1st Quarter 2013
With many pundits declaring the performance in the U.S. equity markets as due to it being the only “game in town”, recent economic news remained less convincing. Non-farm payroll data was particularly disappointing with an increase of only 88,000 during March after February’s figure of 268,000 suggested the labor market might be showing some improvement. Further complicating projections for first quarter growth was the unemployment rate dropping to 7.6% on the back of 206,000 people leaving the labor force.
The continued “jobless” recovery poses significant trade-offs for central bankers, highlighted by the most recent Federal Open Market Committee (FOMC) minutes suggesting some members were in favor of ending quantitative easing programs as early as the end of 2013—based on solid improvement in the outlook for the labor market. Although this meeting convened before March’s jobs report, it offers insight into what might motivate an early exit. Bond markets, however, discounted the effects of such an early exit as yields fell markedly subsequent to the release of the minutes.
Retail sales have also shown resilience thus far in 2013. Downward revisions to January and February, and a contraction in March’s figure show a much weaker picture than how the year started off. With inflation continuing to be contained, it is hard to envision a scenario where economic fundamentals substantiate any alterations to current fed easing policies that would alter the fixed-income landscape anytime soon.
The Fund outperformed its Barclays Capital U.S. Aggregate Bond Index benchmark in posting modest gains during the first quarter of 2013. Most sectors of the benchmark were relatively flat, as US Treasury rates remained relatively steady during the period. An overweight stake in the mortgage-backed security (MBS) sector led the outperformance for the portfolio, as non-Agency residential MBS securities increased in price. In addition, holdings in Emerging Markets fixed-income performed well, adding to the outperformance. This asset class is not part of the index, but we think offers further diversification benefits to the Fund. Finally, an underweight position in the Treasury sector aided relative performance as the sector was down fractionally for the quarter.
Treasury yields spent the first quarter in a narrow range, as bullish and bearish developments were in rough balance in both the U.S. and Europe. The quarter began with a lurch toward higher yields on a combination of fast money selling and the release of the FOMC minutes that spooked investors concerned about an early end to the Fed’s asset purchase program. Throughout the quarter, statements by Chairman Bernanke and other FOMC members convinced observers that the Fed would not prematurely withdraw monetary support for the current weak recovery.
The flight-to-quality bid for Treasuries was boosted in March by the Cyprus banking crisis. The Cyprus “bailout” was the first such operation that included a haircut for unsecured depositors. European politicians and regulators issued conflicting statements as to whether the Cyprus bailout was a “template” for future operations or a one-time occurrence. The prospect of depositor losses threatens to dent confidence in European banks generally, raising the prospect of bank runs and capital flight in future bank solvency crises.
The 10-year Treasury note ended 2012 with a yield of 1.76%, spent the first quarter in a range of 1.85% to 2.05% and ended the first quarter of 2013 at 1.85%. The entire Treasury yield curve seemed frozen in place, with the 2-year note yield pegged near 0.25% and longer yields low by historical standards but well above shorter maturities.
The government agency sector performed slightly better than comparable duration Treasuries. Agency credit quality improved as Fannie Mae and Freddie Mac returned to profitability. The future of these agencies remains unclear, as neither the Administration nor the U.S. Congress seems inclined to tackle the issue.
MBS Still Strong
Prices for non-Agency MBS advanced in March, capping off a strong quarter of performance, with lower-priced securities benefiting the most. This was especially true of the subprime sector, which continued to perform well due to the real or exaggerated housing market recovery. It is important to note that the market is already pricing in a housing market recovery in the fixed-rate prime and alt-A market. For this reason, one of the only places to get some incremental yield is currently in the subprime space.
Currently near-par bonds have traded with relatively low yields (approximately 4%) and subprime allows for some additional yield if one believes the improving housing market story. An improving housing market isn’t the only contributor, however, to the increase in pricing in the marketplace. A slowdown in activity and a shrinkage in supply also helped to explain the price increases.
Agency MBS outperformed Treasuries as well, as prepayment speeds were down 2-3 Conditional Prepayment Rate (CPR). Expectations are for speeds to pick up a few CPR over the next few months. This would put prepayment speeds in the mid to high 20s CPR, which is where prepayments have been for the past year. A stronger housing market could help these numbers grow slightly in the near future. This stronger housing market also could decrease the chances of immediate incremental action by Washington politicians to help the situation.
The European sovereign debt crisis again returned to the forefront of investors’ minds this month as one of the smallest eurozone members, Cyprus, sought a bailout for its slumping financial sector. It also appears that another relatively small eurozone economy, Slovenia, may require a recapitalization of its banks. Despite apparent missteps by European policymakers in immediately addressing the Cypriot crisis, risk assets such as Emerging Markets debt were mostly able to recover from initial headline reactions and finish higher amid mixed-to-positive global economic data.
In other news that could potentially impact Emerging Markets, investors in Argentina continue to await an appellate court ruling on payment to holdout creditors from prior debt swaps. One potential outcome appears to be that the lower court’s ruling will be upheld and Argentina will be ordered to pay par value, even though the government has explicitly stated it would not payout on terms better than those given to creditors in prior debt exchanges. If Argentina does not pay the holdouts as ordered by the court, it may enter technical default. Given its stated willingness to pay creditors who had participated in the prior exchanges, Argentina could potentially offer those creditors the option of swapping their bonds to local law, though significant implementation hurdles would likely affect any swap.
Elsewhere, Venezuela’s President-elect Nicolas Maduro ratcheted up his anti-U.S. rhetoric during his campaign, though it remains to be seen if his bluster is electioneering or a genuinely hardline policy. In East Asia, increasingly harsh rhetoric and a military buildup by North Korea has sharply raised geopolitical risk of a regional conflict erupting.
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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