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Thinking About Bonds and Benchmarks

With interest rates at record lows and relatively rich fixed income valuations across many sectors the bond market is becoming an increasingly tricky place to navigate.  As a result I find myself researching new ways to squeeze returns out of this segment of the market on a near daily basis.  Increasingly, I feel like I am squeezing blood from stones.

One place where that blood is becoming increasingly difficult to squeeze is in the mortgage backed securities market which has been a wonderful place to be in fixed income for the last 7 years.  In essence, if you understood that the default risk of the US government was low (something that I’ve been harping on for years) then the agency MBS space looked like a pretty attractive relative income source. You were essentially buying high yield bonds with a government guarantee.  This is no longer the case and the MBS market is starting to look a lot more like the rest of the low yielding bond market.

Yesterday, I was researching a bunch of mortgage backed securities funds that I hadn’t looked at in a while and I mentioned on Twitter that they all appear benchmarked in a rather misleading way.  That is, many funds like the TCW Total Return, DoubleLine Total Return and Western Asset Mortgage Backed Securities are benchmarked to the Barclays US Bond Aggregate, but they actually operate a lot more like the bond aggregate with a lower credit quality tilt.  For instance, on a 5 year basis the R-Squared of each fund relative to the Barclays agg is 53.5, 66.34 and 20.67.  So, not exactly apples to apples.  The credit quality is certainly lower in these funds, but that doesn’t necessarily mean the portfolios are riskier because a lot of the low rated bonds are just legacy MBS that was downgraded following the crisis.  Still, these funds should not be confused with the aggregate bond market.  They are basically versions of a factor tilt.

This is important when you’re looking for attractive fixed income opportunities because many of these active fund managers are charging upwards of 1% for a fund that isn’t likely to return more than 2.5-4% in the coming years.  So, if you can replicate the fund’s returns through an available low fee alternative then that’s something you’d be silly not to do.  As I’ll describe below, that’s easier said than done in this space.

I see this a lot in various segments of the financial markets and many investors have no idea how much the high fees are detracting from their returns.  For instance, your average “Large Cap Growth” mutual fund is just an S&P 500 fund with a beta tilt and a high fee.  You’ll get 90%+ of the correlation to the S&P (and likely a close return over an entire market cycle), but rather than getting the 10% return you’ll get something like 9% (less after taxes).  Closet indexing is a huge problem in the mutual fund space and investors are slowly coming around to this reality.

The fixed income space is more interesting though because segments like the MBS market  don’t really have good publicly available index alternatives.  The funds mentioned above are all essentially some version of the same agency mortgage debt market (with a non-agency tilt) but the only way to replicate that market right now is to buy an active fund that has access to those markets.  This is a big part of what has made Jeff Gundlach so famous.  He essentially recognized that agency MBS was a higher yielding government bond and that you could tilt this into non-agency MBS or corporates at times and create a really dynamic return.  He was light years ahead of the market in recognizing this and creating what is one of the only publicly available access points to that niche.  But part of me is wondering if even a bond guru like Gundlach is starting to feel like there’s no more blood in these stones.

Although I’ve been bullish about bonds for a long time now I think we’ve reached a point in the bond bull market where the risk/return dynamics are really starting to shift in a dramatic way.   Everything in the fixed income markets is either richly valued or starting to look like cash with a small yield.  And this is putting a lot of pressure on fees and tax efficiency. Squeezing blood from these stones is getting harder by the day.  It doesn’t necessarily mean you shouldn’t own bonds, but it does mean that you should have very different expectations about the future returns on bonds and you should be more concerned about taxes and fees than ever.  As I’ve been repeating all too often here, the next 10 years are likely to be among the most challenging that investors have seen in a good while.

Disclosure – I am and have been an owner of all three of the above funds at times during the last decade.