free money. Barring some significant external shock, it seems unlikely they will get it.
Outlook
We have discussed in prior notes the substantial headwinds facing commercial real estate (CRE). Many billions in maturing CRE mortgages cannot be refinanced due to declines in operating metrics such as occupancy, and of course higher interest rates.
In February another controversy arose in the residential housing sector. This controversy relates to a technical factor for how the inflation numbers are actually calculated by the Bureau of Labor Statistics (BLS). The controversy over the Owners Equivalent Rent (OER) in the reported inflation for February 2024 centers around a technical change in how the government computes OER.
This change added more weight to single-family homes in the calculation, which led to a divergence between OER and non-owner rental rates. Critics argue that this adjustment has caused a distortion in the inflation data, particularly in the shelter component, which is a significant part of the Consumer Price Index (CPI). The CPI report indicated that the indexes for OER increased by 0.6% over the month, contributing to the persistent issue of ‘sticky’ inflation, especially in housing costs. This has sparked debate among economists, policymakers and investors regarding the accuracy and representation of inflation measures.
For background, the actual prices for residential homes do not figure directly into the calculation for inflation as measured by the Consumer Price Index (CPI). Instead, by the logic of government economists, a home provides a service in the form of “shelter.” In the case of rented homes, the calculation is straightforward—shelter cost is equal to the rent payment. But a significant share of the US housing stock is owner-occupied. To produce a figure comparable to the amount paid by renters, the BLS attempts to estimate what a homeowner would theoretically have to pay to rent their home if it was owned by a third party. Needless to say, there is a large amount of estimation in such a calculation, which presents a challenge since shelter makes up over 35% of the CPI.
One of the big changes in the inflation environment over the last 18 months or so has been the shift away from goods inflation and a relative increase in services inflation. As supply bottlenecks related to covid and conflict have eased, goods inflation has fallen materially, especially for energy and transportation (e.g., used cars).
However, services inflation, which makes up 60% of the CPI, has accelerated. Much of that acceleration has been driven by shelter costs, which constitutes more than half (35%/60%) of the services component of the CPI. It is worth noting that the Fed looks at a variety of inflation measures, not only the CPI. But the CPI is a “headline” number, one that gets the attention of markets. And there is clearly something real going on with rising shelter costs.
Therefore, in large measure, the question on which future Fed policy hangs is “what is going to happen to shelter costs and services costs more generally?” It is widely believed that services inflation is more sticky than goods inflation. It is generally understood that it is easier for firms to cut prices for the goods they sell than it is to reduce the prices for services paid to service providers. Rents and therefore OER, are slow to adjust as well.
In fact, the FRB of Atlanta actually produces a “Sticky Price CPI” which takes into account the frequency and ease or difficulty of price adjustment for various constituents in the standard CPI. Ominously, that index has lately turned up, as seen in the chart below.
In short, we believe there is likely to be quite some time before the fight against inflation will be fully won. Fed Chair Powell has said so repeatedly, and the data support this. It is far too soon for most investors to add duration, or position portfolios for lower volatility. Risk management remains the paramount objective.
RISR is designed to have a negative duration, which means it tends to zig when other parts of the market zag. Therefore, by adding RISR to an existing portfolio, investors may be able to reduce their overall duration profile, and can offset some of the heightened volatility in the market. And it can do so while generating an attractive and consistent dividend yield.
Please contact us to explore how RISR might fit into your overall strategy, to help you manage risk while generating an attractive current yield.
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. 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 |
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 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 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 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.
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.
Correlation: a statistic that measures the degree to which two securities move in relation to each other.
Coupon: is the annual interest rate paid on a bond, expressed as a percentage of the bond’s face value.
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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