3rd Quarter 2013
The Barclays Capital U.S. Aggregate Bond Index managed a gain during the third quarter after a rough summer and continued “taper talk” surrounding what the US Federal Reserve might do in regards to their quantitative easing bond-buying program. September economic data was less easy to interpret with scheduled releases due from the Bureau of Labor Statistics (BLS), among other agencies, failing to publish because of the government shutdown. The data that was available, however, indicated more of the same throughout the quarter—low inflation, falling labor force and employment-to-population ratios, and middling growth. Consumer Confidence remained around post-recession highs and the Purchasing Managers Index (PMI) indicated strong growth—two bright spots that have seemed to persist throughout the first nine months of the year. As Washington continues to wrangle over spending levels, it should be noted that deficits continue to be cut at a historic pace.
The Fund modestly underperformed its Barclays Aggregate benchmark during the quarter, with heightened volatility in rates resulting in mixed returns from the various sectors in which it invests. Emerging Markets (EM) debt was the worst performing sector as a relatively longer duration (sensitivity to interest rates) versus other sectors and concerns over broader unrest in the Middle East plagued global markets. Structured product sleeves, such as commercial mortgage-backed securities (CMBS) and collateralized loan obligations (CLOs), were the best performers. CMBS market action centered around anticipation of the Fed taper, with increased trading volumes immediately following the “no taper” decision. CLOs outperformed as prices remained generally insulated from the volatility seen in broader markets, particularly over the first half of the quarter.
Sluggish Growth in EM
Sluggish growth remained a concern across a number of EM economies. The International Monetary Fund (IMF) recently lowered its expected 2013 growth forecast for Asia ex-Japan as well as its 2013 growth estimate for Latin America. China has continued to see modest expansion in manufacturing, but both the official Purchasing Managers Index (PMI) and HSBC’s private gauge were below consensus estimates for September.
Idiosyncratic issues also remained for certain nations. In Egypt, continuing clashes between the ruling military junta and supporters of the ousted Muslim Brotherhood show little sign of dying down. The U.S. Supreme Court declined to hear the preliminary appeal filed by the government of Argentina in the long-running saga between that nation and “holdout creditors”. The arrival of new central bank governor Raghuram Rajan in India appears to have been well-received by investors who had fled the Rupee, while upcoming state elections may provide a litmus test for the growing popularity of the opposition Bharatiya Janata Party heading into 2014 national elections.
The pace of outflows from EM fixed-income funds largely moderated in September in light of the Fed’s commitment to quantitative easing. The pace of issuers returning to markets has gathered steam since the summer slowdown, with a robust pipeline anticipated through year-end. We continued to carefully monitor the pipeline for attractive investment opportunities in this sector. September also witnessed a sharp rebound in EM currencies previously shunned by investors, notably the South African Rand and Brazilian Real. Much of these gains were likely tied to the broader “risk-on” sentiment adopted by investors in the wake of the Fed’s surprise “dovish” decision to hold off tapering until potentially 2014.
The Fed’s decision not to taper brought a slight and short-lived increase in trading volume of commercial mortgage-backed securities immediately after the decision, boosting returns in some segments relative to the rest of the benchmark. The current market dynamics are comprised primarily of the continued influx of legacy commercial supply from government-sponsored enterprises (GSEs) and a fairly robust new issue pipeline. Despite the brief rally, the riskier part of CMBS capital structure has largely underperformed the corporate and high yield sector. We believe this underperformance has increased the relative value and attractiveness of the CMBS sector as a whole.
Our investment focus continued to emphasize security selection. We focused on shorter duration assets, including securities with a more “storied” basis, as our ability to drill down to the collateral and borrower allows us to adequately assess risk. Looking forward, our outlook for the sector is cautious given uncertainties in the macroeconomic environment.
Treasury and Credit Markets
The liquidation cycle in US Treasury bonds that began in early May with the 10-year Treasury at a yield of 1.61% ran out of steam in early September when that yield reached an intra-day high of 3.01%. The 10-year note rallied the remainder of that month finishing at 2.61% as the Government market posted its first positive return in six months.
The shift to a more positive sentiment was due, in part, to higher yields as tighter financial conditions were seen as better aligned with a post-quantitative easing Fed policy. In failing to initiate the widely expected reduction in asset purchases, the Fed signaled concern about the prospects for the economy. Weaker than expected data through the latter half of the third quarter and ongoing merciless dysfunction in Washington is expected to keep the taper on hold until at least the October Fed meeting, and likely through the remainder of the year.
Treasuries saw positive returns for the third quarter in short and short-to-intermediate maturities, while longer issues struggled. Treasury Inflation-Protected Securities (TIPS) had substantially underperformed conventional Treasuries during the second quarter as yields rose, but the reversal in the rise in interest rates during the third quarter resulted in a rebound in the relative performance of TIPS as they beat conventional Treasuries. Municipal bond returns were stellar in September, but still lagged Treasuries for the quarter.
Developed credit markets as a whole showed economic improvement for much of the quarter. The U.S. manufacturing sector expanded at a faster pace, with third quarter Gross Domestic Product (GDP) nearly in-line with expectations at 2.5%, though housing was more of a mixed picture. Manufacturing in the eurozone showed expansion for the fourth straight month in September, illustrating that the rebound in the formerly recession-weary union may be gaining momentum, though unemployment remained stubbornly high at 12.0%.
Performance in the corporate credit space, whether measured by excess or total return, picked up during the third quarter, following a lackluster second quarter. The rally in US Treasuries following the Fed “no taper” decision had positive ramifications for credit markets as well. Investment grade and High Yield corporate bonds both outperformed. Default rates remained well below historical levels. Despite continuing idiosyncratic and systemic risks, credit volatility remains at the lower end of the spectrum overall. This phenomenon is expected to continue as long as easy access to the corporate debt markets facilitates the ability to refinance debt at historically low rates, which in turn support a strong liquidity backdrop for global debt issuance.
U.S. agency mortgage-backed securities (MBS) rebounded and surprisingly outperformed in September as rates fell. We have previously reported that historically the MBS sector has underperformed in a declining rate environment. The biggest reason for this is that normally the sector has a shorter duration than other sectors. The duration of the MBS sector had increased tremendously the past few months, with positive implications for the group when rates fell towards the end of the quarter.
The Fed’s decision not to taper its bond purchases helped the MBS sector as well, as the Fed buys $45 billion per month in Agency MBS, along with reinvestment proceeds from prepaying mortgages. Everything else being equal, a reduction in the amount of mortgages purchased changes the supply/demand dynamic. It was viewed as a positive for the mortgage market that the taper did not occur.
Future Fed policy and actions will affect how MBS securities perform in the months ahead. When the taper actually occurs, the Fed will be buying fewer mortgages, which would be a negative indicator for mortgages—assuming everything else remains the same. Things are rarely stagnant, however. Gross issuance of mortgages in August was $150 billion, but that decreased to $130 billion in September. We would expect that number to decrease further in the months ahead. As a result, even if the Fed tapers, they will probably be buying a greater percentage of new-issue mortgage paper. The major reason we expect lower future issuance of MBS paper is that rising rates tend to slow down prepayment speeds.
Prepayment speeds dropped again during the quarter, finishing at about half of what they were at the beginning of the year. Mortgage rates rose by more than 100 basis points, which helps to explain the drop in prepayment speeds. Without the September rate drop, we would have expected further declines in prepayment speeds.
Technical indicators in the non-Agency MBS market continued to be a driving factor. Spreads tightened and yields compressed as the non-Agency market continued to shrink, and market participants desired to add low duration assets. Similar to what we saw in the Agency MBS market, prepayments slowed in the sector during September. Increasing real estate valuations have helped both voluntary prepayments (higher) as well as involuntary prepayments (lower). Both of these situations are positive signs for the non-Agency MBS market. An increase in voluntary prepayments is a positive sign as these are “good” prepayments (i.e. getting back 100 cents on the dollar). As housing prices have risen, we have seen decreases in both delinquencies and default rates. For those loans that do default, we have seen a slight improvement in the loss severity rate.
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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