Positioning Active Core Bond Portfolios Ahead of the Fed: A Conversation with DoubleLine’s Jeffrey Sherman
With elevated rate volatility and a shifting policy landscape, Matthew Bartolini sat down with Jeffrey Sherman, DoubleLine’s Deputy CIO, to discuss how he and his team are thinking about the current environment and what that means for portfolio positioning.
Seeking to curb inflation risks across the global economy, central bankers are poised to steadfastly raise rates throughout 2022 and most likely into 2023. As a result, rates are higher, bonds are trading lower, and volatility is elevated.
This has led to challenges for the Bloomberg US Aggregate Bond Index (Agg), a benchmark that has never posted back-to-back calendar years of losses but is now likely to do so given the 1.54% return last year and the -4% return in 2022 as of February 11.
As the policy landscape changes, asset allocation, sector selection, and distinct curve positioning will become more important in bond portfolios.
I spoke with Jeffrey Sherman, DoubleLine’s Deputy Chief Investment Officer, about how he and the team at DoubleLine are positioning the SPDR® DoubleLine® Total Return Tactical ETF [TOTL] and the SPDR® DoubleLine® Short Duration Total Return Tactical ETF [STOT] ahead of the Federal Reserve’s (Fed) first rate hike in years as the global economy responds to policy normalization.
Here are excerpts from our conversation.
Matthew Bartolini: Bond markets have been under pressure given the move in rates. The Fed is looking to raise rates at the next meeting. With markets turning volatile, how are you viewing the market and economic environment?
Jeffrey Sherman: Let’s start with data on growth and inflation.
We just saw one of the best nominal GDPs on record for the past 40 years, and that was really on two fronts. First, inflation reached its highest level in roughly 40 years. Second, growth was very strong, albeit off a very low base given the pandemic.
So it's undeniable that nominal GDP is going to be lower this year than it was last year. And it's likely that both of those components — inflation and growth — will be lower than they were last year.
However, we think inflation will still be above historical levels, between four and five percent throughout 2022 given ongoing supply chain issues and wage pressure. The Atlanta Fed Wage Growth tracker, a metric that compares an individual’s current wage to the prior year, shows wages are in an upward trend. In our view, this will likely continue to move higher as a result of the skills mismatch in the labor market, putting upward pressure on CPI.
So, what does this all mean for the market? Well, real yields are still negative pretty much across the Treasury curve, and unless nominal rates move higher, real rates will continue to be negative if our inflation view holds. As a result, we think the stronger-than-expected inflation prints will put upward pressure on rates — with the curve bear-flattening. That means you must be careful with duration positioning.
MB: What about the policy environment?
JS: If I look at the euro dollar futures curve, we have roughly six rate hikes priced into the market this year. That’s the number the market is ready for, and the hawkish Fed has foreshadowed that pace with its recent rhetoric. The Fed’s tone has definitely changed since President Biden renominated Chair Powell. Now, I am not saying the Fed is no longer independent, just that there is a greater emphasis on controlling inflation by the midterm elections in November. After all, inflation is at multi-decade highs. And given the time lag between policy implementation and its realized transmission into the economy, the Fed does have to act.
I expect hikes in March, May and June followed by a pause to let the hikes work their way into the system. Then the Fed could go back to quarterly hikes with the next live meeting of the Federal Open Market Committee in September and start to consider what to do with its balance sheet.
As for the balance sheet, I don’t believe the Fed actually sells assets but rather lets things roll off. That will still put pressure on the entire Treasury curve and mortgage market because the removal of a constant buyer will stoke more noise and rate volatility.
MB: With that as the backdrop, how are you positioning the portfolios from a sector perspective?
JS: Given geopolitical tensions, dollar pressures, and somewhat tighter spreads, we have reduced our exposure to emerging markets. For us, EM just doesn't seem like a great place to be right now given the volatile environment. Volatility in the rates market in the US will exacerbate volatility in emerging markets. So, I might as well stay in the US where we think the economy is in better shape and the general risk will be less.
We started to add investment grade (IG) corporate bonds, which is something that we hadn't done a lot of. We've been underweight that area previously, but we think now is the time to increase the credit quality of your portfolio. Allocating to IG corporates allows us to do that while adding some duration. As part of our quality trade, we also upped our exposure to Treasuries and agency mortgages.
The flexibility of our active approaches in these strategies has also allowed us to be more selective in the securitized market where we feel there is some value. There are some interesting areas where you can take calculated credit risk — whether that’s with floating rate and some short duration assets like bank loans and collateralized loan obligations (CLOs) or parts of the commercial mortgage market or corporate sector.
But we are not taking on more credit risk by adding to high yield corporates. Most exposed to the sensitive short end of the curve, high yield could continue to re-price and spreads could widen as the Fed hikes.
So, overall, right now we're trying to mesh calculated credit risk exposures with higher quality pockets of the IG corporate bond and securitized market.
MB: Any differentiation to how you manage curve positioning within the shorter-duration STOT?
JS: Even though we were starting to extend the duration of TOTL a little bit again on this quality concept, we haven't done so with STOT because we don't like that part of the curve. I should add, we’re still running TOTL with lower duration than the Agg, its benchmark.
STOT obviously has a cap on the duration by mandate (weighted average effective duration between one and three years), but we are trying to keep it inside that of its benchmark, the Bloomberg U.S. Aggregate 1-3 Year Index.
Being extended duration in the short end of the curve doesn’t really do much for you right now, unless you feel the 2- or 3-year rate is going to rally hard and lead to some duration-related gains. And that is not our view.
So, overall, both funds are below their benchmarks in terms of duration positioning.
MB: Last question, do you think the Agg breaks its streak of never posting back-to-back calendar year losses this year?
JS: I think you will have your first back-to-back negative years on the Agg. That’s not a profound statement given the Agg is already down 4% and the outlook for rising rates alongside the Fed’s actions.
The larger point to that question is not about the Agg’s streak, but about what the environment looks like. In our view, a market with elevated volatility, rising rates, shifting policy, and wider return dispersion among bond sectors sets up a time for active management to shine.
So, while the benchmark may have challenges, you can use cross-sector opportunities to manage duration in a way that can add value.
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