3rd Quarter 2011
The Fund significantly outperformed its Barclays Capital U.S. Aggregate Index benchmark from its July 18, 2011 inception through the end of the third quarter. Holdings in investment grade credit outperformed the market while the government portion of the portfolio also outperformed. Both of these sectors continue to be underweight positions in the portfolio versus the index. The Fund’s mortgage-backed securities (MBS) component outperformed the MBS in the benchmark despite the price drop in the non-Agency MBS, which the portfolio is also overweight. Agency MBS outperformed as well due to portfolio holdings in longer duration Agency collateralized mortgage obligations (CMOs). The Fund’s allocation to Emerging Market fixed-income detracted from returns during the quarter.
Global Developed Credit
Pressure on risk assets was in evidence throughout the third quarter. Ongoing signs of U.S. economic weakness along with an increasingly dire fiscal situation in Greece and the continuing deterioration in the economies of other eurozone countries battered the credit markets. Amid this backdrop, U.S. investment-grade corporate bonds posted gains in outperforming declining high-yield bonds, though lagged U.S. Treasury securities.
Among investment-grade corporate bonds, the best performing sectors on a relative basis during the third quarter were Lodging, Pharmaceuticals, and Transportation Services, with Life Insurers, Refining, and Metals and Mining the worst performing groups. Performance by rating category was skewed in favor of higher credit-quality with higher-rated (single A-rated or higher) debt outperforming. With respect to the high yield market, higher-beta (volatility) credits were the big underperformers in that space, consistent with the flight to higher-quality credit during the quarter. All high yield sectors generated negative excess returns relative to the benchmark. In-line with the investment-grade market, lower-rated issues generally underperformed their higher-rated counterparts.
Issuance in both the investment grade and high-yield sectors slowed noticeably during the third quarter from the torrid pace registered earlier in the year. High-yield issuance for the year still represents a mildly healthy increase above last year’s tally through the end of September. High-yield default forecasts are beginning to tick up on the back of ongoing equity volatility as U.S. economic growth decelerates and concern mounts that Europe’s debt crisis spill over into credit markets, making it more difficult for weaker companies to obtain capital.
Option-adjusted spreads of investment grade bonds (represented by the Barclays Capital U.S. Credit Index) and high-yield bonds (Barclays Capital U.S. Corporate High Yield Index) widened during the quarter, most noticeably for high-yield which widened 99 basis points in the month of September alone. Although there appears to be value in credit at these levels for those with a 12-month view, the question remains whether the risk-adjusted value is enough to make this an optimal entry point. Investors are well aware that risk assets have little chance of outperforming while fear of systemic risk fallout from the situation in Europe is the dominant factor in the marketplace. The spread widening experienced thus far in 2011 is substantial, though not close to what was seen at the height of the 2008-2009 sell-off during the last systemic shock. If 2008 taught the market anything, it was that too much is not necessarily enough in a systemically unstable world. Thus, we are maintaining a defensive posture in the portfolio in regards to the corporate credit markets as we head into the fourth quarter, and continue to favor investment-grade over high-yield issuers.
U.S. Government Securities
The Treasury market rallied strongly during the third quarter, resulting in the biggest three-month yield decline since late 2008, and reaching all-time low yields on most benchmark issues. The yield on the 10-year note fell from 3.16% on June 30 to 1.92% at quarter-end after reaching an intra-day low of 1.67% on September 23. The two-year note reached an intra-day low yield of 0.14% on September 19. The 30-year bond yield declined the most, falling 146 basis points from 4.37% on June 30 to 2.91% at quarter-end, making it the star performer in the group.
The rally was fueled by the same factors that have driven the Treasury market throughout 2011—the sovereign debt and banking crisis in Europe, disappointing domestic economic growth, and speculation about potential Federal Reserve policy moves. The Fed, following its September 21 Federal Open Market Committee (FOMC) meeting, unveiled a new program to sell $400 billion of short-maturity Treasuries in its portfolio to fund the purchase of longer maturity issues. The program was somewhat larger than the market consensus called for, with a greater emphasis on the purchase of 30-year bonds, thus adding impetus to the yield curve flattening.
That the U.S. MBS market underperformed other subsectors of the Barclays Capital U.S. Aggregate Bond Index should come as no surprise as the MBS market has a much shorter duration (a measure of interest-rate sensitivity) than the other sectors, and rates declined substantially throughout the quarter.
Two separate incidents during the third quarter caused price movements different from what would be expected due to changes in interest rates. In July, the mortgage market became concerned over a potential downgrade of the U.S. government, though the downgrade actually occurred on August 5. The concern was whether the downgrade would cause investors to shy away from Agency mortgage paper, but within a few days of the announcement it became clear that investors’ interest level in owning Agency mortgages was unchanged.
The second event that occurred in mid-August was an article in the New York Times about a possible “great refi” (re-financing) event in the mortgage market. The mortgage market has been dealing with many issues to help the housing market for the last couple of years. There is no easy solution to this problem. The “great refi” event has been looked into by market participants and deemed unlikely to happen under current conditions. The article brought this topic front and center raising concern among mortgage market participants. It appears that the likely action from Washington DC will be an extension and expansion of the Home Affordability Refinance Program (HARP). This would bring about an increase in mortgage pre-payments, but nothing like what would have happened if the “great refi” had been announced.
Prepayment speeds did increase during the quarter. This was primarily due to the drop in mortgage rates during the past six months. An additional factor was that September was the last month where the conforming jumbo limit was $729,000. This was the last chance for these borrowers to refinance under conforming Government-Sponsored Enterprise (GSE) guidelines. It is important to note that prepayment speeds are still below where they were back in December when rates were 150 basis points higher than they are now.
There are conflicting stories with regards to actual mortgage prepayments. The further the mortgage market’s price varies from par, the greater the variability in the yields for given changes in prepayment speeds. As previously mentioned, the mortgage market is close to an all-time high price, so different prepayment speeds will bring about vastly different yields. Currently, more than 90% of mortgage borrowers have an economic incentive to refinance. Underwriters have tightened their standards over the past couple of years and nationwide real estate valuations are down 35%. As a result, less than one-half of mortgage borrowers have the economic incentive to refinance without having to put more money into the loan. This has, and will, continue to slow prepayment speeds from where they otherwise would be. On the other side of the ledger is the concern of further government involvement in the mortgage process. We believe that HARP will be the immediate focus of governmental policy. Further weakening of the housing market, however, could lead to more action by the government in the future.
The third quarter ended on a lower note in the non-Agency MBS market with several indices falling. Bid list volume increased by a significant amount, almost doubling since August month-end, as the site of liquidations increased significantly. There was a slightly negative tone in non-Agencies with the exception of the most sought-after prime names, where insurance companies and money managers’ demand seemed to increase. Both subprime and alt-B products have suffered the biggest decline, while seasoned product has held up better. At the beginning of 2011, the non-Agency market was approximately $1.3 trillion in current par and this month it appears that the current supply has been reduced to merely $1.13 trillion.
Emerging Markets Fixed-Income
Emerging Markets (EM) returns retreated to negative territory during the third quarter, weighed by a decline across the all three EM sectors—external sovereign, corporate, and local currency bonds—in September. With September’s price action, high-grade bonds in both the sovereign and corporate indices outperformed their high-yield counterparts, and Europe was the worst performer regionally. Local currency bonds were the worst performing sector for the month, driven by large negative currency returns from the Brazilian Real, Hungarian Forint, and South African Rand. The quarterly performance of local currency bonds was also dominated by the negative currency returns out of Europe and Middle East/Africa.
Looking towards the fourth quarter, we expect the European debt and banking crisis to continue to dominate market sentiment. Aside from all the difficulties in Greece itself, the EU still needs a credible plan to insulate Italy and Spain from a Greek default and it needs to recapitalize its banks to cover the credit risk estimated by the IMF. None of this was helped by Moody’s recent three-notch downgrade of Italy to A2 and news that Dexia, Belgium’s largest bank, will need a bailout less than five months after passing the European banks’ stress test. In addition, Moody’s put countries in the entire eurozone on warning that they are not immune from possible downgrades in the future. We expect a lot of noise out of Europe during the next few months.
Despite all of the negative news coming from the developed markets, credit fundamentals remain strong for EM countries and EM companies, which we expect to benefit from rating upgrades during the next 12 months.
Commercial Mortgage-Backed Securities
CMBS sector performance continues to remain volatile amid market expectations of a broader economic slowdown. In addition, without much of a firm resolution plan in the eurozone, broader markets including CMBS continue to trade on a technical basis rather than based on fundamentals. That being said, market performance in the CMBS space has been somewhat lackluster as prices continued to trade down, albeit at a very slow pace, as investors remain on the sidelines. Much of the trading activity in the sector remains at the top of the capital structure as generic last cash-flow super-senior bonds continue to remain liquid with solid two-way flows due to the 30% credit support.
On the commercial real estate (CRE) fundamental side, we have yet to see any meaningful improvement in delinquency rates, though the pace of deterioration has continued to slow. In September, the 30-day plus delinquency rate increased 19 bps to 9.95%, which cancels out August’s delinquency rate improvement. On the commercial property valuation side, the latest Moody’s Commercial Property Price Index (CPPI) showed a rather large improvement reflecting a 5% increase in July. This data point may be a bit skewed, however, as transaction volume continues to remain low such that any large transaction may cause significant change in the Index whether positive or negative.
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 collateral/borrower level allows us to adequately assess risk. Looking forward, our outlook for the sector continues to remain cautious despite a slight improvement in the lending environment as a majority of loans that are able to obtain financing in new vintage CMBS are predominantly higher in quality, off-seasoned transactions. Interest-rate risk and unemployment continue to be large contributing factors for CRE fundamentals and without any real improvement in the unemployment picture, real recovery in CRE will be limited.
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.
Before investing, carefully consider the fund’s investment objectives, risks, charges and expenses. Contact 800 992-8151 for a prospectus containing this and other information. Read it carefully. Aston Funds are distributed by BNY Mellon Distributors Inc.