Perspectives on securitized credit

Securitized credit markets participated in the broad fourth‑quarter credit rally that was sparked by positive surprises in U.S. economic growth data early in the period. Later in the quarter, the rally was further fueled by investors’ expectation that the new administration in the White House would pursue pro‑growth policies and secure necessary support via a new Republican majority in the U.S. Congress to do so. Conversely, the market became much more concerned around the trajectory of inflation given the incoming administration’s campaign objectives concerning tariffs and immigration policies, which the market interpreted to be inflationary. These developments caused investors to reconsider the depth of easing that the Federal Reserve would be able to execute. Consequently, U.S. government bond yields rose, and the yield curve steepened.

While most credit sectors’ spreads tightened early in the quarter, securitized sectors’ participation in the rally was anchored to the back half of the quarter, driven, in part, by a technical tailwind as demand outstripped supply as year‑end approached. For the fourth quarter, securitized credit generally outperformed investment‑grade corporate credit of comparable duration¹ and quality.

The Fed, which had held its policy rate in a 5.25% to 5.5% range for more than a year, cut rates by another 50 basis points during the fourth quarter, following an unusually large 50‑basis‑point cut at its mid‑September meeting. In its updated summary of economic projections, however—given the positive inflection in labor market data, resilient growth, and the uncertainty around the impact of the new administration’s policy on inflation—policymakers adjusted down their forecasts for rate cuts by the end of 2025 compared with their September forecasts as the inflation component of their dual mandate became more significant.

Generally solid performance²

Commercial mortgage‑backed securities (CMBS) delivered some of the strongest returns among securitized sectors in the fourth quarter. The non‑agency segment of the CMBS market generated total returns of ‑0.76% and excess returns³ (versus similar‑duration Treasuries) of 1.02% at the index level.⁴ However, performance for individual bonds varied widely due to high idiosyncratic risks for individual properties.

Asset‑backed securities (ABS) held in better, with total returns of ‑0.05%, but the sector broadly generated excess returns of 0.48% for the quarter.⁵ However, lower‑rated tranches and out‑of‑benchmark segments—such as bonds backed by data centers, commercial equipment, and whole‑business cash flows—recorded stronger results.

Collateralized loan obligations (CLOs) were buoyed by their floating rate coupons and generated positive total returns of 1.84% for the broad sector.⁶ Like the ABS market, lower‑rated CLOs were the best performers, reflecting strong risk appetite and fading near‑term recession concerns. For the quarter, AAA rated tranches returned 1.59%, while BB rated tranches returned 4.31%.⁷

In the diverse non‑agency residential mortgage‑backed securitized sector, where there is not a comprehensive market benchmark, jumbo mortgage loan bonds, which are longer‑duration securities, produced strong results. Single‑family rental (SFR) bonds and re‑performing loans (RPL) also performed well. Credit‑risk transfer securities (CRTs),⁸ which had performed strongly over the past year, delivered less impressive results given that valuations were already quite expensive.

Healthy demand for a wave of supply

The four major securitized credit sectors experienced heavy issuance in 2024 that eclipsed 2023 levels (Figure 1). Issuance in the CLO and ABS markets both set records in 2024.⁹ But demand remained strong, particularly through the end of the year as relative value in certain securitized sectors became more compelling amid a broad rally in high‑grade corporate credit.

Issuance of non‑agency residential mortgage-backed securities (RMBS), at USD 159 billion for full‑year 2024, was two times higher than in 2023. We anticipate that supply will continue to be heavy in 2025, with large issuers forecasting to increase production compared with 2024 volumes. Demand for RMBS paper remained steady into year‑end, especially from the insurance buyer base, and as issuance came to a near standstill ahead of the holiday season, spreads across all subsectors and issuer types (first tier/second tier) compressed. Even inaugural issuers did not have to pay meaningful spread concessions to get deals done. Our expectation for high levels of supply likely creates a floor for spreads. And with rates recently rising again, discount dollar‑priced bonds may not benefit as much as investors were anticipating.

Liquidity and sentiment broadly improved for the CMBS market in 2024 amid hopes for rate relief and a more constructive business environment in 2025. This appeared evident at the CRE Finance Council Conference in January, although negative sentiment still lingers over troubled office loans. Benefiting from the improved sentiment, CMBS issuance had a robust finish to the year totaling USD 219 billion in gross supply. That was a 36% increase in volume year over year. Single‑asset/single‑borrower (SASB) issuance increased the most, but sponsors have also brought more conduit deals to market this year in response to the improved demand environment. While deals backed by lower‑quality properties have continued to struggle to find buyers, demand for issues backed by strong collateral has been ample. We are anticipating continued heavy supply across CMBS subsectors. In combination with the spread compression seen in December and fundamentals potentially more challenged by a higher‑for‑longer rate backdrop, we have moderated exposure to the sector to start the year.

CLO issuance in 2024, including refinancings and resets of previous deals, was enormous at USD 494 billion. Net issuance of USD 202 billion set a record against a backdrop of seemingly insatiable investor demand for variable rate debt.

Exchange‑traded funds that focus on CLOs, which more than doubled in size in 2024, continued to receive an influx of cash. The market’s repricing for fewer future rate cuts during the fourth quarter reinvigorated demand from Japanese and U.S. banks as well as domestic money managers. While this should keep spreads from significantly widening, the robust demand has fueled a meaningful increase in refi/reset activity that likely will limit spread tightening. A moderate easing cycle and sustained U.S. economic expansion—our economics team’s base case—are unlikely to cause a mass exodus from the sector.

Fundamentals mostly benign

The fundamental trend for securitized credit sectors isn’t on an improving path, but it’s also not overly concerning. In the ABS market, we expect continued—but manageable—delinquencies and losses in consumer segments like auto loans and credit cards. A normalization in credit fundamentals following massive COVID-related stimulus measures that bolstered consumer balance sheets has arrived. While this is impacting all borrowers, pressures are most acute for lower‑income borrowers. Credit card balances are elevated, but—positively—repayment rates remain higher than they were in the pre‑COVID period. However, market pricing reflects little, if any, deterioration in fundamentals, which is apparent in the flatness of the credit curve (i.e., spreads on lower‑quality issues are tight relative to higher-quality issues). Activity at restaurants also bears monitoring, especially for weaker and less established whole‑business securitization issuers, as stretched consumers rein in spending.

In the CMBS market, delinquencies, transfers of loans to special servicing, and negative headlines are most glaring in the office segment (Figure 2). Fundamentals there remain highly bifurcated. Bonds backed by high‑quality, in‑demand properties have seen strong demand. On the other hand, there is limited appetite for bonds backed by older buildings that have seen tenants depart for newer structures offering more amenities or simply having less need for office space due to a shift to remote working. Cash flows in certain segments of the lodging sector, which had benefited from a surge in post‑COVID travel, are beginning to weaken. Cash flows remain stable in the industrial and multifamily areas of the market.

For CLOs, the structure of deals matters, and we are focused on the higher‑quality areas of the market. The percentage of defaults and distressed exchanges in the bank loan market reached a 46‑month high of 4.5% in September, according to J.P. Morgan. There has been moderate improvement in credit rating downgrade activity, but the lowest‑quality CCC rated area remains a concern as default rates in this cohort remain elevated by historical standards. However, the Fed lowering rates should help ease the pressures caused by high borrowing costs. The lower‑rated tranches of the CLO market (BBs) are most impacted by loan defaults, downgrades, and haircuts stemming from liability management exercises by debt‑laden companies.

Fundamentals in the non‑agency RMBS market are largely neutral. Affordability remains a problem, but existing homeowners have built up substantial equity as housing prices continue to rise. A strong labor market and slower, but still high, wage growth enables homeowners to make loan payments on time. As such, credit performance has been holding up.

Valuations largely neutral, but pockets of value exist

Credit spreads¹⁰ tightened over the quarter, with CMBS and ABS spreads experiencing the most compression, and spreads generally moved sideways or inched tighter in January.

• In the ABS market specifically, we view valuations as marginally weaker, and credit curves are pricing in little to no disruption in fundamentals. We like areas such as discount‑priced whole‑business securitizations, synthetic prime auto loans (an instrument that banks use to transfer credit risk from their balance sheet to investors), floorplan ABS that auto dealers use to finance their for‑sale inventories, and off‑index equipment‑backed ABS, which have modestly lagged the broader rally in the subsector.
• In the CLO market, valuations look expensive on a historical basis and relative to corporate bonds, but investor demand remains robust. We favor higher‑quality (AAA and AA) rated CLOs, and refinancings of shorter‑maturity, amortizing transactions are an attractive proxy for segments of the ABS sector.
• As for CMBS, we are favoring select seasoned discount front‑cash‑flow conduit transactions for potential early recoveries. We also see value in select office SASB deals with limited impairment risk but trading to overly punitive extension scenarios.
• Lastly, through our valuation framework, RMBS slightly edges out the other three sectors as our preferred segment of the securitized market. We are biased for shorter‑duration, higher‑quality bonds that have more upside potential than downside risk and are relatively liquid. Seasoned SFR bonds and select, seasoned hybrid adjustable rate mortgages are areas where we see opportunities.

All in all, fundamentals remain relatively benign across securitized credit. Though index‑level valuations aren’t screaming as attractive, there continue to be pockets of value versus competing credit sectors in our view. Yields are also attractive, which should sustain demand for yield-focused investors like insurance companies and pension funds.