FPA New Income Fund Q1 2024 Commentary

Dear Shareholder:

FPA New Income Fund (the “Fund”) returned 0.86% in the first quarter of 2024.

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Uncertainty about the pace of disinflation led to an increase in risk-free rates during the quarter as Treasury yields increased by 25-40 bps across the yield curve and spreads narrowed across the bond market. On an absolute basis, we continue to see an attractive opportunity to buy longer duration “High Quality” bonds (rated single-A or higher) that we believe will enhance the Fund’s long-term returns and short-term upside- versus-downside return profile. We do not generally view “Credit” (investments rated BBB or lower, including non-rated investments) as attractively priced, but we continue to search and will opportunistically invest in Credit when we believe prices adequately compensate for the risk of permanent impairment of capital and near-term mark-to-market risk. The Fund’s Credit exposure was essentially unchanged at 10.0% on March 31, 2024 versus 9.9% on December 31, 2023. Cash and equivalents represented 4.6% of the portfolio on March 31, 2024 versus 3.9% on December 31, 2023.

Portfolio Attribution⁴

First Quarter 2024

The largest contributor to performance were asset-backed securities (ABS) backed by equipment due to coupon payments, which were partially offset by lower prices as a result of an increase in risk-free rates. The second- and third-largest contributors to performance were collateralized loan obligations (CLOs) backed by corporate loans and CLOs backed by commercial real estate loans, respectively, which benefited from coupon payments and higher prices due to narrower spreads. These high-quality CLOs are predominantly floating rate.

The only detractor from performance during the quarter were U.S. Treasury bonds, which decreased in price as a result of an increase in risk-free rates. Although there were other individual bonds that detracted from performance during the quarter, there were no other meaningful detractors at the sector level.

Portfolio Activity⁵

The table below shows the portfolio’s sector-level exposures at March 31, 2024 compared to December 31, 2023:

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As yields have increased over the past 27 months, we have taken advantage of this opportunity to buy longer-duration bonds. We believe these bonds not only offer an attractive absolute long-term return but also improve the short-term return profile of the portfolio. The duration of these investments is guided by our duration test, which seeks to identify the longest-duration bonds that we expect will produce at least a breakeven return over a 12-month period, assuming a bond’s yield will increase by 100 bps during that period. Consistent with this test, during the first quarter, we bought fixed-rate, High Quality bonds including agency mortgage pools, ABS backed by equipment, agency-guaranteed commercial mortgage-backed securities (‘CMBS’), non-agency residential mortgage-backed securities (‘RMBS’), ABS backed by credit card receivables, ABS backed by prime quality auto loans, and utility cost-recovery bonds. On average, these investments had a weighted average life of 5.5 years. We also extended the duration of and added to our Treasury holdings. Finally, we bought a AAA-rated floating-rate CLO. Within Credit, we bought a BBB-rated corporate bond.

To fund these investments, we used a combination of proceeds from maturing investments and sales of existing short-maturity holdings including, but not limited to, High Quality ABS, CLOs (both corporate loan- backed CLOs and commercial real estate-backed CLOs) and agency-guaranteed CMBS. The High Quality investments that we sold had a weighted average life of 1.2 years. Lastly, we sold a short-maturity BBB- rated corporate bond to take advantage of other, more attractive opportunities.

Market Commentary

As shown in the following chart, progress on reducing inflation appears to have stalled, casting doubt on the timeline of reaching the Federal Reserve’s 2% target.

CPI Urban Consumers less Food and Energy year/year Change

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By other measures, inflation may have accelerated. Consequently, whereas at the end of 2023 the market was expecting the Federal Reserve to institute more than six cuts to the Fed Funds rate in 2024, at the end of March 2024 the market expected only around three cuts. As of April 2024, those expectations had further decreased to perhaps one rate cut in 2024. There has even been chatter among some commentators that the Fed may need to raise rates at some point. The uncertainty about the macroeconomic environment has led to volatility in expectations for the Fed Funds rate with the market consistently too optimistic about the Fed lowering rates:

Fed Funds Rate and Futures Pricing

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In response, risk-free rates increased during the first quarter, as shown below.

U.S. Treasury Yield Curve

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The market vacillates about what the Fed will or will not do, and for good reason. It’s difficult to forecast the future using data that is both stale (inflation data is published with a lag) and imprecise (inflation statistics don’t accurately capture pricing in the economy because of imputed prices or sticky prices like rent, for example). For this reason, we avoid trying to forecast what the Fed will do because we find that trying to invest by betting on the Fed and the macroeconomy is short-term oriented and speculative and creates a less certain path to attractive long-term returns. Instead, we focus on long-term returns using price as our guide. We define “price” as the combination of factors that could affect the return of and return on our capital including, among other things, dollar price, coupon, spread, maturity, call protection, loan-to-value, and structure.

The following two charts show that Treasury yields and yields on High Quality bonds are currently among the highest in over 15 years.

Treasury Yield

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Bloomberg U.S. Aggregate Bond Index

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As we have described in past commentaries, higher yields over the past couple of years have created what we believe is an attractive opportunity to buy longer-duration, High Quality bonds. We believe our investors will be better off in the long-term earning today’s yields for multiple years. Therefore, we want to lock in today’s yields for as long as possible. However, because the future is uncertain, we also want to be thoughtful about limiting the short-term mark-to-market risk associated with increases in interest rates.

To help strike the balance between locking in yields for as long as possible and providing some short-term price-related downside protection, we select the duration of our investments using the duration test described above. The chart below illustrates our 100 bps duration test.

Hypothetical 12-month U.S. Treasury Returns

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The dark blue bars above show Treasury yields of various maturities at March 29, 2024. The green bars show the results of our 100 bps duration test and represent the short-term downside return potential for these bonds. For example, the 5-year Treasury purchased at a 4.21% yield would be expected to return 0.64% over twelve months if its yield increased by 100 bps from 4.21% to 5.21% during that time. A similar analysis applied to the 7-year Treasury would result in a total return loss of -0.89%. With a better-than- breakeven return, the 5-year Treasury would be a candidate for the portfolio but the 7-year Treasury would not because it produces an expected loss over twelve months.

Shorter-maturity bonds would also pass our duration test in today’s market and would be expected to produce positive short-term returns if yields increase, but longer-maturity bonds add more short-term upside potential to the portfolio. The light blue bars on the chart above show the short-term upside return potential, namely the potential total return over twelve months if rates decrease by 100 bps. The 5-year Treasury offers a potential upside return of 7.9%. Although the 7-year Treasury offers a higher potential total return in the upside scenario, that upside should be balanced with the prospect of losing money in the short-term. The 5-year Treasury captures over 80% of the short-term upside return of the 7-year Treasury but with less short-term downside risk. Likewise, our investments in longer-duration bonds create the potential for the portfolio to capture a meaningful portion of the upside offered by longer-duration bonds like those represented in the Bloomberg Aggregate Bond Index. At the same time, our focus on downside protection means using our 100 bps duration test to identify longer duration bonds that we believe will preserve capital in the short-term if rates rise (within reason), thereby enabling opportunistic redeployment into more attractive investment opportunities if and when they appear.

To that end, we have spent the past 27 months increasing the Fund’s duration. Whereas the average fund in the Morningstar U.S. Short Term bond category had a 2.75-year duration at the end of 2021 – before rates began to increase – and maintained a similar duration of 2.79 years through March 2024, the Fund’s duration increased from 1.39 years at December 31, 2021 to 3.04 years at March 31, 2024, a 1.65 year increase. 6 When rates were very low in 2021, the Fund had a far-below-average duration because we believed investors should take less risk when the market is expensive (i.e., when rates are low). Now that the market is cheaper (i.e., rates are higher), we believe investors should be willing to take on more duration risk because they are now being compensated for that risk through higher yields.

Although we see an attractive opportunity to buy longer-duration High Quality bonds, we do not generally see attractive investment opportunities in lower-rated debt. In the high yield market, yields also remain near 15-year highs, but spreads have retreated to the 16th percentile, as measured by the BB component of the Bloomberg U.S. Corporate High Yield index excluding Energy, an index we believe provides the most consistent view of high yield market prices over time with fewer distortions caused by changes in the composition of the overall high yield index.

Bloomberg U.S. Corporate High Yield BB excl. Energy

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Further, the extra spread offered by high yield bonds in comparison to investment grade bonds has also compressed. For example, the spread on the aforementioned BB-rated high yield index, excluding energy, less the spread on investment grade corporate bonds has decreased to the sixth percentile.

Bloomberg U.S. Corporate High Yield Spread less Bloomberg U.S. Investment Grade Corporate Spread

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Importantly, measures of the high yield market such as yield and spread do not account for changes in the underlying quality of bonds in the market at any given point in time. Suffice it to say, it is our opinion that there has been a degradation in the quality of high yield bonds over the past few years (most notably via weaker structural protections for bondholders) which, all things being equal, makes high yield debt more expensive than the charts above would suggest. Given current prices in the yield market, we generally find that, compared to investment grade bonds, the low spreads in the high yield market do not offer enough incremental compensation for the extra credit risk involved in high yield debt. We continue to research the high yield market for investment opportunities, but these days we typically find High Quality bonds more appealing.

As always, we invest with a flexible, opportunistic, patient, and long-term -oriented investment approach that seeks attractive short- and long-term risk-adjusted returns. Inherent in that approach is a willingness to choose a different tack than other bond investors, whether buying longer-duration bonds or leaning toward higher quality bonds. The chart below shows that our willingness to deviate from the crowd has been beneficial to our investors over the long-term as evidenced by the Fund having compounded capital at a greater rate of return over the past 10 years with less volatility and generally smaller drawdowns compared to other comparable funds, indices or even the broader bond market:

Growth of $10,000 over Ten Years

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With our personal capital invested in the Fund, we are pleased with the returns on our investment and we hope our fellow investors feel the same. Our focus though remains on the present and we are excited about the investment opportunities created by higher yields.

Thank you for your confidence and continued support.

Abhijeet Patwardhan, Portfolio Manager