4th Quarter 2013
In a pivotal year for fixed-income markets, 2013 ended with an announcement from the U.S. Federal Reserve of a much anticipated cut in its quantitative easing (QE) bond purchase program. Among the topics of concern was the plummeting unemployment rate amid a falling proportion of the population who are either working or looking for work and continued low levels of inflation. The Fed deemed the decision to “taper” purchases by $10 billion per month as a prudent first step. Upward revisions to economic growth for the third quarter that came out after the decision served to at least partially substantiate this decision. Non-farm payroll growth of only 74,000 in December—the lowest such growth since 2011—suggested something to the contrary, however. As Janet Yellen takes the helm of the Federal Reserve effective February 1, her ability to navigate this still nascent recovery will be closely monitored.
Domestic equity markets closed the year with strength, just as they began it, while domestic fixed-income followed an opposite trend. U.S. bonds (as measured by the Fund’s Barclays U.S. Aggregate Bond Index benchmark) nearly mirrored the 0.12% decline experienced during the first quarter of the year with a decline of 0.14% during the fourth quarter. Although the index finished the year down 2.0% (its first yearly decline since 1999), most of the movement happened during the relatively sharp rise in benchmark rates that spooked fixed income markets broadly during the second quarter. All told, the yield on the 10-year US Treasury increased 42 basis points (bps) during the fourth quarter, finishing the year at 3.02%. That was the highest such monthly close since June 2011.
The Fund outperformed its benchmark during the fourth quarter. The portfolio performed well as more credit sensitive sectors, such as High Yield and Emerging Markets, led the way. These credit sectors rallied at the beginning of the period primarily due to perception of the QE program at the time. Since then, the same sectors have cooled off, along with the rest of the fixed-income market, as the Fed announced the decision to begin tapering asset purchases and interest rates rose. Not surprisingly, the worst performing sector relative to the benchmark was the Treasury sleeve of the portfolio. Agency residential mortgage-backed securities (MBS) similarly declined due to higher interest rates, with fixed-rate agency collateralized mortgage obligations (CMOs) and “pass-throughs” performing the worst within this sleeve. Other structured products, such as non-Agency residential MBS, collateralized loan obligations (CLOs), and commercial mortgage-backed securities (CMBS) experienced modest gains along with Bank Loans and Investment Grade Corporates.
Although absolute returns for Corporate bonds overall in 2013 came nowhere near the spectacular results posted in 2012, they performed reasonably well relative to the benchmark amid a meaningful rise in Treasury rates. Higher quality issues (those bonds rated single-A or better) materially underperformed their lower-rated counterparts given the continued predilection of investors to trade down the risk curve to reach for yield. As a result, high-yield Corporates posted solid positive returns as a group, with the trend being the lower the credit rating the better the performance. Default activity within the credit market was benign, as both default volume and the high yield default rate reached six-year lows.
The Fund’s holding within Emerging Markets overcame a tough year overall to rebound during the fourth quarter before the Fed’s taper news set in leading to mixed results in December. The promise of an eventual cutback in Fed bond purchases was felt across the asset class most of the year, particularly among those countries running twin deficits with weak growth prospects. A number of countries, whose debt had otherwise enjoyed strong performance in the low-rate environment implemented by the Fed, now saw waning investor support due to a lack of meaningful fiscal and economic reforms. Countries such as South Africa, India, Indonesia, Ukraine, and Venezuela all saw large spikes in volatility within foreign exchange and debt markets during the year.
Socio-political unrest proved to be a theme across many emerging economies in 2013 as well. Although this died down in most countries toward late 2013, protests reignited in Turkey during December amid a major corruption investigation that continues to sweep through the government. Not all Emerging Markets witnessed turmoil, however. Mexico enacted into law a series of major reforms tied to its revenue-critical state oil monopoly, as President Enrique Peña Nieto sought to boost flagging growth. Colombia, wracked by decades of civil war, saw crucial progress made in peace talks between Marxist rebels and the government in November, which may pave the way for the main rebel group to lay down its arms and enter politics.
Weak Government Bonds
US Treasuries finished a tumultuous year on a weak note, as the 10-year Treasury note yield rose from late October through November and December to finish the year at its high closing yield of 3.02%. This contributed to absolute losses in the sector for the fourth quarter, especially in December fueled by the Fed’s taper announcement. Returns were the most negative for longer maturities, typical given their increased sensitivity to rising rates.
The Treasury market sell-off garnered the lion’s share of investors’ attention in 2013, but other government fixed-income sectors—especially those with less liquidity or longer duration (a measure of sensitivity to changes in interest rates)—suffered even larger losses. Treasury Inflation-Protected Securities (TIPS) substantially underperformed conventional Treasuries throughout the year, burdened by both long duration and poor liquidity plus low realized inflation and falling inflation expectations. Tax-exempt municipal bonds fared better, boosted by improving credit fundamentals and a strong fourth quarter, but still posed noticeable losses for the year.
Mortgages and Rising Interest Rates
As evident in 2013, mortgage-backed securities tend to outperform other components of the Barclays Aggregate Bond Index when interest rates rise more than a percentage point. This has historically been due to the shorter duration of the MBS sector relative to those of US Treasuries and Corporate bonds. During the rate rise of 2013, the duration of Agency MBS extended from 3.2 years to 5.7 years by year-end—the longest duration ever reported for the sector. Should rates rise further, we would expect the duration of the MBS sector to extend further also, likely leading to further outperformance of Treasuries. How the sector performs relative to the Corporate sector would depend in large part on what happens to investment grade Corporate spreads.
One of the major reasons MBS experience duration extension during rising rate periods is the expectation of decreasing prepayment speeds on a going forward basis. Prepayment speeds went up marginally for the month of December, for example. This slight increase in speeds broke a string of six consecutive declining months. Prepayment speeds decreased by 60% overall during 2013 and Agency MBS experienced their slowest speeds since December 2008, which was in the middle of the subprime housing crisis.
Future prepayment speeds will depend partly on what happens to interest rates. A secondary factor could be a change in the government’s involvement in the mortgage process. Currently, the Home Affordable Refinance Program (HARP) 2.0 is the government program with one of the largest effects on prepayment speeds. HARP 2.0 is experiencing “burnout”, which is what happens as time passes and the borrowers who qualify have already acted, therefore leaving fewer eligible borrowers than in the past. The mortgage market is also dealing with the confirmation of Mel Watt as the new director of Federal Housing Finance Agency (FHFA), who replaced Ed DeMarco. The market’s perception is that Watt may be more “friendly” towards borrowers than DeMarco, which could lead to policy decisions that could increase the prepayment speeds of certain mortgage securities. Thus far, Watt has indicated that he will postpone the previously announced increase in fees across both Fannie Mae and Freddie Mac.
The powerful fixed-income liquidation cycle that began in May 2013 brought most investor positions into line with post-QE Fed policy and sustained economic growth. We expect the government bond market will find buying interest from some traditional investor groups, such as pension funds and insurance companies, at 10-year Treasury yields above 3.00%. Higher yields could limit domestic economic growth. Although yields may rise modestly in 2014, we do not expect a repeat of 2013.
It is likely that the markets will experience continued interest rate volatility with movements in the Treasury curve reflecting both underlying economic fundamentals as well as further expectations for Fed tapering of the QE program. Corporate credit spreads should continue to tighten in line with fundamental economic improvement, but spread movements could get bumpy as credit investors balance what has become the competing forces of fundamental conditions in the U.S. economy with the challenges faced by the Fed in communicating further tapering actions.
Within Emerging Markets, we believe that many shorter-term investors may have been flushed out of the asset class by the rocky year in 2013, leaving stronger, long-term strategic buyers. Inflows from pension funds, insurance companies, endowments remained in-line with prior years. Many crossover investors, for whom Emerging Markets are not a specialty, had exposure to only the most well-known, liquid names as outflows spiked from May through year-end relative to corporate debt. Furthermore, we feel that the selloff for much of 2013 left many fundamentally sound corporate credits trading at attractive levels simply due to the excessive fear of tapering and rapidly rising rates.
The MBS market seems to have priced in a 12-month tapering process. That would mean no more QE program at the end of 2014. Assuming that scenario plays out, we would not expect any widening of MBS. As in most markets, MBS performance will depend on both supply and demand for securities. Currently, the Fed is the biggest player on the demand side, and therefore its actions are important. There have been adjustments on the supply side of mortgages too, however, possibly an even greater change than the Fed tapering. As rates have risen, gross issuance of MBS has come down significantly, helping to counterbalance the potential for decreased demand from the Fed.
Among commercial mortgage-backed securities (CMBS), our investment focus continues to emphasize security selection. We continue to focus on shorter duration assets, including securities with a more “storied” basis, as our ability to drill down to the collateral and borrower we think allows us to adequately assess risk. We remain cautious, though, 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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