Text transcript

Welcome to Advisor to Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject-matter experts themselves. 

* * * 

Jeffrey Mayberry, fixed-income asset allocation strategist and portfolio manager at DoubleLine Capital 

* * * 

The first half of the year had a pretty good return for fixed income, or at least on the U.S. side. We had about a 4% return on the U.S. Agg [Bloomberg U.S. Aggregate Bond Index] in the first half of the year, and a 1.2% return in the second quarter. It was interesting on the U.S. Treasury curve in the second quarter, you had a pretty good steepening of the Treasury curve, with the two-year down actually 16 basis points, while the 10-year was actually up two basis points, and the long bond was up 20 basis points. 

So, this kind of weird steepening pivot around that 10-year point of the curve is something we’d been expecting, something that we were putting on in our portfolios. But it’s really much more of a move towards the idea that over the long term — and the long-term Treasury’s reflecting this — there are some fiscal problems in the U.S., and that’s really putting upward pressure on longer-term interest rates. 

You have seen, interestingly enough though, credit continuing to do well. Credit spreads have continued to grind in. Certainly, there was a lot of volatility around tariffs and what’s going on in Congress in the U.S. But overall, point to point, spread’s grinding in tighter. Really, if you look at your riskier credits, your high yield was up 2.5% on the quarter. It’s almost doubling the return of the Agg and, your bank floating rate side was up 2.8%. 

Really, the question going forward is, what’s going to happen with inflation, and what’s kind of priced in with inflation? I like to look at inflation swaps. They don’t have the supply/demand dynamics that you do see in Treasury inflation-protected securities. The TIPS really gives you a pure view on inflation. 

And over the shorter term — call it one to two years — zero coupon inflation swaps are pricing in higher inflation, but over the medium to longer term, inflation is coming back down towards a more normal level. If we look at it, we say, yes, that makes sense to us. The tariffs, no matter what level they’re implemented in, will lead to short-term higher inflation, whether it’s year-over-year or maybe a couple years, but shouldn’t affect things over the medium term. 

But really, when we look at it, we think the risk is to higher inflation. The Fed continuing to say inflation is a level that is unacceptable. And so that’s really the risk: that higher inflation. 

No rate cuts at the end of July seems pretty reasonable. But really — and this has been the case throughout the entire year — the probability of rate cuts is continuing to drop. We’re about 65% chance of a rate cut in September. And the first rate cut is continuing to be pushed out. It wouldn’t surprise me if we get, after the July meeting, the September rate probability goes down. And then October rates continuing to come down. And really, you’re at a place where inflation is still at top of mind, given what’s happened over the past five years. And that mindset has to switch in people in order for them to be comfortable with inflation. So I think the risk is to higher inflation. And it’s kind of being priced into bonds, but maybe not to the same extent that we are expecting. 

* * * 

There’s two things to think about here in terms of where we are, in terms of the economy and the credit cycle. Are we going into a recession? There’s kind of two trains of thought here. One is that if you look at the corporate credits, our corporate credit team tells me that earnings are very strong. There’s really a very low probability of defaults over the medium term. And even with the volatility around tariffs — whether the tariffs are going to be implemented or not — the corporations are very strong. 

Now, if you take a step back from the corporate credit side of things, and you look at the labour market, the labour market in the U.S. is starting to maybe show some signs of weakness. The jobless claims number is continuing to go up every single week, not to levels that you’re worried about yet, but the trend is something where we’re probably at a yellow light. “Let’s kind of keep an eye on them and see whether they continue to get worse or not.” But not at a “OK, we’re getting a recession!” level. 

The payroll data continues to be relatively strong, and so you really haven’t seen too many signs of that hard data mirroring the soft data, the sentiment data, that has been looking not terrible, but not great either. There are some signs of maybe a recession on the horizon. We don’t think it’s coming this year as we’re past the first half of the year already. We’re running out of time for there really to be a recession in 2025. But if you kind of say, what’s the probability of recession over the next 12 months, I would say we’re in a little bit higher than average, probably 60% probability of recession in the next 12 months, where it seems like the markets are pricing in a 40% chance of recession. So, we’re kind of inversed flip-flop on what markets are pricing in. 

There are some worrying signs, nothing where we are advocating for selling credit, especially since that corporate credit is continuing to remain strong and earnings are going to remain strong. But something just to keep an eye on, something to have your hand close to the ready button, and ready to make potential moves, depending on whether the data worsens or strengthens from here. 

* * * 

Canadian fixed income and the Canadian economy overall is at a very interesting place here relative to the U.S. And I think most of that’s because the U.S. is trying to decouple themselves from not only Canada, but everywhere else around the world. It used to be that a lot of the developed economies would move along with whatever the U.S. economy did — or at least that was the case over the post-World War II era — and I think that those correlations are still going to be relatively high, but I think the correlations of the future, at least over the medium term, are going to be lower. 

To the extent that, OK, the U.S is going to go into recession, you know, 60% chance of recession, I would discount that level from a Canadian fixed-income side, and maybe look at Canadian fixed income being a potential buying opportunity to move into those types of non-dollar trades, whether it’s in Canada or anywhere else around the world. 

* * * 

Because we’re at an interesting point in time, I think there are pockets of opportunity for fixed-income investors through the end of the year. You’re looking at something like structured credit, whether it’s in residential mortgages, commercial mortgages, asset-backed securities. While those spreads have come in and tightened, we think the probability of default is relatively low, and those spreads still give you some advantages over your investment-grade corporate bonds or higher up the credit stack in your high yield, your double-B high yield. You get some more yield, similar amounts of risk, similar amounts of volatility. So we think that’s a very good opportunity for investors. 

Also, given the moves in the U.S. dollar versus the global markets, we think it could be a good time to invest in some non-dollar names. Start legging into those trades. But certainly that’s a potential opportunity, given the market outlook for the dollar, and really try to take advantage of some of that volatility that happens in the non-dollar names, whether it’s in the sovereign space or in the local currency emerging market space. 

And finally, given our outlook for things, we do think that The Fed is more likely to cut rates, not necessarily over the short term, but we think that The Fed is more likely to cut than to hike. And so, have a little bit more of that exposure to the lower end of the Treasury curve, and less exposure to the longer end of the Treasury curve. 

The Treasury curve, on the long end, hasn’t really reacted too much to the Congress passing tax cuts, and a $5 trillion debt ceiling adjustment and the idea of deficits continuing to expand, but we think over the long term, certainly, that pressure is going to continue to push up longer term interest rates higher than they would be if the U.S. Congress got their fiscal house in order. We don’t think that that’s a very likely scenario — at least until they’re forced to buy the bond market — but certainly, that upward pressure on long-term interest rates would force that move, but it’s going to be significantly higher from here. 

So if you were to look at the Treasury curve, we like the short end of the curve. We don’t like the longer end of the curve. And if you are at a place where you can buy shorter-duration assets, we think that those two-year type assets, whether it’s the two-year Treasury curve or shorter duration structured credit, it’s going to do well in that scenario where the shorter end of the Treasury curve rallies and the Fed is cutting rates, whether it’s from a idea of recession coming or the idea that The Fed is just trying to, kind of, more normalize rates. Certainly the Fed is more inclined to cut rates very slightly from here versus raise rates. 

And so those are kind of the places we like in the market today. Picking and choosing, I think the volatility that we saw in the second quarter could continue here over the rest of the year, and provide some opportunities to pick up some relatively cheap bonds, and try to take advantage of some dislocations in the markets to provide good yielding, good spreading assets with very lower amounts of risk.

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DoubleLine® is a registered trademark of DoubleLine Capital LP.

The views expressed in this material are the views of DoubleLine® as of the date of publication unless otherwise indicated, and are subject to change at any time.

**

This program is intended for Advisor Use Only. The views expressed in this material are the views of CIBC Asset Management Inc., as of the date of publication unless otherwise indicated, and are subject to change at any time. CIBC Asset Management Inc. does not undertake any obligation or responsibility to update such opinions. This material is provided for general informational purposes only and does not constitute financial, investment, tax, legal or accounting advice, it should not be relied upon in that regard or be considered predictive of any future market performance, nor does it constitute an offer or solicitation to buy or sell any securities referred to. Individual circumstances and current events are critical to sound investment planning; anyone wishing to act on this material should consult with their advisor. Forward-looking statements include statements that are predictive in nature, that depend upon or refer to future events or conditions, or that include words such as “expects”, “anticipates”, “intends”, “plans”, “believes”, “estimates”, or other similar wording. In addition, any statements that may be made concerning future performance, strategies, or prospects and possible future actions taken by the fund, are also forward-looking statements. Forward-looking statements are not guarantees of future performance. These statements involve known and unknown risks, uncertainties, and other factors that may cause the actual results and achievements of the fund to differ materially from those expressed or implied by such statements. Such factors include, but are not limited to: general economic, market, and business conditions; fluctuations in securities prices, interest rates, and foreign currency exchange rates; changes in government regulations; and catastrophic events. The above list of important factors that may affect future results is not exhaustive. Before making any investment decisions, we encourage you to consider these and other factors carefully. CIBC Asset Management Inc. does not undertake, and specifically disclaims, any obligation to update or revise any forward-looking statements, whether as a result of new information, future developments, or otherwise prior to the release of the next management report of fund performance. Past performance may not be repeated and is not indicative of future results. The material and/or its contents may not be reproduced without the express written consent of CIBC Asset Management Inc. ^® The CIBC logo and “CIBC Asset Management” are registered trademarks of CIBC, used under license.

Text transcript

Welcome to Advisor to Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject-matter experts themselves. 

* * * 

Jeffrey Mayberry, fixed income asset allocation strategist and portfolio manager at Double Line Capital. 

* * * 

Up until about the middle of February, the U.S. bond market has been in a pretty significant sell-off in terms of interest rates. And they’ve been at recently high levels, and we’ve been at a place where the momentum really has been towards higher rates. 

The U.S. economy continues to be strong at the end of the fourth quarter. And, really, you saw inflation remain at a little bit higher level than maybe the Federal Reserve was comfortable with. All that kind of put together caused interest rates to be at a higher level. 

There’s growing concern, I would say, about the U.S. federal deficit. And the fact that that was continuing to grow also puts further upward pressure on interest rates. 

Now, since mid-February, there’s been some growing growth concerns in the U.S. Consumer confidence has come down, and there is a little bit more of a concern from the bond market and the stock market — both major markets — that the U.S. growth is not going to be as robust as it was in 2024. 

You started to see it in such data as the ISM manufacturing data. You started to see a lot of the import numbers come in. The Atlanta Fed GDP Now numbers have turned negative — and it’s still very early on for the Atlanta Fed GDP numbers, we don’t put much stock in it because as we go through the quarter you get more and more data and more revisions to the data — but it was a pretty significant downturn in that metric. 

And so there have been some growth concerns. And so you did see a pretty significant rally in U.S. interest rates going into the end of February. We think this is probably more short-lived, and that we should see a rebound in rates, especially on the longer end of the curve rates should continue to go higher. 

As we become more and more concerned about what the Presidential administration in the U.S. and the U.S. Congress is going to do in terms of tax cuts, and more specifically the deficit and whether that continues to grow — which certainly seems likely — we think that at some point that will overwhelm the negative sentiment going on. The bond market will become much more concerned with the growing budget deficit and really put upward pressure on interest rates. 

Where we are now, the growth concerns are at the forefront over the short term. Over the medium and long term, the bond market sell off could likely continue. 

The Federal Reserve has maintained that they are going to continue to target a 2% core PCE inflation. When you think about core PCE, that’s ex food and ex energy. And really that data has come down to a level that maybe the Fed is becoming more comfortable with, but we’re not back to that 2% level. We’re around 2.5% as of the February reading of core PCE. 

And when you slice and dice it, there are still some components of the inflation that are at higher levels and are coming down very slowly. Something like the U.S. housing sector is continuing to come down but coming down very slowly. 

And so it makes sense that the Fed is going to remain data dependent, that they’re going to keep rates higher for longer, because they really need to get inflation down to 2%. 

There are some signs that we may get headline inflation. So, including food and energy, those numbers will continue to come down as we’re coming off a relatively high level of energy prices from last year. Those levels will come down but we think that the core PCE is going to continue to take its time coming down. And the Fed will remain higher for longer. The Fed will keep rates at relatively high levels. 

At the beginning of March, the market is pricing in two and a half Fed cuts for the rest of 2025, the first one coming in June. That seems about right. It gives the Fed some runway to see what the data comes out as, and for them to be able to react to incoming data. 

If inflation comes down faster, then that will mean that the Fed can cut rates faster. If inflation remains higher, then they will stay higher for longer. And certainly this is going to impact the fixed-income markets. And if we get that lower inflation, the Fed can cut rates, I think you’ll see the bond market react correspondingly. And longer-term rates should come down. 

You could see a divergence, though, between the short-term rates and the long-term rates, depending on growth outlook for the U.S., but really you’re at a place where — it feels like we’ve been in this place for the past couple of years — we’re very data dependent and want to see how quickly inflation comes down. 

* * * 

The Canadian fixed-income market is in a very interesting place today. 

Certainly the geopolitical risks are at very high levels. It depends on how the energy markets and the commodity markets are going to react to what is happening in the U.S., and correspondingly, what the Canadian government is going to do. 

But really, you’re looking at the Bank of Canada cutting rates pretty aggressively, and a pretty high-interest rate differential between Canada and the U.S. And so I think that the Canadian market is bound to perform well, relative to the U.S. market. 

A lot of that is going to be depending on growth in Canada, how that’s going to shake out, and what’s going to happen in Canada relative to the U.S. 

As I mentioned earlier, the Federal Reserve is probably going to be a little bit slower to cut rates. So you can kind of take advantage of those interest-rate differentials where it makes sense. But we think that it’s a relatively attractive space and certainly gives us some opportunities for relative value. 

* * * 

The current landscape for the fixed-income market across the globe is very interesting. There are pockets of opportunity, places where if you have a relatively wider spread, you have the potential for further spread tightening, which can increase your prices and lead to a higher total return. Certainly you can look at something like the commercial mortgage-backed security space. 

There’s ample opportunity, depending on how much risk you want to take, and something that we’ve been big proponents over the past few years because that market is trading at relatively wide spreads. Being able to pick and choose which subsector of the commercial mortgage-backed securities market gives you some good relative value opportunities. 

Right now we very much like the agency mortgage space. Now, spreads are still relatively wide. Banks haven’t come in to buy agency mortgage-backed securities as much as they were pre-Covid. And so spreads are at a place where they can continue to tighten. 

It does have that zero-credit risk. It is maybe not explicitly backed by the U.S. government, but certainly they have an implicit guarantee from the U.S. government. 

And so you’re at a place where you can use mortgage-backed securities as a U.S. Treasury complement, and be able to pick up some higher yield, get some lighter spreads. And really you can pick and choose where you want to be in duration. 

So, if you want to have a low-interest-rate risk, you can buy agency residential mortgage-backed floating rate risk, and really be able to sleep at night, not have to worry about that, and really could see some spread compression on that side of things, both if we get a recession here in the U.S., which is a potential. The probability of that occurring is a little bit higher today than it was at the beginning of 2025. And because of that, you can get some spread tightening in the flight-to-quality and the agency mortgage-backed security space — both on that floating-rate side and in the pass-through space. So those are really the two sectors we like the most. 

* * * 

What other things are we worried about going into the rest of 2025? 

Certainly the potential slowdown in growth is something that we are keeping an eye on. Whether the consumer confidence is something that — while we don’t necessarily look at the survey data and think that this is a great data point, we’re going to trade based off of it — what we want to do is look at it and kind of feel how the market is reacting to it. And when the market is reacting negatively to the consumer confidence numbers, then that means that there is that potential for a growth slowdown. 

When we look at something like future inflation expectations — we don’t really believe in that survey data, but — overall, when you look at the median data point, that inflation is trending to be higher. So I think you could get the dreaded stagflation scenario, where you have higher inflation, slower growth, and that is something that, over the end of February, early March, has reared its ugly head again as another potential outcome.  

As opposed to the no-landing, soft-landing, hard-landing scenario, you have this stagflationary scenario as another potential outcome. 

It’s still a very low probability event, but the fact that people are discussing it and starting to be worried about it will continue to weigh on markets as a potential outcome. 

The no-landing scenario doesn’t seem as highly probable today, at the beginning of March, as it did middle-end of 2024. That seemed like a high-probability event — that U.S. economy was just going to cruise along. We think that over the first half of the year we’re still likely to cruise along. It’s the second half of the year that we are starting to see some potential speed bumps out there, and something that, when we do to our asset allocations, do we want to be a little bit less heavy on the credit risk side of things, more on the flight-to-quality, no credit risk side of things, as that potential for a slowdown in the second half of the year increases.

* * *

DoubleLine® is a registered trademark of DoubleLine Capital LP.

The views expressed in this material are the views of DoubleLine® as of the date of publication unless otherwise indicated, and are subject to change at any time.

**

This program is intended for Advisor Use Only. The views expressed in this material are the views of CIBC Asset Management Inc., as of the date of publication unless otherwise indicated, and are subject to change at any time. CIBC Asset Management Inc. does not undertake any obligation or responsibility to update such opinions. This material is provided for general informational purposes only and does not constitute financial, investment, tax, legal or accounting advice, it should not be relied upon in that regard or be considered predictive of any future market performance, nor does it constitute an offer or solicitation to buy or sell any securities referred to. Individual circumstances and current events are critical to sound investment planning; anyone wishing to act on this material should consult with their advisor. Forward-looking statements include statements that are predictive in nature, that depend upon or refer to future events or conditions, or that include words such as “expects”, “anticipates”, “intends”, “plans”, “believes”, “estimates”, or other similar wording. In addition, any statements that may be made concerning future performance, strategies, or prospects and possible future actions taken by the fund, are also forward-looking statements. Forward-looking statements are not guarantees of future performance. These statements involve known and unknown risks, uncertainties, and other factors that may cause the actual results and achievements of the fund to differ materially from those expressed or implied by such statements. Such factors include, but are not limited to: general economic, market, and business conditions; fluctuations in securities prices, interest rates, and foreign currency exchange rates; changes in government regulations; and catastrophic events. The above list of important factors that may affect future results is not exhaustive. Before making any investment decisions, we encourage you to consider these and other factors carefully. CIBC Asset Management Inc. does not undertake, and specifically disclaims, any obligation to update or revise any forward-looking statements, whether as a result of new information, future developments, or otherwise prior to the release of the next management report of fund performance. Past performance may not be repeated and is not indicative of future results. The material and/or its contents may not be reproduced without the express written consent of CIBC Asset Management Inc. ^® The CIBC logo and “CIBC Asset Management” are registered trademarks of CIBC, used under license.

Text transcript

Welcome to Advisor To Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject matter experts themselves.  

Jeff Mayberry, portfolio manager at DoubleLine Capital.  

We’re at a pretty interesting time in terms of what the Federal Reserve is thinking or doing, and we’re at an inflection point now where, assuming that inflation is continuing its current trajectory, the Fed is changing its outlook from worried about inflation to worried about growth. And so, they’re starting to signal the, well, they certainly signal the end of the hiking cycle. And they’re starting to signal the fact that interest rate cuts will be imminent, coming up possibly at their next meeting on September 18. And it’ll be interesting to see whether they follow through with that, and obviously it’s going to depend on how the data shakes out before the meeting.  

There’s certainly inflation and growth numbers that they’re going to receive, but it’s a market shift from being worried about inflation to being worried about growth. 

And so, the way this kind of affects things, though, is that for a long time we’ve heard most people are staying and buying a lot of treasury bills, the low duration, kind of no risk asset, because it is yielding so much, especially compared to other parts of the curve, with the U.S. Treasury curve being so inverted. So, when the Fed starts cutting rates, whether it is in September or October or later on this year, certainly we’ve seen the high in T-bill rates, and so it’s actually a very good time for investors to start thinking about or actually moving into alternative fixed-income investments to treasury bills.  

We can lock in fixed rates today, you can lock in spreads today that are higher than T-bill spreads. And though you’re taking on a little bit more, either credit risk or duration risk, at least you’re being compensated for today, and you can kind of lock in these higher rates and these higher yield levels versus where T bills are.  

You’ve certainly seen the high in T-bill rates. The market has priced in anywhere from four to five rate cuts to the end of 2024, if you look out past 2024 to 2025, the markets pricing in even more aggressive cuts. Looking at, you know, as of mid-August, about a couple hundred basis points in Fed cuts. And so being able to lock in rates, lock in these yields today, is a very attractive time.  

If you wait until the Fed starts cutting, the markets are going to have already reacted to a lot of the data points that are coming out and pricing in higher probabilities of rate cuts. And so, it makes sense to kind of move into different fixed-income markets before the Fed starts cutting.  

You’re at a place now where yields and spreads are priced kind of in agreement with the Fed, with no recession on the horizon, and being able to take advantage of those spread levels today makes sense. Now, the idea behind kind of locking in these, I wouldn’t say they’re priced to perfection, but they’re priced somewhere close to perfection, and something like U.S. corporate high yield, but there are opportunities in other sectors of the market, whether it’s in structured products, agency mortgage backed securities, commercial mortgage backed securities, there are ample opportunities out there for picking up spread product, picking up extra yield, without taking on too much extra risk.  

With inflation having come off its highs, but still remaining at higher levels than you’ve seen over the recent past, or, I guess, semi-recent past, it really is a case of people are in a different mindset today. So back, pre-Covid, no one was worried about inflation. Now, people have lived through some inflation and seen the pain of inflation, and so I think that people are a little bit more uncomfortable with having inflation put in the back of your mind. And so, they’re a little bit more worried about inflation, and they’ve seen how inflation can eat away at your kind of real return in the fixed-income market. And so, by and large, you would expect that all else being equal, interest rates would be, interest rates and yields on the fixed income would be at higher absolute levels to account for that possibility of inflation staying higher than historically has been, maybe even higher than the Fed’s expectation of getting back to a 2% inflation target.  

If we settle in at 2.5%, would the Fed be okay with that? I would think that they’d be happy as long as the trajectory is going down, but I think that leads to higher yields overall.  

There are ample opportunities out there in the fixed-income market today for investors that have a broad investing universe, something like the commercial mortgage-backed securities market is, our team likes to say that it’s priced for depression, I would say that is probably not priced to depression, but, you know, a mild recession. Spreads are already being priced into that market. So, if we do get a mild recession, then you would expect that that type of market, the yields and the spreads, would not widen out as much as something that is priced to perfection, something like U.S. corporate high yield, which is priced to really a no-recession scenario. So, if you had a sample set of two credit sectors, you would probably prefer to be in the commercial mortgage backed securities sector versus the high yield sector, just because it is priced to a more downward scenario.  

Now that’s not say it’s not without risk, and certainly there’s a lot of headline risk in the commercial mortgage backed securities market. But if you stay up in the higher credit classes that are collateral that mitigates a lot of that headline risk that you could see in the commercial mortgage backed securities sector overall.  

Something like agency mortgages is actually another very attractive sector treatment, historically wide spreads, or at least post-financial crisis wide spreads, and really at a place where you can get some credit risk free yield or yield advantage over treasuries. And so, that’s something that we’ve really been liking over the past year and a half or so, and really something that we think offers a lot of value.  

If you compare your credit risk side with your non-credit risk, you can build a better portfolio, so something that has a lower duration than your benchmark, something that is a little bit more credit risk, more yield, but really is in a place where, if the U.S. hits a recession, the non-credit risk agency mortgages or treasuries portion of your portfolio will do well, and you can use that as your dry powder to buy credit side of things that have widened out.  

And something that CMBS, where already spreads are already at relative wides should widen out less, and so you can take advantage of those opportunities there. So, it’s really a good time to be a fixed-income investor, certainly compared to where we were pre-Covid, where yields were such low absolute levels, at least here you’re getting some yield, and there’s going to be some opportunities to pick up extra yield if the U.S. gets into recession. If we don’t go into recession, then you have that extra yield, and you’re clipping that extra coupon. And so, putting together a portfolio that can take advantage of both different scenarios, that really is, is a good opportunity for investors out there. 

One of the things that we’ve been thinking about and contemplating in risk for the longer term, not necessarily in the next 12 months or so, but over the next two or three years, is that the budget deficit in the U.S. is at very high levels. Some would say, historically high levels, and really at a place where, if the U.S. does get into a recession, we would expect more fiscal support from Congress, and that would expand the budget deficit even larger than it is today.  

And by itself, that’s not terribly worrisome. The U.S. economy is still growing very fast. And so, when you can kind of compare the budget size to the economy, it doesn’t look terribly out of line. But if we get a recession, then you would expect the economy to contract some, the budget deficit to widen, and that makes your deficit to GDP number explode higher. And at some point, we don’t know when, but we believe that at some point, the so-called bond vigilantes will come into play again and that they’re going to need higher yields in the U.S. on Treasurys than they have historically needed, because they’re going to need to be compensated for that risk of more and more issuance of Treasurys.  

One of the things that we are concerned about is that if we get a recession, you could see the Pavlovian response of flight to quality, buy Treasurys, you want to buy long-duration treasuries and have those, because those are the ones that are going to go up the most if we get a rally in yields, so you want to buy those. But at some point, those are the ones that are also most exposed to this ballooning budget deficit. So, you could see a rally in interest rates, long-term interest rates, in a recession, the fiscal response being very large. The Congress learned that they do a large fiscal response, it worked in Covid, it’s going to work in the next recession. And then you could actually see long-term yields rise from there as the bond vigilantes get worried about the budget. And in that case, you may have a short-lived positive response from bonds and then a negative response after that.  

So, that is more of a longer-term risk. Certainly, it’s independent of whichever party wins the presidency or Congress. Both sides would elect to have a ballooning budget deficit, so that’s something that we are concerned about over the long term.

Text transcript

Welcome to Advisor To Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject matter experts themselves. 

Jeff Mayberry, portfolio manager for DoubleLine Capital. 

We’re in an interesting place in the markets today with the rate cuts, the market having priced in so many rate cuts at the beginning of the year, and now the market has been pushing out the start of the rate-cutting cycle based on the strong economic growth in the U.S. as well as the stronger than expected inflation numbers that we’ve received more recently. 

And I think currently, as of mid-April, that the market is pricing in under two rate cuts for the rest of the year, a broad divergence from when the market was pricing in seven rate cuts earlier this year or late in 2023. But I think the strength of the economy, everyone was expecting that the economy would start to go into more of a recession, there would start to be higher unemployment, there would be more of a drop in inflation, inflation would start to be more comfortable as the Fed would be more comfortable, that the inflation would be getting down closer to their 2% target rate. And so as we’ve come across hotter than expected inflation numbers, the market has pushed out the start of rate cuts. 

So, what does this mean for bonds? 

That’s the real question. Unless you’re trading Fed funds futures, what the Fed’s doing doesn’t affect you directly, but indirectly, what does that mean for bonds?  

And I think that in the higher-for-longer case, that really portends higher rates on the short end of the curve. And it’s been interesting to see whether… We haven’t seen too much of it yet, but if the rates stay up higher for longer, maybe that increases the probability that the Fed is going to engineer a recession. If that’s the case, then you should see maybe that the longer-term interest rates would fall on those recession worries. We haven’t seen that yet. Rates have been moving up across the board whether you’re looking at the short end of the curve or the long end of the curve. 

And so one of the things to keep an eye on is to see whether you do get a rally in the 10-year part of the Treasury curve, and whether that’s because of a rate-cutting cycle happening faster, or recession coming or the Fed actually breaking something. I think that the market has been very much in the idea that the Fed is going to engineer the soft landing or no landing scenario. And the fact that they have to leave rates higher for longer increases the probability of a harder landing than otherwise would be the case. 

Going forward, I think our outlook on fixed income, it’s been very constant over the past call it 12 to 18 months, and it’s really trying to play both sides of the market. We don’t know what’s going to happen with the economy. We don’t know if we’re going to get a recession in the latter half of 2024. We don’t know if we’re going to get a soft landing or a no landing scenario. So, really trying to put portfolios together that can do well in both scenarios. 

So in the no landing scenario, you want to have some credit risk, you want to have that yield pickup that you get, whether it’s from high-yield corporate bonds or emerging markets or structured credit where you’re getting a little bit extra yield there, but also wanting to have a big portion of your portfolio in your flight to safety, your flight to quality-type securities, whether it’s in longer-duration U.S. Treasuries or in agency mortgage-backed securities. 

So being able to put together a portfolio that can do well. Obviously in a recession, your flight to quality, your Treasuries, your agency mortgages are going to do well, but your spreads are going to widen out on your credit side of things. So you have to have that balance there. But if we do get a no landing scenario, then your agency mortgages and Treasuries are going to underperform, but your credit is going to do well. So not having a one-sided view of which way the market is going to go, creating a more balanced view and more balanced portfolio that is able to do well under those two disparate scenarios, I think that that’s really the way to go and then really the way we’ve been positioning our portfolios so that in this time of the markets being very data-dependent, the Fed being very data-dependent, I think it makes sense to also be data-dependent and also try to position your portfolios to do well in either of those scenarios. 

Going forward, we like to say that at least there is yield in the market today versus in the recent past where there was not very much yield in the fixed-income market. I think that now you’re looking at places where there are opportunities across the fixed-income market. So being able to pick and choose where to take those opportunities, which sectors you want to overweight, which sectors you want to underweight is paramount.  

And so a lot of your corporate credit sectors are priced at very tight spreads, not historically tight spreads but getting close to those historically tight levels. And so maybe you want to underweight your investment-grade corporate bonds and your high yield just because those spreads are so tight and really at a place where they’re priced to perfection. You don’t have very much upside in terms of more spread tightening that can go on in those sectors. And you have a lot of downside. If we get a recession, spreads could widen out considerably from there. 

And really, try to focus more on, I would say your structured credit sectors, whether it’s commercial mortgage-backed securities, non-agency residential mortgage-backed securities, or asset-backed securities. Those types of sectors haven’t tightened in as much, so they have better risk-reward balance and really cases where there’s room for the spreads to tighten and really less room for spreads to widen because they haven’t tightened in as much. 

Specifically, I would say that we really like the commercial mortgage-backed security space out there. Spreads are still very wide. You don’t have to invest solely in what people think of when they think of CMBS’s office space and retail malls. You don’t have to invest solely in those sectors. You can invest in industrial spaces or hotels or even multifamily falls under that CMBS umbrella. So, there are opportunities to take good fundamental risks at wider spreads, which is always the goal there. 

Certainly, we also, on the no credit risk side of things, like the agency mortgage-backed security space. Spreads are still very wide. They’re not at the widest levels that they’ve been over the past 10 years, but they are pretty close to those wider levels. And so there are opportunities there. 

And a few years ago when you had to invest in the agency mortgage space, you were very limited in the coupons that you could buy in the agency mortgage space because everything was so low, rates were so low. Today, because rates are much higher you have a broad universe of coupons that you can invest in and you can pick and choose what kind of risks you want to take, what kind of rewards you want to take. So, something that is slightly below par but still in a refinanceable position, those are looking a little bit more attractive there because you do have that prepayment reward. If you do get lower rates and you get a refinancing wave, you can get those prepayment rewards. But if you are buying the very, very low, out of the money Fannie Mae one-and-a-half or two per cent coupons, those are not likely to be refinanceable any time soon. And so even though you would think that you would have much more prepayment reward because they’re much lower dollar price, that refinance ability is such a low probability event that it doesn’t really make sense to us to invest in those. 

So, given the current market environment, it’s not all of a place where we are not without risks. Certainly, if the Fed is staying at this higher for longer rate level, the risks of a recession are increased, maybe not considerably, at least in this point in time, but the probability of a recession has to be higher today than it was at the beginning of the year. 

And I also think that there are risks that people are chasing yield. People are really in a place where they are trying to take advantage of these higher rates overall, these higher yields, absolute yields that you’re getting in credit sectors. So, people are chasing that and that leaves the higher probability of you being less compensated for the default risk that may be in some of these securities. 

It doesn’t seem like that’s a 2024 problem, but more of a later half of 2025 problem in terms of when you could see defaults in corporate credit and high yield in bank loans. 

Text transcript

Welcome to Advisor To Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject matter experts themselves.

I’m Jeff Mayberry. I work for DoubleLine. I am a portfolio manager and a fixed income asset allocator.

Bond yields have been very interesting of late, have kind of bounced off the 5% level on the US 10-year recently, been running between this range of 5% and four and a half. And really after the September Fed meeting it did seem like people were starting to get worried that the issuance in the treasury market was really going to drive rates up.

But things seemed to have settled down based on the fact of a little bit weaker nonfarm payroll number that we did receive in the first week of November. We received CPI, consumer price index, in mid-November. That seemed to show a little bit of a slowdown in inflation, and so really things have started to calm down after the huge volatility that we’ve seen after the September Fed meeting.

Given the backdrop of the current macroeconomic environment almost across the globe, it does seem like most of the major central banks outside of, let’s say, the Bank of Japan, should be done hiking interest rates. There has tended to be a coordinated interest rate increases, and since the Fed leading the way, we’re certainly of the mindset that the Fed is going to try to stay higher for longer, but doesn’t seem like they’re not really planning to hike interest rates anymore, where we’ve been of the mindset since end of the second quarter that the Fed would be done, maybe one more rate hike.

So it seems like the Fed is going to lead the way for the rest of the central banks, outside of the Bank of Japan, which the Bank of Japan has a whole other problem where they’re really trying to get rates higher through their yield curve control. But the other major central banks across the globe were of the idea that they should be done hiking rates, or at least they won’t be hiking rates significantly from here.

It’ll be interesting to see when major central banks begin to cut rates. The market is pricing in rate cuts, or at least in the U.S., the market is pricing in Fed rate cuts to begin early next year into the first quarter, beginning of the second quarter.

And it’s really going to be interesting to see how things play out because I don’t really feel like the Fed is going to feel comfortable with inflation getting down towards their 2% goal anytime soon. And so the probability of the Fed cutting rates maybe is inflated because the probability of a recession in the beginning of the year or the end of the first quarter, beginning of the second quarter of 2024, is a little bit elevated.

So the rate cuts pricing in there, I would take them to mean that the U.S. is going to be in a recession and the Fed needs to cut rates. They’re not going to cut rates 25 basis points in that environment, they’re going to cut rates 200 basis points. So there’s, say, a 10% probability of a 200 basis point rate cut, and that just flows through into the probabilities as a 20 basis point rate cut.

Now, the market is also pricing in further rate cuts out the back half of the year. I think that’s much more likely for the Fed to start to fine-tune where the rate position, fine-tune that as inflation is getting a little bit more in line with where they want to see. But I think that they’re going to be very slow about that. They’ve tried to talk about higher for longer, and they’re going to try to reinforce that over time with all their Fed speak, with the press conferences that Jay Powell does, and really try to get the market to become a little bit more aware that the Fed’s not going to cut rates just because of a little bit of slowdown in the jobs or a little bit of slowdown in inflation. They need to get back to their 2% goal, and that’s their main goal, at least at this point in time.

Our outlook for fixed income is very positive, and obviously there’s been a lot of rate volatility, and that makes it a little bit, I would say, harder to manage but also more fun to manage because that means there’s more opportunities.

Taking on some credit risk today you can get in something like the fixed rate, high-yield market, low investment grade market, you can get close to a 9% yield. That’s the long-term outlook or long-term rate of return that people would expect from the U.S. stock market.

So if you can get that in high yield, if you can get that in a diversified basket of credit risk, then it makes sense to maybe allocate a little bit more to your fixed income market because you can get a larger percentage of your overall goal with a lower volatility.

Now, it’s not to say that we’re not shying away from your flight to quality, your safer securities also, but really being able to take on credit risk where it makes sense to take credit risk. We think a diversified mix of credit risk so you’re not going all in on U.S. corporate credit or emerging market debt or commercial mortgages or residential mortgages. Take a little bit on everywhere, being able to pick up opportunities across the universe really provides a good future outlook for fixed income.

When we do look at the fixed income market, our outlook definitely has an effect on how we view things. And so we’re not going all in on credit risk. We want to have a large allocation to what our boss, Jeffrey Gundlach, calls the sleep-at-night portion of the portfolio, which is typically U.S. treasuries. In something like a longer duration strategy like a Bloomberg aggregate focused strategy, we’ll buy the long bond in the U.S., the 10-year, try to get some duration from that side of things.

In a more shorter duration strategy, we’ll buy the two-year treasury. That’s not necessarily our favourite point on the curve, but it’s really providing us that dry powder for when there is the flight to quality, when there is the recession, the Fed cuts rates, the two-year will rally a lot. You can sell the two-year, that’s obviously gone up a lot, and buy some of your credit that has gone down. Spreads have widened a lot, there’s much more likely to be dislocations in the credit markets and you can really pick and choose where you want to be a little bit more opportunistic in that scenario.

And so we are kind of playing both sides of things. So we’re not all in on the Fed is going to engineer a soft landing, buying credit is okay. Also, the fact that maybe the Fed is going to, or if maybe the Fed has already tightened too much and they’re going to cause a recession, a harder landing, and you want to have treasuries in that portion of your portfolio.

So really having both of these pieces together allows us to feel comfortable, hence the sleep-at-night portion of the portfolio, and really be able to provide a higher yield than kind of the market, but also provide safety, and so you can work both sides of those scenarios.

This is what we really want to do in times like this where we’re at an inflection point where we can see the economy go either way, either the soft landing slash no landing scenario, or the hard landing scenario. We don’t know what’s going to happen, so let’s position the portfolios to take advantage of both scenarios and be able to outperform and then be able to add value in the future depending on which scenario plays out.

The future of interest rates obviously is very hard to predict, and I think that when we look at things we think that you could get, or one of the things we’re thinking about is that when we eventually get a recession, that you could get the reflexive rally in interest rates and the longer-term interest rates. As people go to their flight to quality, they want to buy the safest thing.

But then the underlying fundamentals of the U.S. treasury market are such that there’s so much supply out there, there’s more supply coming, and that no matter who is in charge, the deficit is rising. And so we think that there could be that reflexive drive down in interest rates, and then there could be the rise back up in interest rates. Even though maybe the recession isn’t over, maybe things are still getting worse, it could be that supply-demand dynamic overwhelming, or the supply side overwhelming the demand side, and you could see interest rates rise.

So we’re of the mind that you could move down, certainly not anywhere close to where we were pre-Covid or around that Covid area. We’re not going below 1% on the 10-year. I think we could get 2.5% on the 10-year, but then be aware of we’re not going to kind of stay at that 2.5%. We could go up higher from there and end up with that kind of higher for longer in long-term interest rates.

One of the things that we are worried about for the beginning of next year, beginning to middle of next year, is the probability of a recession rising. If you look at the U.S. two-year, 10-year treasury spread, that inverted in July of 2022, and usually that gives you a lead time of anywhere from 12 to 18 months to the start of a recession.

You also can look at the three-month to 10-year yield spread, that inverted in November of 2022. Similar timeframe, 12 to 18 months. So if you look at just both of those two indicators, then they would kind of point to on the longer end of things, the beginning of 2024 as the start of a recession.

Now we’re not going to look at just those two indicators by themselves and say, “Okay, we’re going to plan for a recession.” You look at something like the unemployment rate in the U.S., and it’s kind of ticked up to 3.9% off of the 3.4-3.5% lows that we’ve had earlier in the year. And really when that number starts to get above that 0.5% difference, that’s really indicative of the start of the recession.

Also, when the curve uninverts is a very good indicator of the start of a recession also. So kind of taking all these things into account, the 2-10 spread has recently been as low as a negative 17 basis points. Mid-November has widened out a little bit more. It remains to be seen whether it goes wider or more inverted or less inverted. But really, those are the indicators we’re looking at to kind of give us a clue on when a recession is going to start.

From a credit spread perspective, credit spreads are still very tight, so the market at least is not planning on a recession anytime soon. So that’s another thing to keep an eye on, whether it’s your high-yield spreads, whether those start to widen out in anticipation of recession. Those are the kind of indicators we’re looking at, but really we’re in the mindset of early to mid next year, 2024, be aware there’s that potential recession out there.

Text transcript

Samuel Lau, portfolio manager, DoubleLine.

One question that’s been on the top of mind for investors is if we are in or if we are headed for an economic recession. And to help answer this, there are a few tried and true indicators that we look at at DoubleLine that offer some insight on if the economy will enter a period of expansion or contraction in the upcoming months. And that’s typically decided in, the actual recession is actually decided in hindsight by an agency called the National Bureau of Economic Research, which is the official book of record for recessions here in the U.S.

But in terms of these indicators that we look at at DoubleLine as a signal for recession, I’ll go through and just highlight three of my favourite ones. And for the short answer for whether or not the U.S. will be entering a recession in the next 10 months is that it does seem to be on the way based on these recession indicators that I’ll go over as they’ve historically had a very good track record of preceding economic contractions. Again, here in the U.S.

So the first one I’ll take a look at is the Leading Economic Index and that is an aggregated number of economic and market variables. And this goes back, with data, back to the 1960s. The LEI, as I mentioned before, has an excellent track record when it comes to looking at proceeding recessions. And the signal there is when the year-over-year index flips negative, and we’d like to see it at least stay negative for two consecutive months before we start to consider it as a signal. But with that as a basis, the LEI has signaled eight of the last nine recessions here in the U.S., missing only that first recession that occurred just shortly after the LEI launched. If memory serves, it was two months after the LEI officially began releasing its data.

So the lead time on that has also been pretty good. It’s generally somewhere in the neighborhood of six to eight months from when it first dips into those two consecutive months of being negative to the beginning of the recession. So between six to eight months before the signal strikes and we see the recession as it’s declared by the NBER. When we take a look at it from a lag time or how much lead time it’s had at the longest part of it, it’s been 12 months. So generally, it’s pretty good from a timing signal as well when you’re talking about inside of a year having that foresight into a slowing in the U.S. economy, eventually being declared a recession. So again, thus far a very good indicator.

But what’s troubling right now is when I take a look at the Leading Economic Index, and I should have said this in the beginning, but this index is managed and aggregated by the entity called the Conference Board. But what’s troubling right now is that the LEI has been in negative territory for the last seven months or so now, and based on the last eight recessions and on this measure alone, we could either be in or very near the beginning of an economic recession in the U.S. as that indicator has already been triggered. That’s certainly within that period of between the six to eight months that I was talking about before.

One other indicator that has also been reliable over the same timeframe, again going back to the sixties, is looking at the U.S. headline unemployment rate relative to its 12-month and its 36-month moving averages. Now, the current print on the headline unemployment rate, when that breaks above the moving averages there, that triggers the recession indicator. And today, March 17th, 2023, the unemployment rate is 3.6%. And when we look at it relative to the 12-month average, the 12-month average is also 3.6%.

The 36-month moving average is 5.7. So, based on those percentages, you can see that we’re on the precipice of triggering that 12-month indicator as it just stands right on top of a 12-month average. But again, it does need to break through for us to consider the signal. But when it does trigger, this historically leads recessions by, again, six to eight months. So similar to the Leading Economic Indicator in terms of the lead time using the 12-month moving average as the indicator.

When we look at it relative to the 36-month, it looks like we still have a ways to go, the 3.6 relative to the 5.7, but as we’ve seen in the past, once the unemployment rate begins to move higher, it can move rather sharply rather quickly. And I will note that the 36-month is a slightly better indicator in terms of it doesn’t have as many false positives, but it is a coincident indicator to recession, meaning that it tends to just fall right around the same time that the recession begins.

And then lastly, I like looking at the shape of the U.S. yield curve here, the treasury yield curve to be specific, as an indicator. And there, looking at the spread between the 10-year note yield and the 3-month T-bill yield as the point on the curve. And this can be useful as it’s based on real time market data rather than the aforementioned economic data prints, which themselves can be lagged anywhere from one to two months, typically. So having the daily real time data can be useful when we’re looking at these things. When the 3-month yield exceeds that of a 10-year yield, you get a negative spread, what we call an inversion in the yield curve there, at least within those two points. And when this yield curve becomes inverted, it has preceded eight of the last eight recessions. And this indicator, when we take a look at it again, the differential between the 3-month and the 10-year yield, that indicator triggered last October. So, as far as timing goes, the average lead time here is a bit longer. It’s about one year, and it has a range of anywhere from nine to 23 months lead time.

So when I take a look at all of these together, I offer up these indicators because again, historically ,they had been good predictors over time. They’re publicly available to listeners if they want to go through and stick through some of the data. And it’s relatively straightforward indicators as well. They’re easy to put together and make adjustments as needed.

The bad news is that all three of these indicators suggest that 2023 is on the table for a possible recession. I guess the question now just remains is one of timing, but it does seem to point to somewhere in the second half of 2023, perhaps the first quarter or the first half of 2024. But the good news here is these indicators give us a little bit of foresight and that allows investors to position accordingly, which there still seems to be time for.

If we look through the markets, the different sectors of a fixed income market, we can begin with the credit markets. And today, within the credit markets, we have a preference for non-traditional fixed income sectors where you can still get high single-digit yields and in some cases, depending on where you’re investing, you can get low double-digit yields while remaining in investment-grade rated securities. So, instead of just relying on U.S. investment grade corporates, which yield around 5%, you can get a bit of the yield pickup over IG corporates here in the U.S. So for that, we like to include and look at non-traditional sectors like asset-backed securities, which are bonds backed by consumer loans, non-government guaranteed commercial, as well as residential mortgage-backed securities. And then the CLOs and merging market debt. For investors who are willing to step outside of that investment-grade arena and into the low investment grade, yields can go up quite quickly from there. But I would say that while these yields can be tantalizing to look at based on the kind of teens type of yields that you can get in some of these areas, given where we are in this economic cycle, I would caution against loading up solely on credit and your fixed income portfolios. I think today, more important than ever, is that one would need some expertise in order to underwrite these securities, understand the risk and how it integrates within the rest of the portfolio.

Now the good news is that for a compliment to credit risk today, U.S. treasury securities also have yields that we haven’t seen in years. And in some cases, depending on where you are on the curve, there are yields that we haven’t seen in excess of a decade. When you take a look at yields from the 2-month T-bill out to the 2-year treasury note, they currently deliver a yield over 4%.

So that can be quite an attractive parking spot for those who are waiting to deploy cash, both for your at-home do-it-yourselfers and investment managers alike. It’s not that we like to sit on cash, but it doesn’t hurt as much today as it did just even last year or a few years ago. But as you move out the curve, yields from, let’s say here, the 5-year treasury on out to the long bond, the 30-year bond, you can still get yields that are in the mid to high threes today. Even after the rallying that we saw earlier here around mid-March. While you do give up some income by going into treasuries and then out the curve, you do get some insurance that can provide protection against adverse moves in riskier assets. Like the aforementioned credit sectors within the fixed income market that do offer some juicier yields.

But the treasury side of the portfolio can also offset other risk assets like the equities within your portfolio. So oftentimes people ask me, would I rather own credit today for yield pickup or would I rather own treasuries for the risk trade off? And I’d like to reply with, why not both? That way if you have both of those sides in your fixed income portfolio, you have offsetting risk and return profiles inside that broader fixed income portfolio. And today, given what we just discussed about yields, you’re able to do so with relatively attractive income stream from both your credit and the treasury side of the portfolios.

For those who are looking for something that’s more in line with a vanilla Bloomberg AG like reward to risk profile, take on a little bit less credit risk, then you can still within an actively managed portfolio that’s benchmarked against the AG, you can get a portfolio that yields somewhere in the mid-fives today. So you’re getting about a percent pick-up in yield over the AG.

Text transcript

Sam Lau, portfolio manager for DoubleLine Capital.

When thinking about the Fed shift in monetary policy, we expect interest rate volatility to continue in the months ahead as the Fed potentially embarks upon a policy-tightening program that would be the most aggressive since Volcker hiked rates to battle inflation back in the late 1970s.

The catalyst for the current round of tightening is the same with consumer inflation baskets as of the last print in March 31, 2022. Those are at 40-year highs. And that spooked the Fed into pivoting towards an aggressively tighter monetary policy. And while we may be near the top in this recent round of inflationary pressure, we’re likely to remain well above the Fed’s target inflation rate of 2% on their favourite measure, the core PCE, for a number of years yet. And that’s what has the Fed worried.

What gives the Fed optimism, however, to start hiking rates and unwinding the balance sheet is the strength of the U.S. economy and its labour market. Economists forecast for real GDP in 2022 is currently just over 3% on that annual basis, which is in the upper end of the range for growth going back to the global financial crisis.

As for the labour market, practically every economic data point that’s related to the labour market suggests strength. The headline unemployment rate is at 3.6%, and that’s the second lowest print going back to the 1970s. Employee wages are higher too with the Atlanta Fed’s Wage Growth measure at its historical high going back to the late 1990s. So with this, the Fed thinks the U.S. labour market is resilient enough to support the economy as it looks to dampen consumer inflation without sending the U.S. economy into a recession.

And the Fed has offered us a glimpse into the path of hikes and quantitative tightening. And by all indications, it looks like they’re planning for a much more aggressive approach than the last Fed tightening cycle that we had back in 2015. The Fed is going old school and it looks like they will raise the target Fed funds rate by 50 basis points at the next two FOMC meetings versus the 25 basis point rate hikes that many of us have become accustomed to.

The bond market right now is pricing in the federal funds target rate of 2.75%, on the upper bound of the range by year end. And this is versus where we were at the beginning of the year at just 25 basis points, again on that upper bound. So it’s an equivalent of 250 basis points of rate hikes in the course of the next 10 months.

For context, the last Fed hiking cycle began with a 25 basis point hike in December of 2015. We had another 25 basis point hike 12 months later in December of 2016, so a full year later. And then that was followed by three quarter-point hikes in 2017 and an additional four 25 basis point rate hikes in 2018. That got us to a target rate on the upper bound of 2.5%, so less than the 2.75 that the market’s expecting today. But it took three years to get to that lower target rate in that cycle versus what the market is pricing in this time to come in at under 10 months.

So on top of this fast and furious rate hike cycle that the market is expecting, the Fed has indicated that it could reduce the balance sheet holdings at almost double the pace of the last round of the balance sheet unwind. So this time around, we’re expecting a much more aggressive rate hike cycle coupled with a potentially faster and larger unwind to the balance sheet to fight the inflation that we haven’t seen in over four decades.

So that brings up the question of whether or not the Fed can orchestrate a soft economic landing. And to do so, let’s take a look at the track record. If one were to define the soft economic landing as one where the Fed hiking policy doesn’t lead to an economic recession let’s say within six quarters after their last hike, that would be a place to start in terms of defining that soft landing.

So going back to 1971, one can see that the Fed has had nine rate hike cycles. And of those nine, seven of them eventually led to an economic recession. So the Fed has successfully avoided recession two out of nine times. So I think my answer to can the Fed achieve a soft landing is maybe, but it just doesn’t look very promising. But please don’t get me wrong here, I’m not calling for a recession in the U.S. right now. And it’s still fairly early yet. The Fed has only begun just taking those steps that typically lead to an economic recession.

But if you’re to look at these charts for the data that I’ve been referencing, if you look at those charts under a microscope, you’ll see that recessions generally don’t occur during the actual Fed rate hikes. It actually doesn’t incur until the Fed reverses course and begins to cut rates. And that’s on the back of them realizing that the economy can no longer absorb those higher rates. But what I am saying is that perhaps recession should be in the back of your mind for those of you investors as you consider your portfolio allocations and assess how they may perform in a slowing economy.

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.

Text transcript

Samuel Lau, I’m a portfolio manager at DoubleLine Capital.

Today, I’ll be discussing one of the big debates that market participants are struggling with, and that’s whether the recent inflationary trends we’ve had, whether or not they’re transitory or if they’re going to be persistent. This debate comes as the U.S. has recently seen its fifth consecutive year-over-year CPI print in excess of 5%. You can compare that 5% level to the 20-year average of really around 2% year over year. It’s been quite a bit of a pickup since the pandemic, but this fifth consecutive print, it hardly strikes me as transitory. And, perhaps even the Fed is starting to take notice as Jerome Powell changed his tone at his most recent post FOMC press conference, where he did note that factors such as supply chain disruptions, which impact the cost of goods, may be present longer than he had previously thought. One area that I continued to look at, to get some information, is the shelter component within the CPI basket for clues as really, it is the largest part of the headline CPI basket, it comprises roughly one third of the total basket there. And with that, we can also get a sense of where shelter inflation is going based on existing economic data. So, shelter in itself in the last print was up over 3% year over year. And more importantly, that rate has been steadily increasing since the depths of the pandemic-led recession. This shelter component is primarily made up of two categories. The first category is rent of primary residence or simply put it’s, how much do you pay if you’re a renter? And then the second component of shelter is known as owner’s equivalent rent. And that’s, essentially, a proxy of how much a homeowner would pay to rent the house that they currently own.

So it’s computed rent based on home ownership. So the shelter component is important in determining future inflation. Number one, because of its heavy weight in the CPI basket, but also because we can get a pretty good sense of where it’s headed. And that’s because historically, we’ve seen a strong relationship between shelter within CPI in the path of home price appreciation on the lag basis of around 12 to 18 months. That’s another way of saying that home price appreciation has been a pretty good predictor of future shelter inflation. And we know with certainty that home prices have already increased significantly since the beginning of the pandemic. And in fact, U.S. home prices are one of the few, if not only economic measures that never dipped negative during the course of the pandemic in 2020. A large contributor to that positive growth that we’ve seen in housing over this period of time is the lack of available units for sale.

The number of existing homes available for sale continued to decline throughout 2020 until it hit its lowest point on record in January 2021, at just over one million homes on the market today. So there’s been a dearth of supply relative to the amount of demand. So today when we look at it for the most recent data point through September, it’s up by about 300,000 units. So it’s just shy of 1.3 million units total available for sale. So it’s a little bit higher, but we’re still well near historical low inventory here in the U.S. So on top of that, you had the backdrop of bull mortgage rates that had come about based on accommodative monetary policy. So the cost of buying a home is somewhat low if you need to finance it. You also have factors like the work from home or hybrid environment, which has really opened up new possibilities of working from a new home in an entirely different city. The last 18 months or so have been on fire for the housing market.

Now with that said the one home price appreciation index is the S&P/Case-Shiller U.S. home price index. And that’s seen double digit year-over-year growth each month since December of last year. That most recent print was just shy of 20% year over year. And that makes it the highest year-over-year growth for that index on record. One of the things that we’ve looked at recently as well, and it was nice to see the confirmation on some of the work that we’ve been doing on our own is that researchers at the Dallas Fed, the Dallas Federal Reserve, to be more specific, have done some work around this need lag between shelter inflation and home price appreciation very recently. And based on this massive run up in home prices, those researchers at the Dallas Fed forecasted that shelter inflation will really begin to accelerate at some point beginning in 2022, and then ultimately reach a 7-8% year over year increase in both the rent and owner’s equivalent rent components by the time we reach December 2023.

Other items that could be driving up costs are rising input costs due to the higher commodity prices that we’ve seen across the commodity complex from the industrial metals to energy based products. Now that we’re heading into the winter season, they’ll become more important as we need to heat our homes, especially in the Northern states here in U.S., as well as in Canada. We’ve also seen it in food prices as well. And don’t forget we had the complexity of the supply chain issues that we’ve all read about in the past few months, the shipping delays, the lack of inventory. But based on these aforementioned reasons, I think that these elevated levels of inflation will likely be with us at least through year-end of 2022.

Text transcript

Samuel Lau, I’m a portfolio manager at DoubleLine Capital.

So as investors, we all know that yield matters. And in today’s challenging environment, it could be more difficult to find the right type of yield. And by right type of yield I’m talking about making sure that you’re getting compensated in exchange for the amount of risk that you’re taking. So in fixed income, there are really two primary risks to consider in any investment. The first is credit risk and the second is interest rate risk. And of these two risks, I believe that credit risk is the more benign, at this point in time. As we’re still in the midst of an economic recovery, which should be supportive to credit risk in general.

Additionally, the past 18 months or so since the depths of the pandemic has been marked by a series of accommodative fiscal, monetary, as well as credit conditions. And that all has allowed companies to recapitalize their balance sheets, leaving most of these companies in stronger credit positions as they’ve had a chance to refinance a lot of their existing debt into longer maturities at much lower yields they were held at previously. With that we’re seeing consumer debt vehicles are also seeing relatively low delinquency rates, as well as defaults over this period of time.

However, it seems that this series of accommodative policy also comes at a cost, and we’re seeing some of those symptoms today with the backdrop of rising rates due to the amount of increased debt that was needed to fund some of these stimulus programs. Ultimately leading to the higher demand from consumers and businesses on the back of that a higher supply of debt. We’ve seen higher rates, but also a little bit of signs of elevated levels of inflation. We may be entering a period of rising interest rates, and that’s a good as well as a bad thing. It’s good because higher rates means higher income. We could all use a little bit more of that, but it’s also bad because yields and bond prices move inversely to one another.

Rates moving up means prices moving down, which can be a drag on your overall return from your fixed income portfolio. Today I would say that between rate and credit risk, I see interest rate risk as being the bigger risk over the next few quarters. Managing the duration of your fixed income portfolio is really going to be critical when you’re seeking to earn income as an objective. The question leads us to where we can find good risk-adjusted yield in today’s market. And to start, I would not look to the Bloomberg U.S. Bond Aggregate where you get a yield of 1.6% while taking on almost seven years of interest rate risk. The highest yielding component in Bloomberg GAG is the U.S. investment grade corporate credit index. And that gets you roughly 60 basis points, more yield than the overall Bloomberg Aggregate.

The IG corporate credit index gets you a 2.2% yield to maturity as of month-end September 30th. And those yields come with a relatively high level of duration. It’s not a very attractive reward to risk setup that we have there. And we’ve seen as a result of that thus far this year with the low to negative returns that we’ve had on the Barclays, I guess, as the treasury yields have risen over the course of 2021. So not a very attractive proposition for those who are seeking to capture income. And instead at DoubleLine, we choose to look outside of these traditional sectors of the fixed income market, outside of treasuries, outside of agency mortgage-backed securities, and outside of investment-grade corporate credit and step out into what we call the non-traditional sectors when looking to deliver yield as an objective. For example, today, investors can look at the areas that we’re participating in. We look to the investment-grade, ABS market, ABS stands for Asset-backed securities, and those generally offer a 1% pickup in yield over IG corporate credit. We’re looking at a yield of maturity of around 3.3% or so, currently. And also, if you want to stay investment grade, you can go down to triple-B CLOs and triple-B CMBS indices. Those have yields of well over 4% today on the yield of maturity basis, and they’re still investment grade. Of course, you can go a little bit lower there as well, as long as you’re able to do your credit work and dip into the below investment grade in those spaces there and get even more attractive yields. As long as again, the key is making sure that you’re getting paid for the risk that you’re taking.

And if you can take some international exposure within your portfolios, if the guidance allows there, then you’ll also find yields in excess of 4% in parts of the Emerging Market Debt. And again, if you can go into it, the opportunities have really opened up there, but if you look at the corporate credit side, USI yields can get you to a yield over the 4% mark, bank loans get you pretty close. They have a yield of just over three and a half percent, somewhere around 3.7%, let’s call it. But those are attractive, especially given it’s a low duration profile based on its floating rate nature. And then, of course, you can find attractive yields in below-investment-grade rated securities in other areas of securitized credit. So anything in the aforementioned CLOs and CMBS, but also more non-agency. Those are the non-government guaranteed mortgage-backed securities, as well as other areas of AVS. But again, we particularly like CLO in bank loans today because they are floating rate. If the short end of the curve starts to move up, then these should benefit from and participate in that in a positive way.