1st Quarter 2014
Record cold temperatures across a broad swath of the U.S. led to disappointing economic data to begin the first quarter of 2014. This posed another opportunity to question the ‘escape velocity’ of the recovery, particularly on the back of data showing Gross Domestic Product (GDP) growth during the second half of 2013 was the strongest such growth in a decade. The poor data spooked equity markets and yields on 10-year US Treasury bonds fell 38 basis points (0.38%).
Since January, however, something of a sea change has occurred as most investors ascribed the poor data purely to weather related issues. With the “tapering” of its Quantitative Easing (QE) program in full swing, investors began questioning when the Federal Reserve would eventually raise rates. This sentiment was largely fueled by an un unemployment rate that was quickly approaching the Fed’s previously stated target of 6.5% (a target which has since been discarded), the belief that the budget agreement reached in December would reduce much of the fiscal drag seen in 2013, and inflation measures that were slowly inching higher into the end of 2013. Hawkish sentiment also was expressed in new Fed Chair Janet Yellen’s first press conference on March 19. When asked to clarify the timing on plans to keep the federal funds rate near zero Yellen replied that it, “probably means … around six months.” This was decidedly a shorter timeline than most market participants had anticipated. Subsequent comments from the Fed have attempted to walk back this hawkish view.
The pickup in intermediate rates offered a contrast to the growing commentary on so-called secular stagnation—continued elevated levels of the long-term unemployed combined with alarmingly low levels of inflation. Data from the eurozone suggested inflation of only 0.5%, with momentum gaining towards their own version of QE. For its own part, the most recent Core Personal Consumption Expenditures (PCE) data in the U.S. was only 1.1%, which is hardly consistent with a robust economy some five years into a recovery. If the rest of the year is anything like the first quarter, markets should continue to be reactive, largely in anticipation of any movement from the Fed.
Emerging Market Boost
The Fund outperformed its Barclays U.S. Aggregate Bond Index benchmark’s 1.84% gain by a fair margin during the first quarter of 2014. From a total return perspective, Emerging Market debt was the best performing sector within the portfolio, as credit spreads tightened because of a flattening yield curve. High Yield was the second best performing sector benefiting from tightening credit spreads and a very benign default environment. Residential mortgages, which continue to be the largest sector of the Fund, outperformed its Barclays index equivalent as well. Both Agency mortgage-backed securities (MBS) and Non-Agency MBS benefited from strong price gains, particularly early during the quarter alongside the decline in longer-term US interest rates. Investment grade corporate debt performed well with most of the performance occurring in the first half of the quarter. Other sectors held in the Fund also contributed strong positive gains as Commercial MBS and Collateralized Loan Obligations (CLOs) performed well. Bank loans lagged behind other sectors, but still contributed positive absolute returns.
Emerging Market debt rebounded strongly from a late January selloff, as risk assets broadly moved higher. Credit markets in developing countries were supported by relatively more robust economic data out of the U.S. and strong technical support as investors deployed cash to the sector. In general, Emerging Market bonds (as represented by the JPM Emerging Markets Bond Index Global Diversified) gained 3.73%, slightly more than twice the Barclays Aggregated Index. The bulk of the performance came in February, with sovereign bonds outperforming both corporates and local bonds.
March was a volatile month in Europe, the Middle East, and Africa (EMEA) after Russia occupied and ultimately annexed the Crimea province of Ukraine, sending the debt and currencies of both nations plunging amid escalating geopolitical tensions and fear of heavy sanctions on Russia from the West. Though Russian troops remain massed on Ukraine’s eastern border, outright war did not erupt and a stalemate appears to have emerged. Furthermore, sanctions from the U.S. were narrowly targeted to individuals and a bank tied to Putin’s administration. Markets reacted positively in the absence of the worst-case scenario thus far, and both nations’ debt and currencies rallied into quarter-end.
High Yield credit products weathered a rise in US Treasury yields in March, despite the tensions between Russia and Ukraine as well as continued uncertainty regarding the Chinese economy. The default backdrop remains very benign. Only eight Moody’s-rated corporate debt issuers defaulted during the period compared with 21 companies in the first quarter 2013. The global speculative-grade bond default rate finished lower than last year as well.
Non-Agency MBS outperformed Agency MBS with Alt-A securities gaining the most. Trading volume was inconsistent at times, but prices reset higher with each large bid list that traded. Longer duration Agency MBS also added to total return gains as Agency Z bonds benefited from strong price appreciations.
This despite Non-Agency MBS kicking off to a sluggish start to the year as the market largely shrugged off the expectations of rising rates from Fed tapering. The lack of volume made it challenging for all market participants despite interest to put money to work. The majority of activity in the prime and Alt-A space was focused on Adjustable-Rate Mortgages (ARMs) and floating-rate bonds during March. Despite positive trending data in mortgage fundamentals, supply technicals remain the primary driver of the rally. Rising mortgage rates dampened prepayment speeds and March remittance reports showed slower speeds across all subsets of the non-Agency MBS marketplace.
The Agency MBS sector outperformed US Treasuries during the quarter due to the longer duration (a measure of sensitivity to changes in interest rates) of the MBS sector. The duration of the Agency MBS sector stood at 5.5 years, close to the all-time high of 5.7 years registered in November 2013. Within the sector, lower-coupon mortgages outperformed higher-coupon mortgages, and 30-year mortgages outperformed 15-year mortgages. There were two main reasons for this: First, interest rates fell and the lower-coupon mortgages and 30-year mortgages have longer durations than the higher-coupon mortgages and 15-year mortgages; second, the yield curve changed shape during the quarter. Longer rates declined substantially more than short-term rates, and the lower-coupon mortgages and 30-year mortgages cash flows are further out the curve than the higher-coupon mortgages and 15-year mortgages, and therefore would appreciate in price more due to a greater rate change for their cash flows.
Overall prepayment speeds for Agencies were down slightly in the quarter as well. Prepayment speeds in aggregate are as low as they have been since 2009, and their previous low before that was in 2000. With the decrease in prepayments there has also been a continued decrease in gross issuance of MBS since last summer. This reduction in supply is important because it comes during an environment where the Fed is “tapering” its QE program. This reduction in demand has been offset by the tremendous decrease in issuance.
The first quarter saw two different announcements pertaining to the future of the Government Sponsored Enterprises (GSEs). We believe that any solution is a ways off and the actual implementation of this solution could be as far away as five years from now. Three bills have been put forward recently in Congress, any of which could end up raising mortgage rates.
Investment Grade Credit
It was a solid quarter for Corporate credit overall, with investment grade bonds up 2.91%, as measured by the Barclays U.S. Credit Index. The flattening of the US Treasury curve had a big impact on investment grade corporate spreads, especially in March. The flattening was due to the Fed’s forward guidance, which the markets viewed as more hawkish than expected, and Yellen’s comment regarding how long before the Fed would hike rates after ending QE. With the significant underperformance of the five-year US Treasury, there was little performance difference between investment grade corporates and high yield corporates, both of which handily outperformed equities for the quarter.
Within investment grade, investors continued to reach down the credit spectrum as BBB-rated bonds outperformed. The opportunity for further spread compression is becoming more challenging given that corporate bond yields are approaching historically tight levels. We continue to remain highly selective with respect to credit purchases across the risk spectrum, concentrating holdings in those firms that have long-term sustainable competitive advantages, proven management teams, and cash flow and balance sheet strength.
CMBS, CLOs, and Bank Loans
The Commercial Mortgaged-Backed Securities (CMBS) market ended the quarter somewhat weakly due to muted legacy supply in the secondary market. Overall, demand for the riskier part of the capital structure continued to remain strong as legacy AJs (legacy seasoned mezzanine CMBS) and new issue BBB- and BB-rated bonds all rallied substantially. Although some portion of this move can be attributed to supply/demand technicals, CMBS showed some relative value when compared to similarly rated investment grade and high yield Corporates. That coupled with improving commercial real estate (CRE) fundamentals would support the rationale for the CMBS credit curve to flatten in the near-term.
Collateralized Loan Obligation (CLO) issuance started the year slowly as managers waited for more clarity on the regulatory front in regards to the Volcker Rule, Risk Retention, and Liquidity Coverage Ratios. The market was initially concerned about future forced selling from banks, mostly due to Volcker Rule implications, which also brought CLO monthly supply to its lowest level in January since the middle of 2012. Since January, there has been a surge of newly issued deals due to positive momentum on the regulatory front.
With strong technical conditions aided by the late surge in CLO issuance, Bank Loan securities as represented by the S&P/LSTA Leveraged Loan Index gained 1.20% during the quarter, mainly due to 1.16% of interest accrual along with just 0.04% from market-value gains. This continued the trend from 2013, which may be the closest thing the loan market has ever had to a coupon-clipping year, with price changes accounting for only 0.33% out of the 5.29% total return.
Lower-rated, higher-spread loans continued to outperform, with CCC-rated loan returns outpacing single-Bs, which in-turn outpaced BBs. This can be tied in part to higher-quality loans having thinner spreads, as evidenced by the average price of loans with a 3.5% all-in coupon decreasing during the quarter while loans with yields greater than 3.5% increased. Strong CLO formation more than offset falling retail inflows that hit a 14-month low. Defaults continued their muted trend. The near-term outlook also appears benign based on low near-term maturities across issuers, substantial liquidity in the credit markets, and continued growth in borrower cash flows.
The US Treasury market (as measured by the Barclays U.S. Government Index) trailed the broader Barclays Aggregate Index during the first quarter, but recovered about half of the loss it realized in calendar 2013. As noted, returns were stronger for longer maturity issues. Treasury Inflation-Protected Securities (TIPS) performed mostly in line with conventional Treasuries.
A maxim of the Treasury market is that the market will move in the direction that causes the greatest pain to market participants. Many Treasury investors, convinced that a rate rise was imminent, reduced positions and shortened duration in late 2013. True to form, the market rallied from the first trading day of 2014. The short covering rally carried the 10-year US Treasury yield down from a high of 3.03% on December 31 to 2.58% on February 3, before moving into a narrow range (2.60% to 2.80%) just above that mark for the remainder of the quarter.
The yield curve flattened throughout the quarter. Concern about the approaching turn in Fed policy limited the rally in short- and intermediate-maturity Treasuries, while longer issues showed sustained strength. The five-year US Treasury ended the quarter near its December 31 level. The 30-year, by contrast, held its January gains and reached a new low yield in late March. The Treasury sell-off followed Fed Chair Yellen’s comments in early March. The alarmist reaction faded over the remainder of the month, however, and yield drifted back to the low end of the range.
DoubleLine Capital LP
Los Angeles, California
Note: Bond funds are subject to interest rate and credit risk similar to individual bonds. As interest rates rise or credit quality suffers, an investor is susceptible to loss of principal.
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