Bond Market Liquidity
Bond market liquidity was historically high before the credit crisis in 2008. But massive dealer positions and excessive risk-taking from leveraged dealer balance sheets have systematically been reduced due to increased regulation, including limitations imposed by Dodd-Frank legislation. Limitations have further reduced dealer inventory size and proprietary trading as banks are required to have higher capital ratios and better leverage standards. As a result, market depth and liquidity have fallen. So what does this mean for investors?
Why Active Fixed Income ETFs
Most investors recognize exchange-traded funds (ETFs) as passive, index-based investments that give broad exposure to markets. Often times these vehicles are low cost, highly liquid products that tend to have diversification benefits and serve as benchmarks for performance and market sentiment. But sometimes overlooked is the construction of the underlying indices themselves and whether or not active management can provide a superior solution.
As investors have poured capital into passive ETFs that seek to replicate an index it is more important than ever to understand index construction issues. Index construction issues include weighting methodology, maintenance rules and inclusion criteria which are the cornerstone of ex-ante standard deviation, returns and correlations. Passive, index-based ETFs tend to have broad inclusion criteria giving investors greater exposure to different types of securities, but may also exhibit investability concerns. For example, an emerging markets index may contain issues by companies domiciled in countries as wealthy as Qatar and Singapore and issues by countries as poor as Guatemala and Bangladesh. This passive investment approach to EM debt, sovereign or corporate, can be fraught with heterogeneous risk exposures as dictated by that index.
ETFs have garnered great success in equity markets as investors held over $1.1 trillion under management at the end of 2014. However, the misapplication of equity investing principles to bond investing has the potential to lower expected future returns, specifically when it comes to index investing by market capitalization. The market capitalization weighting methodology in fixed income could potentially lead to an adverse-selection process in that the investor can wind up being over-concentrated to the most indebted companies. Active management can potentially alleviate what is commonly referred to as the “bum’s problem,” where a market cap-weighted bond index will end up giving a heavier weight to the biggest debtors.
Some concerns regarding active ETF investing, which include believers of the efficient market hypothesis, are market risk and loss of principal given the passive beta exposure. The efficient market hypotheses, which assume stocks trade at fair value, has been difficult to refute when investing in the equity markets, but the same cannot be said for similar conclusions in fixed income investing. Active fixed income managers have been able to persistently outperform their respective indices. In fact, 85% of managers in the Intermediate-Term Bond category have beaten the benchmark (Barclays U.S. Aggregate Bond Index) over the past three years ending October 31, 2014, as seen in the table below.
Some of the primary benefits surrounding actively managed ETFs include the liquidity, visibility and tax efficiency of the vehicles. For instance, the “in kind” transaction in the creation/ redemption process of ETFs, in which shares are traded instead of cash, provides investors with the ability to gain fast, cost efficient exposure to an ETF’s underlying securities. Also, the ability to create and redeem shares to meet market demand helps keep ETF share prices in line with their net asset values (NAVs). Because investors are not affected by other shareholder redemptions, the creation/redemption process may also improve overall tax efficiency.
Source: Morningstar, Fidelity Investments.
Data as of October 31, 2014, using all share classes for all actively managed mutual funds within each category that cite the listed benchmark as their primary prospectus benchmark. Listed benchmark is the most commonly cited for each category. May include some degree of survivorship bias, in that closed and merged funds existing for partial periods are not included. Past performance is no guarantee of future results. All indices are unmanaged. It is not possible to invest directly in an index.
DoubleLine Infrastructure Debt Strategy
Infrastructure debt is a unique component of the credit market that provides essential financing to strategic sectors of the economy. These sectors include, but are not limited to, airports, toll roads, bridges, power, and pipelines.
The infrastructure debt universe also provides excellent diversification benefits outside of traditional fixed income sectors while offering incremental yield and strong defensive attributes. As such, infrastructure investment is an important cornerstone of economic growth, particularly as urbanization and industrialization continue to expand in developing economies.
As infrastructure growth continues to expand, so does the need for financing. According to a recent study from McKinsey Global Institute, approximately $57 trillion of additional infrastructure funding will be needed by 2030.1 However, due to regulatory constraints and rigorous liquidity requirements placed on financial institutions including Basel III limitations, this financing will need to come from a different type of institution. DoubleLine believes this paradigm shift may present a compelling opportunity for investors.
The DoubleLine infrastructure team, which currently manages over $1 billion in infrastructure assets across several DoubleLine investment strategies, plans to take advantage of this growing segment of the market through the DoubleLine Global Infrastructure Debt Strategy. With over 17 years of experience, the team combines a unique skill set in structured products and emerging market research with expertise and knowledge of country and political risks. The strategy utilizes a time-tested five step process by combining bottom-up research with macroeconomic overlays to invest across the capital structure. While maintaining a focus on sectors that are strategic to an economy in order to limit downside risk, the strategy provides investors with income and an absolute return. Furthermore, because the team is already invested in the sector, they should continue to have access to strong sourcing deals and favorable structuring terms.
Source: World Economic Forum, "Infrastructure Investment Policy Blueprint", February 2014.
1. McKinsey Global Institute: "How to Save $1 Trillion a Year"
DoubleLine Video & Articles
Jeffrey Gundlach - DoubleLine Overview
Fixed Income Asset Allocation
Global Developed Credit - Floating Rate
Low Duration Emerging Markets
Mortgage-Backed Securities - Total Return
Shiller Enhanced CAPE®
Articles & Video about DoubleLine
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1-27-15 CNBC Jeffrey Gundlach discusses the markets Click here to view video
8-15-14 CNBC "DoubleLine's Gundlach: Could see U.S. 10-year yields go to 2.2%"
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02-12-14 "Gundlach: QE will not end in 2014"
02-12-14 "Gundlach: Market has discounted tapering" http://video.cnbc.com/gallery/?video=3000245506
4-9-14 The Street "Bank Loans vs. High Yield"
04-14-14 "Housing Finance Reform"
Information presented was current as of the date the material was prepared by an outside party. DoubleLine assumes no duty to update this information.
Thursday, September 11, 2014 at 1:15 pm PT / 4:15 pm ET
"Opportunistic CMBS/CRE Strategy Launch"
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