DoubleLine's Deputy CIO Jeffrey Sherman is managing bond portfolios defensively in an environment of heavy spending on artificial intelligence and potential for higher interest rates. By Amey Stone

Jeffrey Sherman, deputy chief investment officer at bond shop DoubleLine, thinks the U.S. economy and markets look solid through this summer, but he is more cautious after that. He sees excesses building in capital spending related to artificial intelligence and thinks inflation may not be tamed, particularly if hostilities in Iran resume and oil prices turn higher.

Sherman, a member of DoubleLine's fixed-income and global asset allocation committees, is managing portfolios that aim to earn extra yield over Treasuries without taking on too much risk. Barron's spoke with him on June 23 about his strategies: diversifying across fixed-income asset classes including mortgage-backed and asset-backed securities, and largely avoiding higher-risk and longer-term bonds. An edited version of the conversation follows.

Barron's: How does the U.S. economy look to you?

Jeffrey Sherman: When I use a short-term lens, through the summer or the fourth quarter, things look pretty rosy. The business cycle remains strong. We have a relatively low unemployment rate, and we have the tailwinds of this massive capital expenditure boom.

It's not completely spread across all sectors of the economy — it's highly concentrated in tech and AI — but there are signs of an economic boom right now. We've had the most phenomenal sporting events — the NBA finals, the Stanley Cup, the World Cup is going on in all of our cities right now — there is a lot of economic activity.

The average American may not feel an economic boom, and it's true the upper end is driving the spending, but the upper end always drives the economy. The U.S. consumer in aggregate continues to perform extremely well, so it's difficult to see in the very short term how this could get derailed.

I sense a "but" coming.

As investors, we don't just look at current conditions, we think about the future. When I look out over a longer period of time, I see excesses. And usually when the economy rolls over, it's because of excess spending and debt building up.

Today we have a fervor around artificial intelligence. We're in a "no capex is too much" kind of market when it comes to AI right now. This capital spending boom went from being equity financed — since companies like Google, Meta Platforms, and Apple have free cash flow to use to invest. But now we've started to go to the debt markets for the AI trade.

A lot of times, those debt markets go from small to extremely large and they do so in short periods of time. That tends to build up excesses. I don't know if we're in the early or middle stages of the debt buildup in AI, but at some point, the debt market is going to say, I need to make sure you can pay me back.

Typically, the hiccup comes when the unemployment rate goes up, and that's just not the world we live in right now. The U.S. has defied expectations for the past three or four years — we've seen great resilience in the face of on-and-off-again tariff policy, an oil price spike, and inflation. But we have to remember that the U.S. is at the center of this AI boom, and the problem with economic booms is they tend to lead to overinvestment and then we overshoot on the other side.

Does this mean you're avoiding bonds issued for AI spending?

The debt market is more risk averse than the stock market. We want the money back that we lend, and we don't participate in the upside. At some point, that will brew into the market. Now everyone wants to participate. I won't say cooler heads will prevail, but I do think more stringent underwriting standards will come into play. There are going to be winners and losers.

The way to participate in the upside in the bond market is that prices have to come down first. Then you can diversify into a sector, and you have a cushion to offset losers. Today that doesn't exist with AI. So, if you want to participate, why not buy the equity so at least you can participate on the upside?

It's the purview of the Federal Reserve to control excesses in the economy, including inflation. What do you see ahead for Fed policy?

There are a few risks here. With the de-escalation in Iran, one of my concerns now is that if oil prices continue to come down, the Fed may become too complacent about inflation. If the Fed falls behind on fighting inflation, it may have to correct later and may have to hike more than they would have needed to.

The market is pricing in hikes this year. Right now, it's saying the Fed will hike once if not twice. I think September is a fair place to bet on a future hike. We've seen signs of underlying inflation. It's not just oil; it's not just food. We still haven't gotten rid of that core inflation. That is inflation that is not driven by commodity prices. Cuts are off the table unless there are meaningful job losses.

I also think the market is going to learn who Kevin Warsh is in the next few meetings. He has said we'd have less guidance from the Fed, which probably makes the bond market slightly more volatile, all things being equal.

As a money manager, what are you doing to deal with the broader economic risks?

We're trying to dampen volatility. We can identify other parts of the market that have negligible exposure to some of these excesses, and we can diversify into other pockets of the bond market that are doing quite well.

What's a strategy you recommend now?

I like our low-duration strategy. [Duration is a measure of how interest-rate sensitive a bond is that factors in its yield and maturity.] I start with the idea that you can earn 3.5% on cash, and we want to earn investors more than that. If you extend out the lending profile by a year and a half, you can pick up a percent or 1.5 percentage points over cash today. And you can do that by not taking a lot of interest-rate risk.

Our DoubleLine Low Duration Bond fund invests across every part of global fixed income but doesn't take duration greater than three years. Right now, it's about 1.7 years.

Where do you invest outside of Treasuries to get that extra yield?

It's very diversified. Almost the entire portfolio is investment grade, but we don't just own corporate credit. We own things like collateralized loan obligations, or CLOs, that are floating rate. So, if the Federal Reserve has to hike interest rates because of inflation — the market is pricing that in today — your coupons go up. That makes those investments very attractive, and those are triple-A rated.

We also own what are known as nonagency residential mortgage-backed securities, which are mortgages that aren't guaranteed by the U.S. government. Underwriting of these securities has improved significantly in the past 20 years and they are not tied to AI. We also use commercial real estate — very seasoned older paper, including a lot of multifamily housing.

We also have asset-backed securities, whether tied to credit cards, auto loans, or student loans. They're short-term consumer loans that are very attractive today. You pull this together and you have a very well-diversified credit portfolio. Today it yields about 4.6%. That's a big pickup for an investor who doesn't have to go out and take a lot of interest-rate risk and worry about Fed policy.

What do you recommend for investors who are willing to take more risk for extra yield?

Our DoubleLine Flexible Income has a high-yield mandate, but there we're also focused on managing downside risk. The yield is close to 6%, which is comparable to a high-yield fund, but the amount of below-investment-grade debt is less than 20% of the fund.

How do you get those higher yields without investing in junk bonds?

We invest in some of the same sectors of the market as our low-duration fund, but we choose securities with a little riskier profile. We also own some high-yield bonds, some bank loans, and some emerging market debt. We keep duration low, at around 2.1 years.

Right now, we have the least amount of non-investment-grade corporate debt that we've had since inception in 2014 because spreads are so tight that we don't think you're getting paid to own that debt today.

We also manage some exchange-traded funds, such as DoubleLine Multi-Sector Income. It has a shorter track record and owns more debt that is below investment grade, but we don't take a lot of risk since the incremental yield just isn't there today. At some point, we'll take that risk if we think we're starting to get paid for it.

Do your funds hold more cash than usual?

We have Treasuries, but we also have some investment-grade bonds and agency mortgage-backed securities that are high-quality assets that are very liquid. We can go out and sell these and buy riskier assets when we see the opportunity. But you won't see a high cash allocation in our funds.

How did you get into bond investing?

I was a mathematician in undergrad. I went to graduate school, and I got into computer science and did a lot of applied mathematics and simulations, and it led me to this field. To me, this is a job of puzzles. That's what really continues to intrigue me about investing.

No two markets are alike, although there are things that rhyme, like with the risks of excesses that we talked about. You're always looking for ways to solve a problem. At the same time, we're trying to help people achieve their goals, so there is a feel-good component to solving these puzzles.

Thank you, Jeffrey.

Write to Amey Stone at amey.stone@barrons.com

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