2nd Quarter 2014
Risk assets continued to appreciate, along with US Treasury bond prices, during the second quarter, as domestic corporations engaged in a series of mergers and acquisitions (M&A). A continued low-interest rate environment, suppressed risk premia overseas, slow growth in demand, record corporate profitability, record levels of cash holdings by the corporate sector, and the interaction of all these factors were all likely contributors to rising equity prices and a robust bond market. M&A monthly deal volumes above the $150 billion mark that have been common during the year are reminiscent of the heady levels of 2007. Although being long risk has been the position to be thus far in 2014, economic indicators could be interpreted as suggesting quite different positioning.
Revised data released in June showed real U.S. Gross Domestic Product (GDP) contracted at a 2.90% annualized rate during the first quarter. Consumption growth was significantly below preliminary estimates, and a decline in investment trimmed nearly 2% from growth alone. The headline unemployment figure continued to fall finishing the quarter at 6.1%, but the proportion of workers considered “under employed” was unchanged for the quarter at 6.0% of the labor force. The combined rate of those unemployed or underemployed of 12.1% remains highly elevated relative to levels seen before the Great Recession. Add in a labor force participation rate reminiscent of the late 1970s and the labor market does not look as robust as depicted by the headline unemployment rate alone, though 816,000 jobs added in total offered something of a silver lining. June’s Federal Reserve (Fed) minutes suggest the Fed Governors are cognizant of many of these (and other) weaknesses that continue to permeate the economy so many years after the official end of the Great Recession, and the tone regarding future rate increases remains quite dovish. Low levels of inflation corroborate this plan of action. What remains to be seen, however, is if the economic data will eventually substantiate the bull market that continues mostly unabated.
The eurozone economy remains extremely sluggish, supporting the European Central Bank’s (ECB) additional easing policies during the quarter. Consumer prices grew by just 0.5% for the 12-months ending June, less than half the ECB’s 2.0% target. Consumer confidence unexpectedly fell in June, with ECB data indicating that lending to companies and households fell for the 25th straight month in May.
EM Leads the Way Again
The Fund outperformed its Barclays U.S. Aggregate Bond Index benchmark during the quarter. Despite the doom and gloom coming into the year, fixed income markets have performed quite well. Emerging Markets (EM) was the standout area for the Fund, as credit spreads tightened due to a flattening yield curve. The sector’s allocation to mainly European and Latin American debt, which were the best performers during the period, helped to boost returns. Residential mortgage-backed securities (MBS) were the second best performing sector as declining US 10-year Treasury yields aided longer duration Agency MBS, particularly fixed-rate commercial mortgage obligations (CMO) and pass-through securities. Non-Agency MBS also experienced price gains as housing fundamentals continued to improve across the credit quality spectrum, and contributed strong interest income. Corporate Credit, both the Investment Grade and High Yield sectors, performed well as credit spreads tightened and default rates remain close to historical lows. Commercial mortgage-backed securities (CMBS) experienced total return gains as credit spreads broadly tightened over the period and demand remained high for legacy and new issue product. Bank Loans and Collateralized Loan Obligations (CLOs) lagged behind the other sectors within the portfolio, though returns were still positive.
Emerging Markets broadly rallied as mixed-to-improving economic data from developed nations combined with broad policies from global central banks to maintain low interest rates. EM corporate debt spreads tightened as investors continued to pour cash into the space in an apparent search for higher yielding assets. The sector overall gained 4.76% during the quarter, with the bulk of that performance coming in May. Sovereign bonds outperformed both Corporate and local bonds.
The second quarter was characterized by the rise of a number of geopolitical crises within Emerging Markets. From the headline-grabbing Russian buildup of troops along the Ukrainian border to the May ouster of the elected Thai government by the nation’s military, the surprise June attack and rapid gains made by the Islamic State of Iraq and the Levant (ISIL) across much of western Iraq, to the widening strike paralyzing much of South Africa. Each of these situations remains extremely fluid, though broader markets have calmed after initial spikes in volatility.
In Latin America, the U.S. Supreme Court denied a final appeal by Argentina against a lower court ruling that it had to pay holdout creditors in a nearly decade-long legal saga. Initially it appeared that President Cristina Fernandez de Kirchner’s government would attempt to transfer current holders of Argentinean New York-law debt into local-law debt in an effort to circumvent the U.S. court’s ruling, but fairly recent indications have emerged that the government may be nearing a settlement with holdout creditors. Argentina’s debt performed strongly during the quarter in anticipation of some sort of resolution to the saga. Many eyes were also on neighboring Brazil, host of this summer’s World Cup, and its economic and political woes. Brazil continued to undershoot its primary deficit goal of -1.9%, and some investors have looked favorably upon center-left President Dilma Rousseff fading below 40% in recent polls.
MBS outperformed US Treasuries by a healthy margin during the quarter. The yield curve exhibited bull flattener behavior as the long end of the curve tightened while rates on the front end were essentially unchanged. The longer duration (sensitivity to changes in interest rates) in the MBS sector was a driver of the outperformance with rates low and central banks dovish, but technical factors also weighed in as demand continued to exceed supply. Longer duration bonds priced off the long end of the yield curve benefited the most, with 30-year collateral outperforming 15-year collateral and lower coupons faring better than higher coupon bonds.
Agency MBS issuance grew during the period. The increase in issuance coincided with the Fed continuing to taper its asset purchase program, and formally revealing in June that it aims to conclude the program by October 2014. According to Fed officials, the ending of the purchase program is no indication that the first interest rate hike will be imminent, rather, the economy will be observed and if it is able to continue on its current trend, only then will the possibility of a rate hike be considered. Many Wall Street economists feel that the earliest possibility of a rate hike will be the second quarter of 2015.
The non-Agency MBS sector was characterized by improving fundamentals coupled with reduced trading volume. The large liquidation lists seen in the first quarter all but disappeared. Instead, hedge fund and money manager selling drove bid list volume. The bulk of the activity was in Alt-A and subprime collateral. Against the backdrop of improving fundamentals and tighter supply technicals, yields tightened, pushing prices higher.
Investment grade corporate credit continued to post healthy returns, bringing its streak of positive results to six consecutive months. Credit spreads tightened as heavy supply met healthy demand. The favorable credit environment has been positively influenced by the Fed’s dovish forward guidance regarding its zero interest rate policy, signs of an improving U.S. economy, and relatively low market volatility.
Investment grade fund flows remained positive and accelerated in June with $8.0 billion in inflows to the asset class. Geopolitical tensions and the uprising in the Middle East have increased demand for safe-haven assets such as US Treasuries and US investment grade corporate bonds, increasing demand and reducing yields. Monetary policy has also continued to remain accommodative, which has kept yields low. We believe that long-term performance with relatively low volatility is vital for investment grade bonds to continue to perform. The opportunity for further spread compression is becoming less likely given historically tight levels. We continue to value credits that exhibit competitive advantages in their respective industries, such as management teams with proven records and firms that maintain better than average balance sheet fortitude and free cash flow.
High-yield bonds benefitted from a combination of accommodative global central banks, stagnant growth trends, low market volatility, and benign US Treasury yields. While the U.S. economy faltered in the first quarter, this was not reflected in earnings of high-yield issuers. According to Barclays, year-on-year growth for the broad market was 10% for the first quarter and has been increasing for the last four consecutive quarters. Debt growth has slowed down significantly since last year and coverage ratios are at their all-time highs, aided significantly by low interest rates. This divergence stems from increased business spending, which has been boosting high-yield company earnings relative to the weak consumer spending that has been dragging GDP down.
Lagging Bank Loans & CLOs
Collateralized Loan Obligation (CLO) issuance continued at a steady and strong pace during the quarter, though money continued to flow out of retail loan funds. The reversal in retail fund flows was one of the factors propelling the increase in CLO issuance. Except for AAA-rated notes, 2.0 CLO debt spreads widened during the quarter. Spreads up and down the capital structure are still nowhere near the tight levels of 2013.
Although the Bank Loan market benefitted from record CLO new issue volumes—along with accommodative global central banks, stagnant growth trends, and low market volatility—returns lagged the broader market. Retail Bank Loan mutual funds reported noticeable outflows in May and June, with June’s outflows the largest monthly retreat since August 2011. For the most part, investors have been attracted to such funds because they offered better yields in last year’s low-rate environment than could be had in investment-grade bonds and most investors expected the floating rates would cushion them as interest rates rose. While the strong rush of inflows combined with the return of covenant-lite loans into the space has been worrisome for some we see the potential for more buying opportunities in the space. We still maintain a relatively conservative position in the Fund, however, valuing higher quality credits.
Treasuries were positive during the second quarter, but again lagged the broader aggregate index. Support for Treasury prices came from a variety of sources. Geopolitical risk, especially the turmoil in Ukraine and Iraq, provided a flight-to-quality bid. A highly accommodative monetary policy was cemented in place by the ECB. With combating deflation being the primary focus, the easy money policy pushed European sovereign yields lower, in turn adding to downward pressure on Treasury yields resulting in higher prices. Fed Chair Yellen helped the market as well with some dovish comments that allayed investor fears of a shift toward more aggressive policy tightening. Still, low yields overall have served as a drag on total returns from this traditional safe haven.
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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