1st Quarter 2012
The beginning of 2012 saw a resurgence of investor risk appetite. Growing optimism for a healthy U.S. economic recovery helped fuel the reversal of investor sentiment, despite mixed global economic data and headline news during the quarter. Events that were thought of as potential market triggers for a sell-off in risk assets were shrugged off by the market. Investors largely ignored rating agency downgrades of the European Financial Stability Facility and nine eurozone sovereign country ratings (including France losing its AAA rating), the International Monetary Fund (IMF) lowering global growth targets, and oil supply pressures—including possible military action against Iran’s nuclear ambitions. Risk assets were supported by a strong technical bid with cash being put to work as investors sought out higher yields.
Amid this environment of increasing Treasury rates and surging “risk-on” assets, notably low-quality U.S. equities, the Fund gained ground and outperformed its Barclays Capital U.S. Aggregate Bond Index benchmark during the quarter. Contributing to that outperformance was security selection and an underweight position in the U.S. Treasuries, an overweight position in the Mortgage Backed Security (MBS) sector aided by both Agency and non-Agency securities, and healthy gains within Emerging Market debt.
The lone area of relative underperformance came from the Credit sector, where the Fund remained defensively positioned with underweight stakes in Banking and Finance, and had no European Bank exposure. This hurt as market sentiment remained upbeat during the rally and the “yield grab” mentality continued to hold sway with fixed-income investors throughout the quarter.
U.S. Government Securities
The Government market spent the first half of March on track to repeat its narrow, range-bound performance of January and February, but that pattern changed abruptly at the conclusion of the Federal Reserve’s March 13 meeting. The Fed dashed persistent expectations of some form of additional monetary easing, sending Treasury yields sharply higher. The 10-year Treasury yield rose to its highest level since October 2011, and above the top of the range established in recent months, before partially recovering by quarter end.
Yields ended the first quarter higher across the board as the yield curve steepened. The steeper yield curve was not kind to longer dated securities, and returns became progressively more negative with increasing term-to-maturity. Inflation-indexed Treasuries suffered a modest hiccup relative to conventional notes and bonds in March but performed significantly better over the entire quarter.
The MBS market experienced the sale of more than $18 billion of non-Agency MBS by Maiden Lane. These auctions were tremendous successes. In addition, the Federal Housing Administration (FHA) introduced a new streamline refinance program, while the US Treasury was busy introducing another round of mortgage relief programs (HAMP 2.0 and HARP 2.0), and talk of more quantitative easing (QE3) was back on the table as well.
Agency securities in the Fund benefitted from higher income streams and slight price gains despite the slight rise in interest-rates during the quarter. The Freddie Mac and Fannie Mae sectors slightly outperformed Ginnie Maes. All of these sectors were influenced in various ways by changes with regards to prepayments. For Fannie and Freddie, they are now showing the effects of the HARP 2.0 mortgage relief program at faster speeds. The Ginnie Mae sector is dealing with the upcoming changes by FHA for Mortgage Insurance Premiums. The proposed changes will make older vintage FHA loans more likely to refinance and newer FHA loans less likely to refinance.
Prepayment speeds increased throughout the quarter owing primarily to HARP 2.0. Although speeds have picked up the past few months, they are nowhere near where they were in the past during “refinancing windows”. The fact remains that while most borrowers have economic incentive to refinance, many of these borrowers would have to come up with cash in order to refinance. This is due to the tightening of underwriting standards in conjunction with real estate valuations being down by more than 30% during the past 4 years. This situation will not change unless nationwide incomes or real estate valuations rise. We do not believe either of those events will occur to a meaningful extent any time in the near future. As such, the only way prepayment speeds will approach speeds seen in those previous “refinancing windows” would be if the government got more involved and initiated something new and different for mortgage borrowers. We do not foresee this happening in the immediate future either. If real estate valuations were to go down 10% to 15% from current levels, then government involvement would become more likely.
The non-Agency MBS market continued to perform well and shrink at the same time. The volume of non-Agency supply for the month of March was impressive. Even though Maiden Lane had finished its auction of mortgage paper in February, the strong results and equally strong demand for the product continued into March. Volume mostly came from a few European and domestic bank liquidations. With the overall improvement in pricing, it appears that the time for some of these investors to exit the market has arrived.
Finally, a number of banks agreed to a mortgage settlement with an unprecedented 49 state Attorneys General that amounted to more than $25 billion in fines. Other than speculation, there were no details released about the suit during the quarter until March 15. It appears that some of the concerns about this settlement voiced by investors seemed to be evident in the details, including the potential use of investor funds to pay the fines levied against the banks. The banks will only be paying out $5 billion of the $25 billion settlement in cash, while doing modifications for the bulk of the $20 billion remainder. Therefore, if a bank reduces the principal balance of a mortgage by $100, for example, that sum would get credited toward the bank’s fine. If the bank reduces principal on a loan serviced for others (typically for a non-Agency security), however, they would receive only a $45 credit towards their fine. To investors—who played no part in the legal conversation or had any responsibility for the robo-signing fiasco that the settlement cures—this credit is akin to paying with actual investor funds. Thus, investors are viewing this as another bank bailout.
Emerging Markets Fixed-Income
The Fund’s allocation to Emerging Market (EM) fixed-income aided relative returns for the portfolio as the group outperformed the overall benchmark. The EM sector is solely in US Dollar denominated assets with overweight stakes to Corporate and Investment Grade issues. All three EM debt subsectors—external sovereign, corporate debt, and local currency bonds—posted positive returns during the quarter, despite mixed results in March. Local currency bonds led the way with a gain of more than 7%, the bulk of which came in January as EM currencies rallied after the European Central Bank’s Long-Term Refinancing Operations (LTRO) auction in December. Corporate debt was the next best performing areas, returning 5%, followed closely by sovereign bonds. In both groups the high yield sub-index outperformed its investment grade counterpart. In addition, all three EM debt subsectors benefited from strong inflows to the asset class during the quarter.
Although performance was strong during the first quarter, we suspect the rest of 2012 could be more challenging as negative global risks remain looming in the background. The second LTRO auction helped to improve interbank lending and eased credit concerns across the European Union, though growth data remains sluggish. In addition, the directional uncertainty of Europe and a U.S. recovery will continue to weigh on the external demand of China’s exports. While we do not believe China will experience a hard landing, a slowing growth landscape will likely have direct effects on commodity producing Emerging Market countries. Over the upcoming quarters, we expect that the new issue pipeline will provide attractively priced opportunities. We will seek to take advantage of these new issues as well as any pricing anomalies that may occur if the market environment becomes more turbulent.
Global Developed Credit
Excess returns for U.S. credit relative to Treasuries were impressive during the first quarter. Investment grade credits outperformed Treasuries by more than 3%, while high-yield credit outgained Treasuries by nearly 6%. U.S. credit began to show some signs of moderation in March on the heels of mixed economic data. In addition, sovereign fears seem to be flaring mildly given Spain’s budget issues and Portugal. There seems to be some concern developing that spring 2012 spring is shaping up to be a carbon copy of the springs of 2011 and 2010. This idea is arguably gaining acceptance as prices for risky assets move higher, especially when coupled with developing risks in China, the Middle East, higher gas prices, and an always developing situation in Europe.
With respect to the broader U.S. economy, the data flow has been mixed, featuring stronger than expected personal spending and sentiment, but softer than expected business spending and personal income. Overseas, uncertainty in Europe remains. In particular, there has been increasing speculation over how problems in Portugal, Spain, and Italy would be resolved as Europe weathers the financial crisis. Sentiment was lifted last week as European finance ministers finalized additional funding to be made available for new programs beyond the €200 billion already being provided. In addition, with the upcoming elections in both France and Greece there are significant risks that the new governments will be less committed to austerity measures and the European Union process. Another risk facing markets is the conclusion of Moody’s downgrade review of banks with global capital markets operations which is scheduled for completion during the week of May 14. In Moody’s opinion, these operations face challenges that are not yet fully captured in their current ratings.
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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