Perspectives on securitized credit

Securitized credit markets participated in the broad third‑quarter (Q3) fixed income rally that was fueled by positive inflation trends and signs of a softening labor market. These developments convinced investors that the Federal Reserve will be able to cut interest rates more deeply than previously thought. The Fed easing policy while the U.S. economy is still in a relatively healthy state was beneficial for U.S. government bonds, driving yields lower, as well as risk assets, as a proactive Fed reduced concerns that tight monetary policy will tip the economy into recession. Although securitized assets delivered positive excess returns¹ over the quarter at the index level, they underperformed investment‑grade corporate bonds after outperforming in the previous quarter.

The Fed, which had held its policy rate in a 5.25% to 5.5% range for more than a year, cut rates by an unusually large 50 basis points at its mid‑September meeting. In their updated summary of economic projections, policymakers forecast more rate cuts by the end of next year than they did in June as their focus shifted from combating high inflation to maintaining a strong labor market. At his press conference, Fed Chair Jerome Powell justified the rate cut by saying that the objective is to restore price stability “without the kind of painful increase in unemployment that has come sometimes with disinflation,” indicating that the central bank is keenly aiming to engineer a soft economic landing.

However, following quarter‑end, upside surprises in U.S. economic data caused the market to price out some of these rate cuts. Treasury yields rebounded following a steep decline since late April, and interest rate volatility spiked to new year‑to‑date highs.

Generally solid performance

Commercial mortgage‑backed securities (CMBS) delivered some of the strongest returns among our sectors in Q3. The non‑agency segment of the CMBS market generated total returns of 4.55% and excess returns (versus similar‑duration² Treasuries) of 0.51% at the index level.³ However, performance for individual bonds varied widely due to high idiosyncratic risks for individual properties.

Asset‑backed securities (ABS) produced positive, but less robust, total returns of 3.35%, due in part to their lower‑duration profile in a falling rate environment.⁴ The sector broadly generated excess returns of 0.15% for the quarter. 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.

Similarly, collateralized loan obligations (CLOs)⁵ generated positive, but lower, returns due to having low sensitivity to movements in interest rates given their floating rate coupons (instead, returns for the CLO sector are driven more by spread duration, or sensitivity to movements in credit spreads).⁶ The broad sector returned 1.84%, which translates to excess returns of about 0.45%.⁷ Like the ABS market, lower‑rated CLOs were the best performers, reflecting strong risk appetite and fading near‑term recession concerns.

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 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 have experienced heavy issuance year‑to‑date that has already exceeded the totals for full‑year 2023 (Figure 1). Issuance has been on a record‑setting pace in the ABS market, totaling USD 262 billion in early October compared with USD 256 billion last year.⁹ But demand remains just as strong as the supply glut has helped keep spreads in the high‑quality sector at relatively attractive levels.

Issuance of non‑agency RMBS, at USD 114 billion, is already 44% higher than the total for all of 2023. We anticipate that supply will remain relentless due to refinancings of earlier deals and new production in the pipeline, which could accelerate if mortgage rates resume falling. Demand for new issuance has been choppier than in the ABS market. However, insurers have shown voracious demand for the sector due to attractive yields, particularly focusing on the nonqualified mortgage subsector.

Benefiting from broadly improved sentiment amid hopes for rate relief, CMBS issuance has been robust year‑to‑date, reaching USD 152 billion. That puts the sector well on its way to exceed the amount for last year, which was the lowest since 2016, but well short of the record high of USD 351 billion in 2021 when rates were lower and the floodgates were wide open. Single‑asset/single‑borrower issuance has increased the most by far, 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.

CLO issuance, including refinancings and resets of previous deals, has been enormous at USD 344 billion around quarter‑end. But demand has been resilient. Domestic banks have started buying again, and Japanese institutions remain active participants. Exchange‑traded funds that focus on CLOs, which have grown in number, continued to receive an influx of cash. The Fed’s rate‑cutting regime could eventually reduce demand from some yield‑focused investors. But a moderate cutting cycle and sustained U.S. economic expansion—our economics team’s base case—are unlikely to cause a mass exodus from the sector. And, despite spreads being narrow, we believe that spreads for AAA rated tranches could tighten further into year‑end.

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 pandemic‑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. Yet market pricing doesn’t reflect 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). Spending 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 have less need for office space due to a shift to remote working. Cash flows in the lodging segment, which benefited from a surge in post‑pandemic travel, have also been declining more recently, which bears watching. 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 43‑month high of 3.7% 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. 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 spreads were relatively steady over the quarter, although they meaningfully tightened for some areas like CMBS and subprime auto loan ABS. Spreads have generally tightened further in October. CMBS continued to offer the widest spreads, followed by RMBS, but those sectors also possess higher spread duration compared with ABS, a sector that tends to be more defensive and less volatile in times of market turbulence.

Looking at specific sectors, these are our current views:

• ABS: With the recent increase in market volatility, ABS is our favored sector that generally screens as more attractive than other parts of securitized credit markets. Valuations are fair, liquidity is relatively good, and investor sentiment for the sector remains positive. We also expect the torrid pace of issuance to slow heading into year‑end, which could provide technical support. We like areas like discount‑priced whole‑business securitizations, synthetic prime auto loans (an instrument that banks use to transfer credit risk from their balance sheet to investors), and floorplan ABS that auto dealers use to finance their for‑sale inventories.
• CLO: Valuations look expensive on a historical basis and relative to corporate bonds, but investor demand remains robust. This should keep spreads from significantly widening, and we believe there is potential for further tightening. Lower rates should be fundamentally supportive for loan issuers struggling with high financing costs. Additionally, the potential for the Fed to loosen tight policy, but by less than the market is currently pricing, may help sustain demand. We favor higher‑quality (AAA and AA) rated CLOs. Longer new issue and reset transactions should benefit from very strong demand technicals, while refinancings of shorter‑maturity, amortizing transactions are an attractive proxy for segments of the ABS sector.
• CMBS: While fundamentals for many issues are negative, particularly within the office space, they may be no longer worsening. Liquidity and sentiment have broadly improved this year amid expectations that rates will fall to more economical levels and the economy will remain healthy. The financing market has also reopened for issuers owning solid assets. We are favoring higher‑quality new issue conduit deals. The quality of collateral has improved, as have underwriting standards. Many older‑vintage conduit deals look cheap, but investors are unlikely to earn the returns implied by yields and credit spreads due to default risk.
• RMBS: Our securitized team downgraded its view on the sector to negative in August. Although we were comfortable with credit fundamentals due to healthy amounts of homeowner equity, we believed the market was underestimating the potential for faster prepayment speeds following the decline in mortgage rates, which have more recently climbed again. RMBS valuations improved somewhat since August, and we now have a generally neutral view on the sector. However, valuations still aren’t cheap, and we anticipate high levels of supply. And with rates recently rising again, discount dollar‑priced bonds may not benefit as much as investors were anticipating. 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 prime jumbo and agency investor bonds that are priced at a discount are areas where we see opportunities.

All in all, we remain constructive on the securitized credit asset class. Fundamentals remain benign. Though index‑level valuations aren’t screaming as attractive, there continue to be pockets of value versus competing credit sectors. Yields are also attractive, which should sustain demand for yield‑focused investors like insurance companies and pension funds. We continue to rely on our strong credit research and trading platforms to identify fundamentally sound, reasonably priced opportunities.