2nd Quarter 2012
Events in Europe continued to control the headlines during the second quarter, but it was data showing the U.S. economy still struggling to gain momentum that weighed heavily on domestic markets. Although the Federal Reserve still officially maintains its dual mandate of stable prices and full employment, it appears their focus on the former has come at the cost of sacrificing the latter. The May personal consumption expenditures (PCE), the Fed’s preferred inflation index, indicated that price inflation slowed during the first five months of 2012. The unemployment rate, meanwhile, remained unchanged at 8.2% throughout the second quarter.
Consumer Confidence trended down each month of the quarter. With PCE making up more than 70% of the first quarter Gross Domestic Product (GDP), this does not bode well for the still-to-be-released second quarter GDP figure. With initial jobless claims again trending upward, and new net additions growing at a very disappointing pace, the question becomes at what point the Federal Reserve will begin fighting the unemployment battle and ease the reins around inflation.
Mortgage Holdings Shine
The Fund outperformed its Barclays Capital U.S. Aggregate Bond Index benchmark during the second quarter on the strength of an overweight position in the outperforming mortgage-backed securities (MBS) area. Both Agency- and non-Agency MBS performed well. Agency collateralized mortgage obligations (CMOs) benefitted from higher income streams and price increases as rates fell during the period. The non-Agency market continues to rise in price with the Alt-A market benefitting the most.
The Credit sector portion of the portfolio performed in-line with the benchmark, while an underweight stake in US Treasuries versus the index hurt performance. The US Treasury sector was the best performing sector of the benchmark as the Eurozone crisis intensified early in the quarter driving yields sharply lower. A slight underweight in Credit offset the sector’s marginal outperformance versus the benchmark as risk assets rallied despite evidence of slowing global economic growth. The Fund’s allocation to Emerging Markets fixed income detracted from performance as a stream of mixed data continued to shake investor confidence. It is worth noting that the portfolio’s allocation to the sector is denominated entirely in US Dollar securities.
With US Treasury rates falling by more than 60 basis points during the quarter, the positive return for mortgage-backed securities should come as no surprise. Lower coupon mortgages were up as much as two percentage points, and are close to their all-time high dollar price. Higher coupon mortgages were actually down in price during the quarter, hurt by concerns of faster prepayments due to the HARP 2.0 federal refinancing program that has caused higher coupons to prepay faster. June prepayment speeds actually showed a slowdown for some of these coupons, so maybe these mortgages will experience the concept of “burnout”.
Even though the Mortgage Bankers Association (MBA) Refinance Index decreased at the end of June, it remains much higher than it has the past couple of years. This should come as no surprise as 10-year US Treasury rates have dropped almost two percentage points the past two years. The aggregate prepayment speeds have increased by only a very small amount given this drop in rates, reflecting the current economic times. We do not expect this situation to change overnight and future changes in prepayments are just as likely to come from further government intervention (possibly HARP 3.0?) as it is from borrowers being able to take advantage of lower rates on their own.
After the European disruption appeared to affect the market in the early part of the quarter, non-Agency mortgage indices improved dramatically in June with the cash market seeing strong bids for quality on fixed paper. We believe this is due to the increasing “reach for credit” trade that is happening within the non-Agency space as the market has decreased in size from $2.3 trillion to just roughly $1 trillion. As the collateral continues to amortize, those dollars must be put to use so the demand continues as the supply contracts. This should be beneficial for performance, but challenging for executing top quality asset selection and supply.
The legislative efforts surrounding the mortgage market have continued to impress. Some efforts seem unaware that 2012 is an election year, including the Menendez-Boxer HARP bill, which increases competition for Fannie Mae and Freddie Mac refinancings among mortgage bankers. This bill may actually bring current mortgage rates down even further.
Senator Diane Feinstein of California has introduced legislation in the U.S. Senate to allow those homeowners with loans in private label securities and bank owned portfolios, where there is a history of current payments and no late payments during the last 12 months, to refinance into a FHA loan with a current loan-to-value (LTV) of anywhere from 95% to 140%. This would reduce interest rates and at the same time incent good payment performance of borrowers. There are still discussions on the upper limit, but the best estimates are somewhere between 120-140% LTV.
Just when it seemed the Federal government might stop interfering with the private mortgage market, San Bernardino County in California joined the fray. They have put together a Joint Power Authority to examine ways to help their local economy through some sort of refinancing or home building activity. Due to a large budget gap and 150,000 homes underwater, San Bernardino County is considering a plan for using eminent domain, in part because a company called MRP suggested that the county could use eminent domain to remove performing mortgages at private label securities at a deep discount, collect a fee, and then allow MRP to refinance these loans. The county would potentially receive a 5% fee for each loan. Obviously, the performing loan is worth at least what the current value of the property is worth. Unless there is a significant discount placed on the loan purchased, this program will likely not work. DoubleLine, as a participant in The Association of Mortgage Investors (AMI), coordinated a conference call with the county and more than 50 of the largest mortgage investors in the country to discuss many of these issues with them.
Global Developed Credit
In a similar outcome to what we saw in 2011, after a record first quarter the second quarter of 2012 proved to be far more challenging as increased eurozone and global growth concerns dominated the macroeconomic picture. Greek elections generated notable uncertainty throughout the first part of the quarter, while Spain and Cyprus became the latest eurozone members to request financial support. While excess returns for both investment grade and high-yield indices versus Treasuries were negative, excess returns for both remain positive for the year-to-date through the end of June because of the spectacular credit rally during the first quarter.
In addition to European sovereign fears, developing risks in China and the Middle East further affected the market. U.S. corporate credit began to show some signs of moderation as the quarter progressed on the heels of mixed domestic economic data. In the end, June represented a moderate “risk-on” month after two months of “risk-off”. The key catalysts that led to spread tightening at the end of the quarter included the favorable outcome of the Greek elections, the less severe than anticipated outcome of Moody’s global bank downgrades, a better-than-anticipated outcome from the European Union (EU) Summit, and increased expectations for global Central Bank easing. The last trading day of June saw a dramatic end to the first half of 2012, with many markets seeing their best day of the year after the EU Summit helped to overcome low expectations. In terms of secondary market intervention, there was nothing particularly new out of the Summit and the question mark on the funding capacity of the European Financial Stability Facility (EFSF) and European Stability Mechanism (ESM) remains.
The US Treasury market continued to mirror the economic problems around the globe. The quarter began with Treasury yields near the highs of the year, as the release of the minutes of a recent Federal Open Market Committee (FOMC) meeting discouraged investors hoping for a new round of Fed asset purchases. Yield turned sharply lower in early April as the Greek bailout threatened to unravel and the eurozone crisis intensified. Adding to the dismal outlook was a parade of domestic economic data coming in below expectations and escalating concern about a slowdown in China.
The Barclays Capital U.S. Government Index gained 2.6% during the quarter. Returns favored long maturity issues, which doubly benefitted from sharper yield declines and greater duration. The 30-year Treasury bond returned more than 12%, while the 10-year gained less than half that and the 5-year and 2-year notes returned 1.95% and 0.12%, respectively.
Emerging Markets (EM) debt posted mixed returns as investors lacked conviction on the direction of the market as a stream of mixed data continued to shake confidence. April was generally a positive month for risk assets as data supported a rebound in U.S. and global growth figures. Markets capitulated in May as renewed fears surfaced regarding the eurozone debt problem. June once again saw a swing in investor sentiment, as investors priced in expectations for the European Central Bank (ECB) lowering rates to stimulate growth, a plan for Spanish bank bailouts, and a favorable outcome to the Greek election/coalition. EM sovereign debt ended the quarter on top, gaining nearly 3%, followed by EM corporate debt. Despite some volatile swings in foreign exchange markets, EM local currency ended the quarter down a modest amount.
Commercial Mortgage-Backed Securities (CMBS) rebounded in June after a two-month “risk-off” period due to macroeconomic volatility and uncertainty surrounding Europe on a combination of positive market technicals. With 10-year Treasuries in the 1.6% range, CMBS garnered positive interest due to the combination of structural enhancement as well as a decent spread pickup versus similarly rated asset-backed securities (ABS) and Corporate bonds.
Our investment focus for the CMBS 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 assess risk adequately. We remain cautious in regards to the sector given the large year-to-date run up in prices, despite improvement in the lending environment, as the majority of the loans that are able to obtain financing in new vintage CMBS are predominantly higher in quality. We would also note that unemployment continues to be a large contributing factor for commercial real estate fundamentals and without any real improvement in the unemployment picture, real recovery in commercial real estate sector will be limited.
Looking toward the second half of 2012, Greece and the eurozone debt/banking crisis will likely continue to weigh on the markets, with the U.S. fiscal crisis increasing in importance as the U.S. nears the expiration of numerous tax cuts and the implementation of automatic spending cuts at year-end. A couple of questions come to mind concerning the Greek crisis: 1) In the short-term, will Greece’s new pro-austerity coalition be able to implement a sufficient amount of austerity measures to keep billions of euros in aid coming? 2) Will Greece be able to remain a member of the eurozone over the medium- to long-term? Some of the answers to these questions may come from Germany. A softening of Germany’s position regarding austerity, including its move to add growth elements into the eurozone discussions along with the possibility of agreeing to a relaxation of fiscal tightening targets, could help to reduce the pressures faced by periphery governments from their opposition parties. The downside to Germany making these compromises could be increased domestic political pressure on Chancellor Merkel and other Northern and Central European countries such as Finland, the Netherlands, and Slovakia.
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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