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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.

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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.

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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.

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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.

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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.

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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.

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Samuel Lau, DoubleLine Capital, portfolio manager.

So, the current environment that we are in is a difficult one, and that’s a low-yielding fixed-income environment. So, while it’s difficult for fixed-income investors, what makes it even more challenging is the fact that we are not only in a low-yielding world, but we’re also in one where at DoubleLine we’re projecting a trend of higher rates. So, that’s kind of where we’re at today.

We all know that bond prices and interest rates move inversely to one another. So, when we start off with a lower yield, you have less income to protect your portfolio from changes in interest rates.

So, we think that the key to navigating the fixed-income market for the remainder of 2021 and likely beyond will be properly managing your interest-rate risk within your bond portfolio.

Now, with that said, we do have tailwinds in the fixed-income market. Beyond just struggling with the low yields, we do have a recovering economic environment, which is generally supportive of credit.

So, in this environment I favour sectors with minimal rate risk that can still provide attractive income. So, my preference today is for areas of non-traditional credit. And these are areas that you can still find relatively attractive yields, and in some cases you can still find yields above 4% while still remaining investment-grade rated.

And by non-traditional sectors, I’ll qualify that by saying that I mean those sectors that aren’t found within the Barclays Aggregate. So, the ones that aren’t Treasuries, the ones that aren’t sovereign bonds, the ones that aren’t agency-mortgage-backed-securities and the ones that are not investment-grade corporate credit. So, all the other areas are the ones that I’m referring to as non-traditional assets. And those are the assets in fixed income that are harder to access for the average investor, and in many cases even it’s hard to access for the professional investors to source as well.

So, some of these areas are what we refer to as securitized or structured credit. If you think about non-agency residential mortgage-backed securities, commercial mortgage-backed securities. Areas of asset-backed securities are a little bit more esoteric, so not your traditional credit card ABS or a car ABS but some of the other things that might be backed by infrastructure type assets or transportation type assets — things that are a little bit more difficult and less trafficked again for the common investor.

And then finally within that securitized structured credit cohort, we also like CLOs or collateralized loan obligations. And part of the reason why we like this is the yield-to-duration profiles in these sectors are relatively attractive. Taking a step back to define the yield-to-duration as a metric we look at, at DoubleLine — that indicates how much income you receive relative to how much interest-rate risk you take on. So, the higher the ratio, the better when thinking about rate risk.

Keep in mind that you do need to be mindful of the credit risk that these assets bring. And in markets where many of the industries have run up significantly in price, you need to be able to shake out those mispriced assets that still have good value in them and separate those from the ones that are grossly overpriced.

On top of that, we do think it’s OK to own a little bit of high yield and bank loans in a well-diversified portfolio, as well as other areas of below investment-grade credit, again, with the right security selection and team managing the portfolio.

But there’s also other areas that are outside of the U.S. — parts of the EM world, you’re also seeing attractive yields in the EM sovereign market.

So, if your primary objective is to generate income and you’re able to hold on to your fixed-income positions without getting nervous and selling at the wrong time, then I would lean to portfolios and managers that have experience in running diversified portfolios that do include these non-traditional assets. That way, you can pick up some income; you can also manage your interest-rate risk, as most of these credit-sensitive sectors of the market do have less interest-rate risk and should do better in a rising-rate environment, all else equal.

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Samuel Lau, DoubleLine Capital, portfolio manager.

Rates have certainly been on the march higher since the pandemic and really since last August. And when I’m looking at the screen today, I see that the 10-year Treasury yield is right around 155 basis points. So, all in all, since the depths of the pandemic, we’ve seen the 10-year Treasury move higher by about a hundred basis points, let’s say. What that means is negative bond performance for our traditional fixed-income portfolios during that period. And in looking at the drivers of that move higher in rates, I would look first to the strength of the economic recovery here in the U.S., as the path of Treasury yields and economic growth usually trend in the same direction, particularly when we go into or are coming out of a recession, which is where we’re at today.

Now, on the nominal basis, GDP is above its previous high. We have now exceeded the pre-pandemic highs. And it’s a similar type of view when we’re looking at real GDP, which is adjusted by inflation. But either way, it still has been a fast recovery when looking at GDP alone. Real GDP is still about a percent under its previous high, but either way, it just does seem like a very sharp recovery here in the U.S. on the economic activity standpoint.

So, in terms of our forward expectations for 2021 GDP, economists at the start of this year were forecasting a 4% real GDP for the U.S. in 2021, but that outlook has since increased to six and a quarter percent. So, the expectations for economic activity are on the rise as we get more and more data sets that come in.

And thus, we think that interest rates will continue to rise on that — particularly using the 10-year Treasury nominal yield as an indicator there.

So, while the economic recovery has been strong, it wasn’t organic. We have to think back to all the massive debt that was used to get us here. The budget deficit today stands at 19% of GDP versus where it was at pre-pandemic at 5%. So that’s a record level. And just for context, the previous record for deficit to GDP was set back in 2010 during the global financial crisis where it reached 10%, so we’re significantly higher than the previous highs.

So, what that means is an increase of supply of Treasurys, and that increasing supply pressures yields higher as well.

So, on top of that, the debt that was used to fund cheques directly into the U.S consumer pockets was part of the rationale for that debt. So, having the increased cheques going directly in the consumer’s pockets has served to fuel inflation expectations.

So, when we’re thinking about the nominal trader yield and how it rolls a hundred basis points over this period, partly on the economic recovery, but when we dis-aggregate the nominal yield into various components, we can derive what’s called a breakeven rate. And that’s the differential between the nominal yield and the TIPS yield, which is a proxy for what we call real yields. So, this breakeven rate, the differential again between nominal yields and TIPS yields, is the market’s expectations for annualized inflation. This rate has been also on the rise and has probably been the driver of the move higher in nominal yields.

We’re also seeing indications of expectations for inflation to increase based on consumer searches within the Google search engine.

So, consumers are worried about inflation, and this can be a self-fulfilling prophecy as well, because if people think prices are going to be higher in the future, then they’re more likely to start looking to buy today, which would front load demand forward.

I think when we’re thinking about inflation expectations are on the rise, we can look to the extraordinary policies that have been undertaken both by monetary authorities as well as fiscal authorities. And if we’re just focused solely on the U.S., then you’d see that we’ve already allocated over six trillion dollars in fiscal spending toward battling this pandemic over the last year or so. And then we also have an additional four trillion of spending currently being proposed. So, to put this in perspective, the U.S spent under two trillion dollars during the GFC.

So, all of this money that was spent first to support the economy is now transitioning into efforts to stimulate the economy from here. And this has the real potential to be inflationary — that’s not just transitory, as the Fed likes to think. It’s kind of like letting the genie out of the bottle. You don’t really know what you’re going to get until it’s too late.

So, in thinking about the rest of 2021, I think that we do end the year higher on the 10-year Treasury yield. And I wouldn’t be surprised at all if we get close to or even touch 2%.

But that trend up is not going to be a straight path. We will take some detours along the way. While the U.S has shown significant progress in reopening, we could stumble along the way as we continue to navigate our way through this economic recovery and reopening, while simultaneously managing the impact of the pandemic.

So, in addition to the U.S., we of course need to see improvements in the rest of world, which has been very uneven thus far. So, there are going to be ups and downs, but I think the intermediate-term trend is for higher rates on nominal Treasury yields.