May 2023 / INVESTMENT INSIGHTS
Perspectives on Securitised Credit
First Quarter 2023
Key Insights
- Securitized markets experienced turbulence in March amid banking system stress but generally rebounded in the first quarter, aided by supportive technicals.
- In our diverse markets, we see opportunities for both defensive investors seeking reliable income and more risk‑tolerant investors seeking larger gains.
- Despite risks in the commercial real estate market, we believe uncertainty should lead to opportunities for prudent investors.
Despite turbulence in March as banking system stress sapped recovering investor confidence, securitized credit sectors generally recorded gains in the first quarter of 2023. Most of those gains occurred in January, extending a rally that began in late 2022, on hopes that the Federal Reserve would soon finish tightening policy without triggering a recession. Credit spreads1 steadily tightened in January and February before spiking in March as a series of bank failures disrupted the “soft landing” narrative that had boosted investor sentiment. However, risk premiums steadied and generally rolled lower into April as sentiment improved after the Federal Reserve and other bank regulators took steps to provide the financial system with emergency liquidity and contain contagion.
The four major sectors—asset‑backed securities (ABS), collateralized loan obligations (CLOs), commercial mortgage‑backed securities (CMBS), and non‑agency residential mortgage‑backed securities (RMBS)—produced positive total returns in the first quarter on the back of declining Treasury yields. Excess returns over similar‑duration2 Treasuries were mixed as credit spread widening in March wiped out tightening‑driven gains experienced in January and February to varying degrees. The commercial mortgage sector was a notable standout—selling off to a greater extent and recovering to a lesser degree than peers—as the commercial real estate market, particularly the office subsector, became an increasing focus of investors’ concerns.
Conviction Shifted Amid Market Turbulence
After entering 2023 with a cautiously optimistic outlook, our securitized credit sector team turned more cautious on their asset class in early March on the heels of the strong recovery in credit spreads. They broadly lowered their conviction level, suggesting that our platform’s diversified fixed income mandates moderate exposure to the asset class.
In addition to less competitive relative valuations, the team highlighted the increased risk that interest rates could remain higher for longer given an exceptionally resilient labor market and slow progress on extinguishing high inflation. The team was concerned that if rates persisted at high levels, it could eventually become a true fundamental problem, with issuers facing uneconomical short‑term funding costs and potentially unable to refinance or extend maturing loans at affordable terms. Those risks would be exacerbated if a recession hits—a downside scenario that seemed increasingly likely as banks tightened lending standards and consumers, battered by inflation and declining savings, cut back on spending.
In the wake of the spread widening that transpired in March across sectors, the team upgraded the asset class back to a neutral conviction level at the end of the quarter. Credit spreads for each of the sectors had widened toward the top of the range that they had traversed since 2016, providing a more favorable risk/return profile. More liquid corporate credit sectors had also recovered more rapidly than securitized credit markets.
Along with improved relative value following March’s bank‑related stress, the risks of a higher‑for‑longer rate environment that had prompted the earlier downgrade had moderated. While we believe the Fed will wait as long as possible to cut rates, financial stability concerns should convince policymakers that they have tightened financial conditions sufficiently to return inflation to an acceptable level. The central bank being close to the end of its tightening cycle provided a more supportive macro backdrop for securitized markets, in our view. The reopening of the new issue market has provided more opportunities to invest at attractive spread levels. Light issuance in a more prohibitive rate environment should also be a tailwind that helps offset diminished bank demand, and we do not anticipate the same elevated levels of rate volatility and associated illiquidity that we experienced last year with the Fed closer to finished tightening.
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Chris Brown is the head of the Securitized Products team and a portfolio manager in the Fixed Income Division, where he co-manages the Total Return Bond Strategy and the U.S. Core Plus Bond separate accounts. He is the co-president and cochairman of the Investment Advisory Committee for the Total Return Fund, a vice president of the International Funds and Multi-Sector Account Portfolios, and a vice president and Investment Advisory Committee member of the GNMA, New Income, Global Multi-Sector Bond, QM U.S. Bond Index, and Short Duration Income Funds. Chris also is a member of the Mortgage-Backed Securities Multi-Sector Account Portfolio and Dynamic Credit Fund Investment Advisory Committees, a member of the Core/Core Plus Portfolio Strategy team, and a cochair of the Sector Strategy Advisory Group. Chris is a vice president of T. Rowe Price Group, Inc., and T. Rowe Price Associates, Inc.
Ramon de Castro is a portfolio manager in the Fixed Income Division. He manages and is a vice president of the GNMA Fund and manages the Mortgage-Backed Securities Multi-Sector Account Portfolio. Ramon also is a sector portfolio manager responsible for the agency and non-agency residential mortgage-backed securities (RMBS) sleeves of various multi-sector fixed income portfolios, and he is a member of the Money Market Credit Policy Committee. Ramon is a vice president of T. Rowe Price Group, Inc., and T. Rowe Price Associates, Inc.
Jean-Marc Breaux is a sector portfolio manager in the Fixed Income Division. He is a member of the Money Market Credit Policy Committee. He also is a member of the Investment Advisory Committees for the Short-Term Bond Fund, New Income Fund, and Total Return Fund. Jean-Marc is a vice president of T. Rowe Price Group, Inc., and T. Rowe Price Associates, Inc.
