No corner of the fixed income market has been immune to the unprecedented impact of COVID-19, experiencing whipsaw volatility along with other markets.
An already low yield environment became even lower yielding, as essentially every central bank cut rates, and the Federal Reserve returned to Great Financial Crisis (GFC)-era stimulus tools to reassure markets. US Treasury rates plummeted as a result of the risk off-tone, but have risen off of the pandemic lows from the first week of March. Meanwhile, investment-grade and high yield markets saw widespread selling and increased credit spread levels, before buyers of both credit types returned once the Fed announced policy measures aimed at extending much-needed liquidity and capital to corporate borrowers. Despite the announcements and slight reversion, spreads still remain above long-term averages as uncertainty regarding the potential downstream impacts of closing the majority of the global economy has yet to be fully realized.
Amid this volatility, the actively managed SPDR® DoubleLine® Total Return Tactical ETF (TOTL) has seen lower drawdowns than its peers, with its year-to-date max drawdown plotting in the top 7th percentile of its Morningstar Intermediate Core Plus category. A figure that is also 3.3% better than the median manager in that peer group.1
To gain more insight into how TOTL has navigated fixed income markets during this pandemic, I spoke with Jeffrey Sherman, DoubleLine’s Deputy Chief Investment Officer. We discussed the path forward from the pandemic and where he thinks opportunities and pitfalls lie in the months ahead.
Here are excerpts from that conversation.
Matthew: With rate and credit volatility no bond sector was immune to the whipsaw volatility we have witnessed recently. However, TOTL did see lower drawdowns than most of its peers. Is this the byproduct of DoubleLine’s philosophy?
Jeffrey: In the pre-COVID-19 world, we had expected some form of a US economic slowdown. So TOTL’s positioning was not overallocated to risk as we headed into this period of significant volatility. It was heavily allocated, as it has been for some time, to the agency mortgage-backed securities (MBS) market. We had relatively higher credit quality, with the bulk of the portfolio in either Treasuries or MBS. Those were the two best performing markets during this meltdown. There was a flight to safety, and neither market saw a significant drawdown.
In terms of credit risk, we have had relatively mild positions in high yield bonds and bank loan securities, two sectors it was helpful not to have significant exposure to. Further, we have been very underweight in investment-grade corporate bonds over the course of the last year—a detriment previously but then very helpful to the portfolio starting in late February to early March.
Matthew: With an overweight mortgage position, are you concerned that the consumer orientation of this crisis may have a spillover effect into housing, and into commercial mortgage-backed securities (CMBS), agency MBS, and non-agency MBS?
Jeffrey: Our overweight to MBS is primarily in the government backed sectors. Some of the spillover effects into the mortgage market in general—delinquencies or forbearance—depend on the underlying borrower in those markets. In the agency MBS market, it depends on if you are buying Fannie Mae, Freddie Mac, or Ginnie Mae-type borrowers. We primarily own MBS in the Fannie- and Freddie-space. Ginnies, which we do not have a huge position in, tend to be lower quality than those in the Fannie and Freddie pools, so they are a little more susceptible to delinquencies. Then the question becomes are those delinquencies just temporary? Or do they actually turn into people defaulting on their mortgages?
If a homeowner defaults in the agency MBS market, the investor gets back par since the government backs the mortgage. Some agency MBS securities do currently trade at a premium to par, but we don’t think this risk is rampant from what we see in delinquency behavior. With respect to non-agency residential MBS, there is more spillover risk, but this has been priced in. Yields blew out in early March, and non-agency MBS still looks like a relatively attractive market. I think fears about these markets are a little unwarranted at this stage.
Matthew: Given the sizeable uncertainty, from a macro perspective and from a fundamental one where we are likely to see a sizeable amount of fallen angels, how are you managing credit risks? Some view this as a great opportunity to add risk.
Jeffrey: At the end of March, we tried to allocate a bit of capital into investment-grade corporates, because of how beaten up they were. They were starting to bounce back a bit, with the Fed’s announcements of programs trying to help provide liquidity into those markets. We also reduced a bit of our emerging market exposure. These weren’t significant moves. They were just a couple of percentage points around the margin in order to upgrade the credit quality of our portfolio.
We think that there could be more challenges in the emerging market space. Emerging markets don’t have the fiscal wherewithal that the developed world has. They don’t have unlimited printing presses, and a lot of their debt is denominated in US dollars, so they need access to dollars. Corporate bonds, meanwhile, have clawed back significantly, with a huge move on April 9 when the Fed expanded its programs to support the corporate market. I think this has extracted a lot of value from the investment-grade market, which now suggests that the economy will be back to January 2020 levels in six months. I think we all have to scratch our heads a little on that. I think the market has run a bit ahead of itself.
We’re focusing now on keeping our credit quality high and on selling some of these assets that are trading very rich. We have some positions that we have taken down a bit; for instance, consumer-related positions in the asset-backed security (ABS) market, such as student loans, that trade today above February levels. We are trying to keep risk relatively low because we think that the market is starting to price in a massive recovery. I don’t see how we can just turn the switch back on when we open up the economy, and it’s business as usual. It will be slow. There will be people who won’t be able to recoup their jobs. There will be pockets of the economy that will be shut down for longer. And I think some of these markets haven’t really thought that through.
Equity markets and corporate bonds are up, but not all credit markets are up and pricing in a rosy scenario. Take some of the securitized space in credit, specifically in CMBS with a lot of exposure to the leisure sector. There is a big disconnect, which causes me a bit of concern about going down in credit quality right now. We think patience is the right way to approach this. We have had a technical correction, a liquidity correction, and a price discovery correction. We’ve rallied off of some of that. I think that we could have another fundamental correction, as we start to get guidance on what earnings look like and how companies are going to pay their debentures.
Matthew: The S&P 500® valuations are back to the pre-February levels of 18x next year’s earnings …
Jeffrey: Right now we’re in a bull market in stocks, if you bought at the low. If you haven’t bought anything since the beginning of the year, you’re in a bear market. Where you are depends on your perspective. Today’s risk-on sentiment seems like a bear market rally to us, and we need to be cautious still. There is going to be a lot more noise as we continue through. We haven’t flattened the curve. We know stay-at-home policies are going to be in place for at least another month, and we know that when the economy opens up, it’s not going to be back to full capacity again. I think there needs to be a re-pricing of expectations out there.
There are a lot of players in the market that grew up in the “buy the dip” and “the Fed always has your back” mentality. The challenge is you can’t just throw monetary policy at a health problem. We all expect that magic bullet, and there could be some disappointment.
This is one of those distinctive moments that is going to change behavior in unpredictable ways and will be a catalyst for change. There is massive uncertainty, and I don’t think anyone can have high conviction on the path out. What is certain is we’re not going to back to a pre-COVID-19 world. We’re not going to look back and say “it was just a blip.” This is going to be a longer slog. It’s going to take us a few years to claw back to where we were in terms of real gross domestic product (GDP). From an investing perspective, it’s important not to get caught up in the momentum and have FOMO.
Matthew: Do you think the Fed will come close to deploying the $750 billion allocated to its Primary Market Corporate Credit Facility (PMCCF) and Secondary Market Corporate Credit Facility (SMCCF)? What’s your view on the Fed’s actions?
Jeffrey: It was a classic “buy the rumor, sell the news” thing. These programs have been announced but have not been executed. Effectively these are temporary lending facilities, and they are unprecedented. Government policies that are temporary tend to become permanent, so the question is do these facilities ever go away?
There also are some conflicting elements within the Fed’s repertoire at this point. The April 9 expansion of the Fed’s corporate buying program to include fallen angels also specified that the Fed could buy high yield ETFs. Yet the definition of a high yield ETF is not a fallen angel. To me that connotes that the Fed is really in the targeting of spreads, with the aim of keeping the high yield market functioning at a certain level.
Sectors of the market that have received the Fed’s support have rallied, but the other sectors have been left behind. We think market areas that have been overlooked by the Fed, intentionally or not, are where you can find true price discovery and potentially some value. Those are the areas that we’re going to want to try to buy more of in the next leg down.
Matthew: Last question, what is more likely by year’s end: high yield spreads back to long-term average 500 levels or the 10-year Treasury over 1%?
Jeffrey: The 10-year going to 1%. I don’t think the 10-year offers a lot of value at 60 basis points, and so I don’t see people wanting to buy it. The Fed has spent so much capital driving rates down through Treasury and MBS purchases—and since the Fed announced unlimited quantitative easing (QE) in March, rates are higher. I think there will continue to be pressure on the rates market.
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