2nd Quarter 2013
In contrast to the slightly positive returns of the first quarter, the second quarter of 2013 proved to be a more challenging market environment for fixed-income, and markets in general. The market was rattled beginning in May by the prospect of an end to the Federal Reserve’s quantitative easing (QE) bond-buying program. Nearly all major asset classes, ranging from U.S. government securities to equities to precious metals fell sharply. The Fed’s so-called “tapering talk” was reinforced by strong economic news in June, including a greater-than-forecast expansion of the manufacturing sector, continuing consumer confidence, and another month of double-digit year-over-year percentage increases in pending home sales and housing prices.
Although Chairman Bernanke did reiterate that the Fed would adjust its policy should economic data vary, both equity and fixed-income investors reacted extremely negatively to the prospect of the Fed dialing back its bond buying program. As the Fed maintains a stance that it would continue its QE program until unemployment fell to the 7% vicinity, the recent stronger economic data points increase the likelihood of the target being met sooner rather than later.
The Fund underperformed its Barclays Capital U.S. Aggregate Bond Index benchmark as both lost ground during the second quarter 2013. Most sectors of the portfolio were down as interest rates rose at the long end of the curve. Emerging Markets (EM) and investment grade credit were the worst performing sectors of the market. Although securitized sectors such as non-Agency mortgage-backed securities (MBS) and commercial MBS were among the better performers during the quarter, they both still turned in negative returns. The lone positive sector was in collateralized loan obligations (CLOs), which does not have the same level of interest rate exposure as the other sectors of the Fund.
Spreads for EM bonds widened during the quarter on concerns about the Fed’s talk of tapering bond purchases, but socio-political upheaval and weaker economic data in a number of EM countries reinforced the selloff. In Turkey, protests from the urban, secular middle class against the perceived autocratic- and Islamist-tendencies of Prime Minister Recep Erdogan continued to cause some unrest in the country. Egypt, which has been rocked by instability since the popular ouster of autocratic President Hosni Mubarak in 2011, was also the scene of massive protests against President Mohamed Morsi, who has been viewed as autocratic by many locals since dismissing Egypt’s prosecutor general and was eventually removed from power by the country’s military.
Widespread protests also affected Brazil in June, initially incited by a government hike in bus and train ticket prices but spreading with claims of police brutality and wasteful spending on the upcoming 2014 World Cup. Brazil’s 12-month inflation increased to 6.7%, outside the central bank’s upper target band of 6.5%, fueled in part by a weakening Brazilian Real. To fight a depreciating currency, the Central Bank eliminated the 6% tax on foreign exchange transactions on local-denominated bonds to little avail. The Central Bank was then forced to intervene almost daily, selling billions of US dollars through swaps and funding lines since the end of May.
Chinese banks experienced a sharp cash crunch in June. The overnight Shanghai Interbank Offered Rate (Shibor) briefly jumped more than 13% on June 20. The spike in overnight rates was apparently allowed to occur by the People’s Bank of China as a means of warning banks that had complacently lent too much expecting easy liquidity. Communication of the central bank’s exact intentions was poor, though it did eventually intervene by ordering large banks to lend to smaller ones and promising to stabilize the Shibor. Still, Chinese financial institutions, especially small-to-medium sized ones, remain shaken by the fact that the People’s Bank initially chose to remain on the sidelines as a liquidity crunch developed.
June witnessed the first monthly outflows from EM fixed income funds since September 2011, limiting the supply of new issues. We believe that more issuers will once again return to the new issue market as volatility dies down. As of early July, we have begun to see sovereign and quasi-sovereign issuers test the waters of the new issue market. We will continue to carefully monitor the pipeline for attractive investment opportunities.
Credit and Treasury Markets
Higher core government bond yields had negative ramifications for broader global developed credit markets as well. Returns for investment grade corporate bonds were negative for the quarter, underperforming high-yield, with total returns generally worse for higher-quality paper due to duration (interest-rate sensitivity) for much of the period. Although we think underlying credit fundamentals remain solid, the credit sectors cannot escape the general re-pricing of risk assets which is currently underway. Liquidity is an additional concern. An active primary market is a prerequisite for accurate price discovery. Summer is usually a time of lower volumes, yet a period of record issuance (much of which has been refinancing) in conjunction with recent rate volatility rates gives us pause as credit markets may struggle in the midst of a primary market drought.
The tone of the Treasury market shifted dramatically and abruptly during the second quarter. The quiet market environment of previous months became a mad rush to liquidate accumulated positions. The shift was sparked by a stronger than expected April employment report released on May 3. The 10-year Treasury yield had hit a 2013 low of 1.63% the previous day. The employment report, combined with a bearish view of additional economic data and comments from Federal Reserve members, caused investors to move forward their estimate of when Fed asset purchases would wind down and short rates would begin to move higher. Yields across the curve moved sharply higher, with the 10-year note reaching an intra-day high of 2.67% on June 24.
The rise in Treasury yields garnered considerable press during the period even though other sectors performed worse. The Fed’s efforts to lower yields pushed many investors out of Treasuries and into riskier assets. Those sectors generally fared worse than Treasuries through the “great unwind.” The relatively less liquid market for inflation indexed Treasuries (TIPS) was ravaged, retuning -3.58% in June and -7.05% for the second quarter.
Primary mortgage rates increased by 55 basis points (0.55) in June, 90 basis points for the quarter. These rises were substantially more than the rises in US Treasury rates during the same periods. As the Fed has been buying up to $65 billion a month in Agency mortgages, a reduction in purchases could cause Agency mortgage spreads to widen. Even with this spread widening, the MBS sector outperformed the Corporate sector and had a similar return to the Treasury sector, primarily owing to the shorter duration of the MBS sector.
Although the duration of the MBS sector is shorter than both Corporates and Treasuries, it has extended as rates have risen. The duration of the Agency MBS sector was as low as 3.69 years as of the end of April, and extended to 5.22 years as of June month-end. A duration of 5.22 years is the longest for the Barclays U.S. MBS Index going back to 1990. In fact, it is 0.4 years longer than the next longest recorded duration of 4.83, which was reported for May 1994. We expect the duration to extend even more if rates were to rise going forward, though the improved convexity that would come with the lower prices will most likely prevent the duration from getting much longer.
Prepayment speeds declined somewhat during the quarter. There is a lag factor in analyzing prepayments so this recent rise in rates should affect prepayment speeds over the next few months. Aggregate speeds should decline from the low to mid-20 Conditional Prepayment Rates (CPRs) down to a mid-to-high teen CPR number.
After the May 30 sale of the $8.8 billion of non-Agency mortgage assets, that market initially fell then recovered only to run into Chairman Bernanke’s speech regarding the future of QE on June 19 and widen out in terms of risk-adjusted yield. With the volatility in the marketplace, the volume of product put out for bid dropped dramatically from May to June.
In terms of value for non-agencies, the value is in the reduced pricing and more importantly the increased yield. For the quarter, April and May were more of the same type of story we were used to hearing about the non-Agency market: steady volume followed by shrinking supply and higher prices. Volume, volatility and value created an interesting environment during the month of June, however. We preemptively held sufficient cash as the movement provided various opportunities to buy assets as prices dropped and value resurfaced.
Commercial MBS performance was lackluster, though better than other areas of the market, as concerns with the Fed’s tapering of QE programs and rising interest rates plagued the market. Our investment focus for this sector remains largely the same, with an emphasis on security selection. We continue to prefer shorter duration assets, including securities with a more “storied” basis, as our ability to drill down to the collateral and borrower level allows us to adequately assess risk. Our outlook for the sector continues to remain cautious, however, given uncertainties in the macroeconomic environment.
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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