4th Quarter 2012
Through the effects of Superstorm Sandy, the fourth quarter witnessed an additional round of quantitative easing from the Federal Reserve and a resolution to the so-called “fiscal cliff” that was not reached until after markets closed on New Year’s Eve. The S&P 500 Index finished the fourth quarter only down slightly and the Barclays Aggregate Bond Index finished the quarter up slightly. The lack of real movement among these two broad indices largely supported the economic news during the quarter. After seeing a large spike during November, jobless claims ended the quarter at roughly the same level they started. Construction spending expanded in October, and then subsequently contracted in November (December’s figures were not yet available).
Factory orders were similarly subdued. Commentators partially, and in some cases largely, blamed these and other tepid growth figures in both the financial markets and the broader economy on the uncertainty of the fiscal cliff. With that obstacle now passed, the looming debt ceiling debate seems the next most plausible rationale for weak economic expansion in the quarter to come. Some causes for optimism in the coming year include the rebound in the housing market, which showed solid performance in new, existing, and pending home sales figures that have risen strongly from post-recession lows. As the economy heads into the 43rd month since the official end of the recession, economic figures have turned the corner and shown stabilization if not growth in most areas. Hopefully, the upcoming fiscal cliff negotiations will not hinder this progress.
The Fund outperformed its Barclays Capital U.S. Aggregate Bond Index benchmark during the quarter. An underweight to US Treasuries helped relative performance as that sector declined. Allocations to Emerging Markets fixed-income and Commercial mortgage-backed securities (CMBS) added to the relative outperformance as these asset classes performed well. An overweight position to the entire mortgage-backed securities (MBS) sector, which delivered negative returns in the benchmark for the quarter, ended up being a mixed bag as the portfolio’s holdings outperformed as non-Agency MBS did well. Finally, while the credit sector was the top performing area of the index, the Fund was slightly underweight.
The Fund substantially outperformed the benchmark for calendar year 2012, with allocations to Emerging Markets and non-Agency MBS leading the way. The Fund was underweight the US Treasury sector the entire year, further helping performance as that sector was the worst performing area of the index.
Fiscal cliff negotiations drove US Treasury trading through December as bond prices rose or fell with each press release, news story, or rumor in the market. Thus, December was typical of 2012 as a whole, as governments around the globe intervened in markets with the objective of boosting liquidity and pushing rates lower. The Federal Reserve ended 2012 extending its MBS purchase program and replacing “Operation Twist” with a new program of outright Treasury buying. The Fed was active in the Treasury and Agency MBS markets throughout the year in pursuit of the full employment half of its dual mandate. The result was a yield curve at year-end that was remarkably close to where it began the year. Short-term interest-rates were virtually unchanged, not surprising as the Fed maintained the 0% to 0.25% Federal Funds target rate that has been in place since December 2008. The short-rate “guidance” convinced investors that low-rate policy would continue for the foreseeable future, helping intermediate-term yields.
Among other government securities, the year saw improved financial stability at Fannie Mae and Freddie Mac. Income-starved investors looking for yield responded by shifting funds into these agencies, with agency spreads to Treasuries narrowing throughout the year. The agency sector gained 2.16% for the year, besting comparable duration Treasuries by nearly a percentage point. Five-year agencies were only slightly cheaper to Treasuries by year-end, however, leaving dim prospects for further outperformance in 2013.
Treasury Inflation-Protected Securities (TIPS) performed well in 2012 as the Federal Reserve’s aggressive monetary accommodation increased concerns about future inflation. Tax-exempt issues likewise did well. The prospect of higher tax rates helped municipal bonds throughout most of the year, though in December the market was hit with fears of a cap on the interest exemption for municipals.
Strong Emerging Markets
All three sectors of Emerging Markets (EM) fixed-income—external sovereign, corporate debt, and local currency bonds—posted strong positive returns during the month of December and for all of 2012. Entering 2012, global markets faced several key risk factors that carried over from 2011, including the sovereign debt and liquidity crisis in the eurozone and slowing growth in China. In addition, the November presidential elections and the looming “fiscal cliff” of government spending cuts and tax increases raised uncertainty as to whether one of the bright spots in the global economy would lose its luster. Many of these challenges were met by central bankers providing supportive monetary policy as government policymakers’ fiscal actions were limited. Much of the accommodative policy came from lowering or maintaining historically low rates, which made EM debt, in comparison to developed markets, an attractive alternative asset class given their comparatively higher yields.
Going into 2013, EM performance looks like it can expect support from a number of tailwinds.
We think the sector is in a strong technical position as inflows are expected to remain strong, with some third parties (EPFR Global and JP Morgan) anticipating $70 billion into the asset class for 2013. Credit fundamentals have improved for EM issuers as well. In conjunction with those two points, EM bonds are likely to see more rating upgrades, though perhaps at a slower pace.
Given this backdrop, we continue to favor corporate issues over sovereigns, as they offer the potential for credit improvements at relatively attractive valuations. Although we anticipate credit fundamentals to continue improving for both EM corporates and sovereigns, we feel that the sovereign sector has already priced in a significant amount of optimistic market conditions, especially relative to corporate credits. The yields offered by EM corporate credits remain attractive relative to those of similarly rated U.S. Industrial credits, as we find that EM corporates across all rating categories are trading cheaper than their developed market counterparts—often by significant margins. We expect these spread differentials to contract as global market sentiment improves throughout the year and EM corporates improve their credit metrics. By contrast, EM sovereign credits are trading significantly tighter than similarly rated U.S. Industrial credits.
CMBS ended the fourth quarter with somewhat of a muted tone after a stellar year comprised of consistent supply and demand technicals. During the quarter, the market was well supported despite a robust new issuance calendar. Markets were also well bid on the secondary side as the low-rate environment and risk rally in other asset classes caused CMBS to garner attention on a relative-value basis.
Our investment focus for this sector remains largely the same with an emphasis on security selection and focus in shorter duration assets, including securities with a more “storied” basis as our ability to drill down to the borrower level allows us to assess risk adequately. Looking forward, our outlook for the sector remains cautious given uncertainties surrounding fiscal cliff implications as well as macroeconomic headwinds.
Still Overweight Mortgages
The fourth quarter 2012 was not simply a continuum of the entire year in the mortgage space. During the quarter, we had upward price movement, reduction in tradable supply, and better performance in defaults and severities. The issue of the difference between primary and secondary mortgage spreads continued to be a very hot topic with the Federal Reserve that will probably not resolve itself until the industry catches up and gains more capacity. We expect a continued reduction in supply in the year ahead, with increasing prices on the supply that remains. We also expect continued eminent domain discussions and new rulings for underwriters on how to underwrite and who can qualify.
Agency MBS outperformed the benchmark in December but underperformed for the year. Lower coupon mortgages were down in price while mid-to-higher coupons were flat. During the year, lower coupon passthroughs ended up in price while higher coupon passthroughs declined. This price action was generally attributable to higher prepayments on HARP-eligible higher coupon collateral driving down prices, while the Federal Reserve focused their purchasing power on the lower coupon MBS driving those yields down.
Housing prices have leveled off on a non-seasonally adjusted basis nationwide the past few months. If this trend continues, or if housing takes a turn for the worse, there could be a greater likelihood of further government involvement in the mortgage market. Overall prepayment speeds (pre-payment risk is an important component in mortgage investing) have remained at historic lows relative to the current low primary mortgage rate levels. The spread between the primary and secondary rate remains relatively wide, with no basis for this to change over the short-term in order to keep future prepayment expectations in line with current rates. The Fund continues to be overweight the entire MBS sector of the market.
The tightening of corporate credit spreads coupled with lower interest rates contributed to outstanding returns for investment grade and high yield corporate bonds in 2012. In stark contrast to 2011, excess returns for both investment grade and high yield corporate bonds were positive in 2012 as corporate credit outpaced the returns posted by US Treasury securities. Bonds from the Financials sector led the spread tightening in both the investment grade and high yield markets.
Higher-quality issues (rated single-A or better) underperformed their lower rated counterparts within investment grade bonds given the predilection of investors to trade down the risk curve to reach for yield. The same was true for high yield, as lower quality bonds outperformed their higher rated counterparts. The trailing 12-month speculative grade default rate picked up slightly in high yield from its 2011 year-end low. According to Barclays, ratings migration will likely continue to favor downgrades in 2013.
It could be mathematically difficult to experience anywhere near the same returns in investment grade and high yield corporate bonds in 2013 as those generated in 2012, unless one assumes that credit spreads return to the tightest levels recorded (February 2007) or interest rates drop significantly below current levels. Assuming corporate credit spreads tighten modestly and interest rates remain steady, corporate credit could generate returns in the low-to-mid single digits in 2013. Technical factors dominated the corporate bond market to a significant extent in 2012 given investors’ appetite for yield.
Long-term, the preponderance of credit spread tightening may have run its course as fundamental considerations eventually prevail. A number of domestic and global factors could adversely affect issuers’ credit strength from a fundamental risk perspective in 2013. U.S. domestic budget deficit issues, slowing growth in China, and deepening recessions in Europe and Japan could pressure cash flow for issuers with global operations. For that reason, DoubleLine continues to remain defensively positioned in corporate bonds issued by firms with long-term, sustainable competitive advantages and strong balance sheets able to better weather economic storms.
Similar to 2011, the first several months of 2012 saw strong gains in “riskier” asset classes such as equities and commodities, as apprehension over a disorderly eurozone breakup from the fall of the prior year faded. Improving signs in the U.S. economy supported this “risk-on” environment as investors appeared to shake off ratings downgrades of troubled “periphery” nations in the eurozone. The lack of dire headline developments from the struggling currency block and the European Central Bank’s second Long-Term Refinancing Operation (LTRO) plan to provide additional liquidity to banks across the union helped to drive Corporate and EM spreads tighter.
Many of the same near-term headwinds that affected the markets over the past year are likely to be seen in 2013. The eurozone and European periphery will continue to struggle with weak growth, high unemployment, high debt/Gross Domestic Product (GDP) and extremely strict austerity measures. Fiscal cliff uncertainty in the U.S. has given way to a new debate over the debt ceiling. Global markets may be underestimating the negative sentiment that may come out of this debate over the next few months, which could prove nastier than recent negotiations over the fiscal cliff. Even with the comfort of China guiding towards healthy growth for 2013, its next generation of leaders will still have their plates full with a slowing growth rate, domestic issues such as the one child policy and rampant corruption, and increasing foreign policy turmoil as they relate to the U.S. and its neighbors, particularly Japan. In Japan, the ramifications of a new extremely pro-growth government have yet to be fully felt throughout Asia. Remaining on the radar screen are the ongoing geopolitical tensions between Israel and Iran, as well as reverberations of the “Arab Spring” in countries like Syria and Egypt.
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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