4th Quarter 2011 Commentary - ASTON/DoubleLine Core Plus Fixed Income Fund
4th Quarter 2011
The Fund outperformed its Barclays Capital U.S. Aggregate Index benchmark during the fourth quarter of 2011. Holdings in investment-grade credit outperformed the market, while the government portion of the Fund performed in-line with the index. Both of these sectors continue to be underweight allocations in the portfolio relative to the benchmark. The Fund’s overweight allocation to Emerging Market fixed-income added to returns as well. Finally, the mortgage-backed securities (MBS) portion of the portfolio continued to outperform that area of the benchmark despite prices on non-Agency MBS remaining stagnant. Holdings in Agency MBS outperformed due to positions in longer duration Agency collateralized mortgage obligations (CMOs).
Global Developed Credit
It was a volatile year for corporate credit markets in 2011. Excess returns for both investment-grade and high-yield Corporate bonds were difficult to come by as corporate credit was unable to rival the returns posted by U.S. Treasury securities. Spreads widened for both areas during the year, and while issuance was active it was primarily at the front-end for high-yield. Volatility in early August shut down the high-yield market almost completely with only a fraction of new high-yield priced during the final five months of the year.
Investors seeking yield had little choice but to increase their risk exposure and, as a result, all-in yields in the high-yield market fell to their lowest level in history in May 2011. As market participants became increasingly focused on Europe, volatility escalated and performance suffered. In addition, default activity picked up during the fourth quarter and ratings migration momentum has decidedly swung downward, strongly suggesting that default rates may soon begin to rise.
We believe another year of global uncertainty awaits investors in 2012, driven not only by concerns in Europe but also by slowing domestic economic growth. During the fourth quarter, European Union (EU) leaders unveiled the fifth plan since May 2010 to address the sovereign debt problems in the region. The implementation of such a plan remains elusive and the immediate problems remain—Europe has approximately €1.1 trillion of EU government debt maturing in 2012, with half of that maturing in the first six months. Slowing European growth may be expected to impair U.S. exports and further cause the U.S. dollar to strengthen, thereby pressuring corporate profitability and corporate bond spreads. Added to that is a recent Bloomberg report highlighting that U.S. corporate profit growth in 2011 was the lowest in two years. Structural domestic economic issues persist, including a stubbornly high unemployment rate, deflating home prices, and huge state and local government budget gaps. Domestic economic concerns coupled with continuing problems in the eurozone will likely foster another year of low interest-rates and heightened volatility in the capital markets.
U.S. Government Securities
Volatility during the fourth quarter was sharply lower compared with the third quarter. The 10-year Treasury yield moved only five basis points during the period, while the 5-year Treasury yield dropped 13 basis points and the 30-year bond moved only 3 basis points. November and December were especially subdued, with only the occasional market-moving announcement from the eurozone and a gradual downtrend in yields. The Federal Reserve’s so-called ‘Operation Twist’ went forward without causing any turmoil in the marketplace.
Opportunities for profitable relative value trades declined during the quarter. Sliding volatility and the Federal Reserve’s buying drove this decline. In response, the portfolio’s government holdings shifted to more closely resemble that of the benchmark. Looking forward to 2012, we expect to favor the 7- to10-year maturity range. We think these issues offer the best risk/return tradeoff and stand to benefit most if the Federal Reserve adopts an inflation-targeted or interest-rate targeted strategy.
Emerging Markets Fixed-Income
Emerging Markets (EM)—external sovereign, corporate debt, and local currency—performed well overall during the fourth quarter, overcoming mixed returns for the month of December and throughout 2011. EM assets remained hostage to the European debt crisis that continued to unfold throughout the year. Securities traded in sympathy with news flowing out of the eurozone, with EM local currency bonds being most affected, while EM sovereign bonds were the most insulated. Uncertainty arising from the global macro backdrop in Europe, Asia, and the U.S. generally led investors to flock to the safe haven of U.S. Treasuries.
Late in December, the European Central Bank (ECB) provided a massive liquidity injection of €489.2 billion in cheap funding to more than 500 eurozone banks through its long-term refinancing program (3-year long-term refinancing operation—LTRO). The market briefly rallied and then traded off as it appeared banks were likely to recycle the liquidity back to the ECB and not put it to work in the economy. Rating downgrades, or the threat of downgrades, uncertainty surrounding the effectiveness of Europe’s most recent plan announced in early December, the magnitude of Europe’s ongoing slowdown and the seasonal “risk-off” trade all contributed to year-end market weakness. Going forward market participants want to know whether favorable sales, consumer sentiment, and improving job data out of the U.S. can be sustained, or if it is just seasonal strength waiting to slip away in the first quarter of 2012.
There seemed to be four major causes of the “risk-on/risk-off” trade during 2011. First, the European turmoil, which affected all markets, has affected the non-Agency MBS market significantly due to that market’s credit sensitivity. Additionally, there is no good estimate on how much some of these European banks hold in the non-Agency MBS space and how much they could be forced to sell. Even considering some of the more aggressive estimates, we believe the amount could be absorbed going forward if the supply was not released all at once. It is our anticipation that the supply would be released on a more orderly basis.
Second, layer that turmoil with the new Basel 3 accords and the questions continue as to how much additional supply could be force sold into the market by those same banks. Basel 3 will increase the reserves in all these banks, and even though its full implementation does not begin until 2015, most European banks are already starting to implement these changes.
Third, throughout the year, the continuing decline in the value of housing has put pressure on the non-Agency market. Looking at some of the price action, we see a clear indication of this housing price decline. Granted, some of the price decline was the realigning of the underlying bond prices with overstated index prices, yet it isn’t hard to see that the value of most American real estate still hasn’t seen the bottom. This situation shows itself in the high level of delinquency and severity prints which continue to persist, especially in the subprime sector.
And finally, the potential introduction of the “Volker Rule”, a portion of the Dodd-Frank legislation passed by Congress in 2010, has had its potential unintended consequence on Wall Street. Non-Agency MBS positions have been reduced by more than 50% and Wall Street’s risk appetite cut back significantly. The result of this has been to remove a major price support in this space that has allowed prices to seek levels that investors are actually finding more compelling. Of course a reduction in liquidity is not the most sought after condition, but it can provide opportunistic situations to investors.
Although there were lawsuits, congressional investigations, more attorneys general headlines, and even more legislation introduced in 2011, nothing really came to adjudication in terms of Washington significantly affecting the MBS markets. Only the Bank of America settlement with 22 institutional investors actually came to fruition in 2011, and even that settlement has been called into question by the likes of the FDIC and the Federal Home Loan Bank that has sought to intercede in the settlement. This settlement is now in the appeals court to determine which jurisdiction (state or federal) has the final say in the matter, which could extend the outcome for at least six months.
The Agency MBS market underperformed the broader Barclays Capital U.S. Aggregate Bond Index during the fourth quarter and the Barclays Capital MBS Index was the worst performer out of the major sectors of the index in 2011. This underperformance is as expected given the fall in interest-rates during the year, since the Barclays Capital MBS Index has the lowest duration.
One substantial legislative process that found its way into the market, however, was the October FHFA announcement that provided an update to the Home Affordable Refinance Program (HARP) whose final guidelines were formally announced mid-November. Most borrowers have an economic incentive to refinance but cannot afford to make the changes in underwriting standards and/or loan-to-value (LTV) ratios. This dilemma is not lost on the U.S. government and there were multiple rumors throughout 2011 regarding a “Great Refi” plan to offer historic low rates to all mortgagees. What the market received instead was FHFA, which included eliminating the LTV cap of 125%. We think this change will only lead to an increase in Agency MBS prepayments by a 5 to 10 Conditional Prepayment Rate (CPR) per year, spanning the next few years. We expect that if there is further weakening in the national housing market, then the government will intervene. This intervention could lead to higher prepayment speeds, especially in higher coupon securities.
Commercial Mortgage-Backed Securities
The CMBS market experienced quite a tumultuous ride in 2011, a year where prices across the credit spectrum whipsawed alongside with macro markets and ultimately ended December with a fairly strong rally at the top of the capital stack. We continue to see tiering across deals in addition to a steepening credit curve as credit “cuspy” tranches, such as junior AAA CMBS (AJs) and below, continue to lag behind the outperformance in mezzanine AAA super senior CMBS (AMs) and last cash flow (LCF) super seniors. With that said, the market continues to chug along, albeit on a technical basis, as investors appear skittish on broader economic headlines.
On the commercial real estate (CRE) fundamental side, delinquency rates remained flat to slightly down due to a slower pace of deterioration coupled with servicer loan modifications. There continues to be increasing trends of servicer loan modifications which effectively splits a loan into pieces: an A note pays interest and a B note does not pay interest and is effectively a hope note. We view these types of modifications as worrisome due to the fact that the hope notes are effectively a delayed write-down for the trust and in the interim may show lower cumulative losses on a deal level then what is occurring in reality. On the commercial property valuation side, the latest Moody’s Commercial Property Price Index (CPPI) showed a 1.4% decrease in September. This may be skewed 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 in shorter duration assets. Unemployment continues to be a large contributing factor for CRE fundamentals and without any real improvement in the unemployment picture, real recovery in the CRE sector 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.
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