Breaking down the U.S. bond market

Getting a good read on the U.S. fixed income market isn’t an easy task these days.

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The pandemic has “impacted everybody in almost every way imaginable,” said Ignacio Sosa, director of international relationship management at DoubleLine Capital in Los Angeles, Calif.

“There are bonds that have performed extremely well and bonds that haven’t,” he said in a May 12 interview.

Bonds with the least amount of risk — such as Treasurys, mortgages explicitly guaranteed by the government, and agency mortgage-backed securities with an implicit government guarantee — have performed best, Sosa said.

“These have done very well and are generally up — in some cases quite a bit year to date — because rates are falling so dramatically,” he said.

“Since they don’t really have credit risk, you benefit from the fact that rates have fallen.”

The Fed lowered the federal funds rate to a range of 0% to 0.25% in March and has signalled it will keep it there for the foreseeable future.

The central bank has also taken unprecedented action with lending and bond purchases. The Fed said it will buy up to $750 billion in corporate bonds — including “fallen angels,” or investment-grade debt that was recently downgraded to high yield — and up to $500 billion in municipal bonds.

Sosa said the bonds for which the Fed has signalled support have performed “relatively well” after the central bank’s measures “caused a massive rally in the prices of those assets,” but that the gains are now priced in.

Against this backdrop, debt instruments that aren’t being supported by the Fed are trailing their peers, Sosa said.

This includes securitized debt, non-government-backed residential mortgages and commercial mortgages, and collateralized loan obligations — a security that’s backed by a pool of debt.

While many investors think the Fed’s corporate bond purchases make those assets less risky, Sosa said the recessionary economic backdrop actually makes those bonds riskier.

“Ironically, if I bifurcate the credit market into those that are supported by the government and those that are not supported by the government,” he said, he prefers the latter.

Securitized credit is “the most attractive because the prices actually reflect the uncertainty that we all have to live under,” he said. “In many cases, these securities have been priced in such a way that they are signalling dire scenarios that we don’t see.”

He and his team at DoubleLine, which manages the Renaissance Flexible Yield Fund, expect a “substantial downturn that will be worse than what people expect.”

Sosa pointed to the U.S. unemployment rate, which spiked to 14.7% in April from less than 5% a month earlier, and which he believes underestimates the total. He also believes the collapse in economic growth caused by the pandemic will be “worse than what the market is expecting” when the figures are updated at the end of May.

He and his team are examining what they own — whether that’s corporate debt or securitized credit — to assess cash flows. The goal is for those flows to continue, he said, “even if we have a very substantial downturn of the economy.”

They’re also conducting stress tests. If the underlying assets don’t perform well, “we try to get rid of them and replace them with securities that will do better,” Sosa said.

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