Silver Linings After the Bond Rout

Featuring

Sam Lau

From

Related Article

Text transcript

Sam Lau, portfolio manager for DoubleLine Capital.

It’s been a difficult start to the year for fixed income and it’s because we’ve been in this environment where rates have moved higher across the entire yield curve. So when we’re thinking about what’s attractive in fixed income today, sectors that have less sensitivity to interest rate moves come to mind. So areas like securitized credit, perhaps, such as your non-government guaranteed mortgage backed securities, both in the residential and the commercial space. Also, bank loans and collateralized loan obligations, or CLOs for short. Those are floating rate products that have performed relatively well as well.

So these non-traditional sectors within fixed income markets share those characteristics of having a lower duration or interest rate sensitivity and relatively attractive yields when compared to their traditional sector counterparts. Longer duration sectors with relatively low yields like those traditional sectors that comprise the Bloomberg US Bond Aggregate have been especially challenged as rates rose across the US Treasury curve year to date. I’m talking about through April 20th, 2022 here, but the two year treasury yield is up nearly 200 basis points from the end of last year.

The 10 year yield is up 140 basis points and the 30 year bond yield is up over a hundred basis points at this point. With that backdrop, the aggregate is off to the worst start in over three decades and that negative performance can be attributed to the index’s high interest rate sensitivity as measured by its duration. That duration is currently standing at six and a half years, approximately, and that is on top of a yield of less than 3.5%.

So with that, the aggregate is down 9% through April 20th and the Treasury and agency mortgage-backed securities component within the ag, they’re both down to approximately 8.5%. And the U.S. investment grade corporate credit component within there is down a staggering 12.5% since the end of last year. These sectors are all highly interest rate sensitive with relatively low yields to compensate you for that interest rate risk. But they do have relatively low credit risk when you’re looking at the U.S. IG corporate credit space there.

The silver lining through all of this is that we’re now at yield levels that we haven’t seen in years and things are starting to look a bit more enticing at these levels. What I find most attractive in today’s market for income generation and lower interest rate sensitivity are those aforementioned, non-traditional sectors of a fixed income market. In particular, I like those areas that many investors may be less familiar with and many investment managers themselves actually may not have the expertise to analyze and implement. But those who can do the due diligence on these credits, these areas of the market do provide interesting opportunities for those managers with that expertise and the experience to do the credit work.

These specialty sectors like Non-agency RMBS, CMBS, CLOs, ABS, they generally have higher yields and less rate risk than their traditional bond counterparts, but they do come with credit risk. At the index level, we’re seeing yields north of 4% today for Triple A-rated securities and you can get up to 6% or even higher if you go out to the Triple B space. So still maintaining the investment grade rating. I also like those CLOs, as well as those bank loans because of their floating rate nature. So those have performed relatively well even despite the rate rise that we’ve seen here today.

For those managers that do have the wherewithal to step into below investment grade credit, there’s also opportunity to pick up even more yield as long as you have the ability to analyze those credits and understand what the potential risk these bonds may add to your overall portfolio.

When we start to think about it from a fundamental standpoint, shifting over to the credit backdrop, both corporate and consumer balance sheets are relatively healthy, which should continue to be supported for credit fundamentals in the near term. Corporations took advantage of those lower interest rates that we saw in 2020 and 2021 by refinancing their existing debt at a lower cost of capital. Then by doing so, they extended the maturities of their debt obligations.

On the consumer side, the labour market is strong. Wages have been rising and looking at US consumers and aggregate household net debt has now fallen to zero since we’ve come out of the pandemic. In the current market, the expertise to manage that credit risk, you can still diversify fixed income portfolios that yield somewhere in the mid fives, have duration levels less than two years and you can still have a credit rating of double B plus or just right there on investment grade’s doorstep.

So we’re talking about well diversified fixed income portfolios that don’t just rely heavily on one or two sectors of the market. Instead, they can spread capital to where they think the best rewards and risk opportunities lie.

So to wrap it up, we’ve seen cheaper entry points to bonds and that translates to materially higher yields than even just what we saw four months ago. In some areas of credit, we’ve seen the highest level of yields in five years. However, not all fixed income sectors are the same. The flight to safety aspect of traditional sectors are still very important today and you need that allocation in your portfolio, but great volatility will persist. And thus, we prefer to maintain a shorter duration at the portfolio level.

Portfolios that include securitized credit and floating rate assets like bank loans and CLOs can compliment your traditional fixed income holdings and thoughtful inclusion of these sectors can improve the overall portfolio characteristics through higher yields and less interest rate risk, but you need to be able to manage that credit risk.