Income Fund - 3Q24 Commentary

Intrepid Capital - 3Q2024 Income Fund

October 10, 2024

Dear Fellow Shareholders,

The Federal Reserve finally kicked off the long-anticipated easing cycle with a 50-basis point rate cut in September. While later than many hoped, credit markets cheered the news. High yield credit spreads tightened and ended the quarter at a multi-year low. The new issue market ramped up considerably, with September high yield bond issuance ($37B) reaching the highest monthly level since 2021.

This backdrop fueled exceptional performance for bonds during the third calendar quarter of 2024. The Bloomberg US Aggregate Index returned 5.20%, while the ICE BoA High Yield Index returned 5.31%. The Intrepid Income Fund’s (“the Fund”) benchmark Bloomberg US Gov/Credit 1-5 Year Index returned 3.50%.

The Intrepid Income Fund returned 3.80% during calendar Q3, which bested its benchmark but trailed the performance of the US Aggregate and High Yield indexes mentioned earlier. Our return represents an upside capture of approximately 70% of these broader indices. We view this as acceptable relative performance given the context of market movements in both rates and spreads during the quarter.

First, on rates. As we have written in prior commentaries, it’s reasonable to expect the Fund to underperform broader indices during periods of sharply falling rates, due to our bias toward shorter duration credits. This is exactly what happened during Q3, as the 10-year treasury rate fell by 61 basis points.

To a lesser extent, this is also true with credit risk. Historically, the Fund’s relative performance has been stronger during risk- off periods featuring widening credit spreads, due to our careful underwriting and avoidance of excessive credit risk. Conversely, relative performance can lag during periods when lower quality credit rallies sharply. The lowest rated credits contributed significantly to to the high yield index in Q3, with the ICE BofA CCC & Lower Index gaining 11.61% in the third quarter alone.

Rather than reach for duration in anticipation of a further rally, we remain focused on finding small issue credits that remain the core focus for the Fund. This discipline comes with the side effect of temporary underperformance when the credit market jolts higher (i.e. Q3), but we expect it to deliver favorable performance with less rate volatility over longer periods of time.

Positioning

The Fund ended the quarter with a yield-to-worst of 8.3%. The step down in yield from the 9.5% level as of 6/30 was mostly due to the change in rates during the quarter, as the Fund’s spread vs the High Yield Index is similar to that of the past several quarters. However, there was also an impact from a resurgence in the new issue market.

With the credit markets wide open, many companies are choosing to refinance their debt now rather than risk facing a tougher market when their debt ultimately comes due. This is especially true for companies with riskier business models who can’t afford to be picky when timing a refinancing. Not surprisingly, a handful of the Fund’s higher yielding positions chose to refinance their bonds during the quarter. This included a few bonds that were refinanced on the last day of the quarter, creating a timing issue that was a partial drag on quarter-end yield.

The drag on yield that can result from a healthy new issue market should be balanced against the favorable impact it can have on performance. For instance, note that the 8.3% yield metric is a yield-to-worst, which usually means the yield that would be earned if the bond was held to maturity, and the issuer does not default. During periods when many issues are being called early, however, it understates the yield that could actually be earned, as many companies pay a premium to repay bonds early. The Fund holds a number of positions that are candidates to be called in Q4, and whose yield-to-call is meaningfully higher than the yield-to-worst. When adjusting for the positions we expect to be called within the next year, we estimate the yield of portfolio to be slightly over 10%.

The Fund’s effective duration was 2.3 years at quarter-end. Like the yield, the Fund’s duration was also impacted from a robust new issue market in which a number of shorter-dated holdings were called during the quarter.

We are often asked how our shorter duration portfolio will fare as the Fed embarks on a rate cutting cycle. Can relative performance keep pace? To that end, we would point to the fact that credit markets have already priced in a substantial amount of cuts. At quarter end, Fed Fund futures forecast a rate of ~3% by the end of 2025, implying an additional 8 cuts. If the extent of cuts significantly exceeds this, then it’s reasonable to expect this will be a headwind to the Fund’s relative performance. However, we would argue the conditions that would justify such a sharp decline in rates would likely portend a significant slowdown in the economy and therefore an increase in credit spreads. We believe this would be a counterbalance to any duration headwind, due to the Fund’s historical outperformance during periods of rising credit spreads. On the other hand, if conditions remain strong enough to justify the current level of credit spreads, we question whether the market’s expectations for cuts might be a tad too optimistic.

Closing

Fortunately, our investment process does not require that we predict the path of rates. Instead, we limit this risk through a shorter duration positioning and focus on identifying small issue credits we can confidently underwrite and that we believe are more likely to be structurally mispriced. Over time, we hope to deliver an attractive absolute performance with less rate volatility.

If there is anything we can do to better serve you, please give us a call. Thank you for your investment.

Sincerely,