Breaking Down the U.S. Bond Market

Related article

This interview took place on May 12.

Text transcript

Ignacio Sosa, director of international relationship management at DoubleLine Capital in Los Angeles, Calif.

How has COVID-19 impacted bond investors? Well, the answer is that it’s impacted everybody in almost every way imaginable. In the case of bonds, it’s a tale of two cities, if you will. There are bonds that have performed extremely well and bonds that have not done so well. And the ones that have done the best I would say are of course, the one with the least amount of risk, which is anything either guaranteed explicitly by the American government, like treasury bills and certain mortgages, or have an implicit guarantee of the American government, which also includes what we call agency mortgages. So these have done very well and are generally up, in some cases quite a bit year to date, because rates are falling, so dramatically, and since they don’t really have credit risk, you benefit from the fact that rates have fallen.

Then you go into another universe of bonds, which have done less well, but have done relatively well, and those are bonds that the Federal Reserve and the Treasury of the United States have signalled that they would like to support. And these are for example, investment-grade bonds. On April 9th of 2020, the government announced that it would be setting up a special purpose vehicle to buy investment-grade and high-yield ETFs, Exchange-traded funds, as well as bonds. And that caused a massive rally in the prices of those assets. It did not cause a massive rally in the prices of assets like securitized credit, which were not included. Fast forward to May and on May 12th, the government announced the first step in this process of buying investment grade and high-yield ETFs and bonds, and they’re starting off with the purchase of investment grade ETFs. This I’m sure will move to investment grade bonds, and also to high-yield ETFs, and high-yield bonds.

But the high tick for these asset prices was actually the day they were announced, the program was announced, which was April 9th. At this point, the market’s already priced this in. Many in the market think that the buying of these investment grade and high yield bonds somehow means that they’re less risky than they were before. The fact is that there more risky than they have been because of what has happened to the American economy.

And then you have a whole universe of debt that has not been supported by the American government in any shape or form. This generally falls into the category of securitized debt. So for example, non-government guaranteed residential mortgages, non-government guaranteed commercial mortgages. Asset backed securities, for example, those that have credit cards that backs them up, or airplane leases, collateralized loan obligations, have not been included in these facilities either. And so these assets which have not been supported by the government in some shape or form have performed the least. Now, ironically, if I bifurcate the credit market into those that are supported by the government and those that are not supported by the government, those that are not supported by the government, in other words, all securitized credit, or most of it, is frankly the most attractive, because their prices actually reflect the uncertainty that we all have to live under and in many cases, these securities have been priced in such a way that they are signaling dire scenarios which we don’t see.

Probably the most important thing that we’ve done is really take a look at what we own, whether it’s corporate debt or securitized credit, and make sure that we are comfortable that the cash flows associated with these assets will continue, even if we have a very substantial downturn of the economy. And by very substantial downturn, we think that it will be worse than what people expect. For example, the unemployment rate today is roughly around 14%. We think this underestimates the amount of people who are really either underemployed, or all practical purposes are unemployed but they don’t show up in unemployed. That number’s probably around 21%. So when you start assuming that that’s really the unemployment rate, that the unemployment rate is 21%, and that the GDP level is worse than what the market is expecting, I think you have a pretty good idea of how your fixed income portfolios will perform. So I think in cases where we conduct stress tests and the underlying asset doesn’t perform well, in these kind of dire scenarios, we try to get rid of them, and replace them with securities that will do better.