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Ignacio Sosa. I’m the director of international relationship management at DoubleLine Capital in Los Angeles, California.
In terms of corporate bonds, our view is that this is, perhaps, one of the sectors of the fixed income market where investors really need to be careful. There’s been an enormous amount of issuance of corporate bonds since the financial crisis. Approximately half of the investment-grade index of corporate bonds is at the lower credit rating spectrum. So if we have any sort of slowing down of the economy, which could lead to further credit downgrades, you’re talking about a large number of corporate issues potentially being downgraded to below investment grade.
So if we were to look at the corporate bond market overall, we’re very cautious of it. We think it contains some potential landmines. I wouldn’t say that we are focused on a particular sector or region or industry. I would just say that we’re looking for companies, overall, that have strong balance sheets, that have relatively moderate levels of leverage, and good cash flow. Things that would not likely lead to a downgrade if we have a slower economy. And we think the likelihood of a slower economy, certainly next year and beyond, is a real possibility. All risk schedules have done very well this year, 2019, because the Federal Reserve has done an about-face and announced, basically, that their hiking cycle is pretty close to over. There’s also a strong likelihood that running off the federal balance sheet is probably coming to an end, what’s called quantitative tightening.
All the things I’ve previously mentioned have helped support corporate bonds, but in fact, all these things have also helped support all risk assets. Many investors often think of corporate bonds as the only way that one can get exposure to credit assets, but in fact, there are many other asset classes that have embedded in them credit risk and, in many cases, provide better potential return. One of the things about the investment-grade corporate bond market, in particular, is that they’re highly sensitive to changes in interest rates. So if interest rates were to rise from the current variable level, corporate bonds will likely be hurt. Since the spread over Treasury, the difference between the yield and the corresponding Treasury, is relatively tight, there’s not a lot of cushion there to absorb a higher rate. So this is one of the more important aspects of investing in corporate bonds, in addition to analyzing corporate investment risk.
DoubleLine Capital has been managing the flexible yield strategy in a pretty consistent way almost since its inception. We have tried to maximize yield from a diversified portfolio of different types of asset classes with little to no investment-grade corporate risk, but including emerging market debt in dollars from high-yield bonds, from loans, securitized credit. We’ve done all of this while maintaining a relatively low sensitivity to interest rate. So when you look at the source of the yield for the strategy, we’re really not dependent on corporate bonds to deliver that yield.
Going back to the yield of the flexible yield strategy, again, like I said, we try to keep our sensitivity to interest rates, also known as duration, at a relatively low level. We’ve tried to have the yield of the strategy be higher than that duration, because there’s really no better protection against rising rates than having an attractive yield. So the strategy performed well in different markets. It performed well in 2018. It performed well, so far, in 2019, and frankly, these were two completely different markets.
So if we look at the flexible yield strategy so far in 2019, yes, it’s clear that there has been a pause in the Federal Reserve hiking cycle, and it’s clear, also, that that is moving to reduce what we would call quantitative tightening. At least, this is what Fed Chairman Powell has indicated. So this has led to what I would characterize as a bull market in risk assets, and the riskier the asset, the better it’s done, whether it’s stocks or even high-risk business fixed income.
So when it comes to the flexible yield portfolio, our view is really to stay the course. Again, we have an 18- to 24-month horizon. We don’t manage for the next month. We look out a little bit further. But even then, if I look out today, I mean, some of the things that we liked a few months ago, we’ll continue to like. So emerging market denominated bonds, denominated dollars are, in our view, much more attractive than investment-grade corporate bonds in the developed world that have similar durations.
We continue to prefer securitized assets over corporate bonds, in general. We have a relatively modest allocation to high yield, which I think will do OK, as long as there isn’t a recession. But again, going back to investment-grade corporate, the spread over Treasuries is very low, and the sensitivity to interest rates is very high. This does not make a convincing case, for us, to focus on these sectors. So we prefer not to have investment-grade corporate for the time being.
If we look at the 10-year Treasury, it’s kind of range bound. I would say, at this point, it’s been trading within a very tight range this year. So I don’t see any reason to change our portfolio at this moment, and I would characterize this as being somewhat neutral. Of course, the lower we go in that range, the less, shall we say, bullish we are in fixed income and the higher, I think, the more attractive the fixed income markets are within that tight range. The whole range overall, I would say, is something that we view as neutral.