Pondering Fixed Income in 2013

• I recently had a chance to speak with Loomis Sayles’ Matthew Eagan who is co-manager of the famous Loomis Sayles Bond Fund led by Dan Fuss. We covered a number of topics ranging from the Fed, Europe, High Yield, Hedging Tail Risk, and many others.  You won’t want to miss it as he’s a very bright PM.  It should be posted Wednesday or Thursday on the CFA’s Inside Investor blog found here.
• I was honored to participate in Reuters 2013 Investment Summit last week in New York.  In Katya Wachtel’s article titled “Chasing yield, investors favor credit again in 2013” I join in the conversation.  Chasing yield is no doubt a continuing theme heading into 2013 as institutional investors far and wide are finding a diminishing set of opportunities available.  You are starting to see non-agency MBS become almost “too popular” as every HF is suddenly an expert!  Everyone thinks its a great play on a housing recover and an “easy way” to earn 4-6% returns.  The low hanging fruit has been picked!  Funds such as DoubleLine, Ellington, and Elliot have apparently moved more towards CMBS & CLOs versus incremental non-agency investments.
• Heading into next year, I’d have to think that the majority of the run in high yield is over.  HY spreads and yields are down 111bps and 131bps respectively.  Defaults, which have run under 2% (and likely will next year too) really have no room to improve.  At the same time you have very positive factors supporting the market.  The boom has caused a flood of refinancings, thus debt maturing in the next few years has been dramatically reduced.  HY becomes negatively convex as prices rise, so I anticipate little price appreciation, but rather just the “clipping of coupons” for investors which isn’t a terrible thing.
• I’d prefer leveraged loans to HY:  According to JPM, high yield absolute yields less leveraged loan yields are at only 57bps as of mid-November.  Traditionally this spread is a fair degree higher given that loans are higher in the capital structure.  As concern about interest rate risk grows, I think the retail sponsorship of leveraged loans will continue to grow as investors seek floating rate alternatives; and LL’s provide that.  This along with growing CLO demand could boost LL’s next year.  The average investor can gain exposure to LL’s through various mutual funds or a closed end fund such as $VTA.
• UST Rate Explosion Unlikely:  Sure UST rates could rise. Or they could fall. My prediction for 2013 is that it’s unlikely we see a dramatic rise in UST yields.  Overall, there is still a dramatic lack of risk in the financial system.  Everyone’s waiting for the next crisis, and in my opinion, that’s not what bubbles look like.  While base money continues to explode through the Fed’s QE programs, broad money supply has been kept in check through a lack of bank lending.  More or less, the money multiplier is negative at the margin.  I find it unlikely we see a large rise in yields without a strong lending led recovery.
• Agency Derivatives:   Yes, this sounds like somewhat of an obscure asset class but that’s a good thing.  The natural pool of buyers for securities such as IO’s, Inverse IO’s, etc is small and as a result option adjusted spreads are extremely attractive.  You really can’t buy these on your own, but you can get exposure through closed end funds such as $DBL and $PDI.  
• Mortgage REITs:   No way I was getting through this post without mentioning mortgage REITs.  I mentioned at the Reuters summit that I thought mREITs (particularly pure GSE mREITs) would be poor investments going forward.  Leveraging a bond that yields 1.5%-2% (same bonds the Fed is buying via QE) over 8x is not a great business proposition.  As the Fed keeps their foot down via QE-infinity, prepayments will continue to accelerate causing margin pressures at the mREITs.  At the same time prepayments accelerate, they will be forced to redeploy this cash back into lower yielding bonds.  This is a bad formula and dividends will be cut more than investors realize.  I can’t tell you when, but you’ll see names like AGNC, NLY and others trade a lot lower next year.  If you remember, I was actually a HUGE mREIT bull last year into the first half of 2012.  Here was my post on Two Harbors written last July.  The massive price appreciation in Agency MBS fueled large gains in mREITs, but I think this party is largely over.  MBS prices may tread water, but margins are in trouble and that equals lower dividends and subsequently lower share prices.