3rd Quarter 2012
The US Federal Reserve initiated another round of quantitative easing (QE3) in September on concerns that economic growth was not strong enough to improve the labor market. The $40 billion per month in additional agency mortgage-backed securities (MBS) purchases has thus far not spurred the rally in risk assets that had previously followed such announcements. Markets that had seen further easing by the Fed as almost inevitable had already gained ground prior to the announcement, boosting returns during the quarter. Data suggests that despite the actions of the Fed, the labor market continues to face headwinds, even as other measures of economic activity moved in an encouraging direction. The service, manufacturing, and housing sectors all showed improvement during the period.
The Fund outperformed its Barclays Capital U.S. Aggregate Bond Index benchmark by a healthy margin during the quarter. Relative performance was aided by an underweight position to the US Treasury sector and an overweight stake in outperforming agency and non-agency MBS. Prices on agency collateralized mortgage obligations (CMOs) increased due to the slight fall in interest rates, while prices in the non-agency market rose with Prime and Alt-A securities both significantly outperforming. In addition, the Fund’s allocation to Emerging Markets helped relative returns. The portfolio held a neutral weighting in credit sector, which was the top performing area of the index on an absolute basis.
The Treasury market saw a sharp rise in intermediate- and long-term yields during the early parts of August and September followed by a recovery during the second half of each month, with yields modestly higher than at the start. The new quantitative easing program surprised investors in being open ended. The announcement led to a sharp Treasury market sell-off on September 14, which set the stage for lower yields through the remainder of the quarter.
Strong Mortgage Performance
The announcement of QE3 was the most important piece of news for the mortgage market during the quarter. The mortgage market was expecting QE3 and the inclusion of purchases of agency mortgages, but the size of the program surprised. Keep in mind that one of the mandates in the Operation Twist announcement a few months ago was a reinvestment back into mortgages for the paydowns of the Fed’s mortgage portfolio purchased in QE1. This number amounts to around $25 billion a month. Thus, these two conditions bring the Fed’s total monthly additions for mortgages to $65 billion. The market is producing between $120 and $150 billion of new mortgages a month, so the Fed is buying about one-half of all new mortgages.
Among agency MBS, lower coupon mortgages were up by as much as two points while higher coupon mortgages were actually down a few ticks. The lower coupons benefitted from the larger than expected size of the QE3 program, as the Fed aims to buy lower coupon mortgages. Higher coupons were likely down in price due to a creeping up in overall prepayment speeds the past few months.
The drop in rates from earlier in the year is probably the catalyst for the increase in prepayment speeds. What the market is trying to see is if the housing market has turned the corner. If it has and things get better economically then there would be an expectation of further increases in prepayment speeds. We believe there has been a structural change in the financial status of borrowers and their ability to refinance their mortgages and it will take a while to bring this situation more in line with its historical norm. At the same time, however, we recognize that rates have come down and many borrowers do have the financial wherewithal to refinance. These borrowers, who mostly reside in lower coupon mortgages, should be very responsive to any further reduction in interest rates.
Non-agency mortgage prices continued their rapid climb as outstanding supply continues to dwindle. The market is currently just below $1 trillion in overall non-agency mortgage assets down from a high of more than $2.4 trillion back in 2006. The third quarter was certainly not without tradable supply, however, as the increase in prices has started to bring out positions where sellers are recognizing profits and moving into other asset classes or just reducing exposure to the sector.
The rally in Emerging Markets fixed-income that began in May continued through September as spreads tightened relative to US Treasuries. Expectations for reduced risk out of Europe stemming from commitments by both the European Central Bank (ECB) and the Fed to provide market support and liquidity helped to boost risk assets.
Global Developed Credit
The third quarter of 2012 delivered generous returns in the credit markets despite ongoing evidence of a global economic soft patch. The Barclays Capital U.S. Credit Index delivered 3.5% of total return, bringing year-to-date total returns up to more than 8%. High-yield similarly outperformed. The market’s enthusiasm for risky assets remained on track despite ongoing signs of US economic weakness along with the largely unresolved concerns in the eurozone as the benefits of central bank stimulus are causing investors to overlook the fundamental outlook for corporate credit.
Performance by rating category was skewed in favor of lower credit quality among both investment-grade and high-yield credit. Within investment-grade, BBB-rated debt outperformed issues A-rated and above. With respect to the high yield market, higher beta (volatility) credits were also among the best outperformers along with lower-rated issues.
By committing themselves to open-ended and unlimited asset purchase programs, the Fed and ECB effectively changed the game by casting their policy towards diminishing burgeoning tail risks as a measure of downside protection to the market. Despite anemic to negative levels of growth in many parts of the global economy, liquidity-driven asset reflation has played a crucial role in the powerful rally among risk assets. Although the market as a whole appears driven by monetary policy as opposed to individual fundamental analysis, we continue to exercise caution in issue selection lest the market takes a turn for the worse in view of recently reduced earnings guidance pronouncements by U.S. blue chip corporations.
Looking ahead, the key headwinds facing global markets will continue to be the European banking and debt crisis, U.S. elections and fiscal cliff, and slowing Chinese growth. Despite the fact that liquidity provided by the ECB, U.S., and other central banks around the world have supported the market the past four months, these issues have not been resolved and will likely weigh on global growth through the end of 2012 and into 2013. The ECB’s easing program has yet to be tested as ECB President Draghi has been successful in talking down yields in the European periphery without putting any skin in the game. Greek and Spanish governments still face uphill battles in convincing coalition partners and citizens to continue forward with increasingly burdensome austerity measures if growth targets continue to be missed. Not to be underestimated is that ‘bail-out fatigue’ from Germany, Finland, Netherlands and other core European countries could escalate if the bailout costs for the periphery of Europe rises. Over the longer term, the eurozone’s creation of a banking union and advance toward full fiscal union should continue to proceed, albeit at a start-and stop pace.
A U.S. policy response to the fiscal crisis is not expected until after the November presidential election, or around the time of the expiration of numerous tax cuts and the implementation of automatic spending cuts begin at year-end. Chinese officials are likely to continue to provide just enough stimuli to maintain growth and avoid a hard landing, without showing any real new growth programs, ahead of its leadership changes starting in October/November 2012 and ending in March 2013 with the change in Presidency and Premiership at the National People’s Congress. Another risk that remains on our radar screen is the growing geopolitical tensions between Israel and Iran.
As always, we continue to seek to take advantage of any pricing anomalies that may occur should the market environment become more dislocated.
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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