August 2024 -
Securitized credit sectors performed well entering the second quarter (Q2), extending a strong run that began in late 2023, when Federal Reserve policymakers signaled that the rate-hiking cycle was probably finished. But the prolonged rally lost steam around late April/early May as investors became fatigued in the face of rampant new issuance, which has been a key theme for our markets this year. Credit spreads1 drifted wider over the subsequent two months and generally ended Q2 near where they started. Still, total and excess returns2 largely remained in positive territory due to the sectors’ yield premiums versus U.S. Treasuries (Figure 1).
Securitized credit spreads lost tightening momentum in Q2 2024
(Fig. 1) Returns were still broadly positive due to coupon income
June 30, 2023, through July 31, 2024. Past performance is not a reliable indicator of future performance.
Source: Bloomberg Index Services Limited. Please see Additional Disclosures page for additional information.Indexes shown are different credit quality tranches of the Bloomberg Non-Agency Investment-Grade CMBS Index and the Bloomberg ABS Index.
A basis point equals one hundredth of one percentage point, or 0.01%.Index data are for illustrative purposes only and are not indicative of any specific investment. Investors cannot invest directly in an index.
Treasury yields ended the quarter higher due to a sharp sell-off in April that weighed on total returns for most major fixed income sectors. The rate rout followed hotter-than-expected inflation reports and comments from Fed policymakers indicating that, while they were contemplating lowering interest rates, they were in no rush to do so without more evidence that inflation is definitively cooling. Yields then retraced much of the April spike over the next two months as disinflation resumed and economic growth data largely disappointed. The Treasury market rebound, combined with coupon income, led to positive total returns, particularly in shorter-duration3 securitized segments like asset-backed securities (ABS) and collateralized loan obligations (CLOs).
In contrast with investment-grade corporate bonds, which experienced their first negative quarter of excess returns since 2022, excess returns for major securitized credit sectors were broadly positive in Q2.
Non-agency commercial mortgage-backed securities (CMBS) produced excess returns of 0.21% at the overall index level.4 This was largely driven by lower-quality CMBS, which benefited from expectations for lower rates, a resilient U.S. economy, and their high yields, which led to continued spread tightening from wide levels. Performance for CMBS backed by office buildings was quite mixed, though. High‑quality properties tended to perform well, and some deeply discounted bonds rebounded as investors reassessed their terminal value. However, some other office bonds repriced lower due to factors such as appraisal reductions, expected tenant departures, maturity extensions, and increased default concerns.
Asset-backed securities generated comparable excess returns of 0.17%, with non-AAA rated ABS outperforming on the back of their higher spread carry.5 Within the ABS index, prime and subprime auto loans were top-performing subsectors. Areas outside of the benchmark, such as private student loans, whole-business securitizations, and data centers, also performed well.
CLOs6 produced steady results over the quarter, leading to solid overall total returns of 2.07%,7 which equates to excess returns of roughly 0.70%. Similar to the ABS and CMBS markets, lower-quality CLO tranches were performance leaders as tight spreads at the AAA level drove investors down the capital structure in search of better value.
In non-agency residential mortgage‑backed securities (RMBS), which lack a broad market benchmark, performance was positive for major subsectors. From our vantage point, credit risk transfer securities (CRTs) produced some of the best results as issuance was relatively light and demand was solid.8 Returns were less robust for nonqualified mortgages (non-QM) and single-family rentals as demand for new issuance waned toward the end of the quarter. With a longer duration profile, returns were more subdued for jumbo mortgage bonds as Treasury yields rose during the quarter.
Issuance remained abundant across securitized credit sectors (Figure 2). As of early July, RMBS issuance, at USD 67 billion, was not far below the total for all of 2023. Although demand has been strong, the market began to feel some indigestion more recently.9
Private-label CMBS issuance climbed 155% from last year’s midpoint and sat at USD 49 billion year-to-date. Higher rates and well-publicized troubles in the commercial property market put a damper on issuance last year. But this year, issuers took advantage of more favorable market conditions and somewhat lower interest costs to refinance existing loans and issue new debt. Issuance in the single-asset/single‑borrower subsector, where most bonds are floating rate, was especially robust.
Meanwhile, the ABS market is on track for a record year of new supply. Issuance stood near USD 181 billion year-to-date, and the supply pipeline shows no signs of slowing in the second half of 2024. This has been driven by auto-related subsectors, but issuance was higher than at last year’s midpoint in most segments. More esoteric areas of the ABS market, such as whole business, data center, device payment, and solar securitizations saw a considerable increase in supply as issuers took advantage of easier financial conditions and strong investor demand. The market has also seen a notable increase in synthetic credit risk transfers, which allow banks to hedge risk on consumer loan portfolios and reduce capital burdens amid regulatory uncertainty.
CLO gross issuance was likewise on a record-setting pace, sitting around USD 207 billion in early July. More than half of that total resulted from refinancings and resets of previously issued deals. The refinancing and reset surge stems from spread compression for CLO liabilities; a large number of CLOs exiting their reinvestment periods, which means that CLO managers can no longer actively buy and sell loans in their portfolios; and a refinancing wave in the underlying loan market, where many loans are priced at or above par value, incentivizing companies to refinance before maturity.
Heavy new issuance across U.S. securitized credit sectors in 2024
(Fig. 2) Supply has been relatively well digested to date
As of July 12, 2024.
Source: J.P. Morgan.
Although spreads widened somewhat in recent weeks, valuations are broadly fair or expensive, based on our historical analysis, following a months-long rally. ABS generally look cheaper than other sectors, while CLOs are on the expensive side of fair. Pricing for CMBS appears reasonable, with some cheapening recently seen at the higher end of the capital structure. Valuations for RMBS are mixed. The credit curve is very flat for CRTs (i.e., spreads on lower-quality issues are tight relative to higher quality), and the subsector broadly looks expensive following strong recent performance. Somewhat better value can be found in the non-QM and reperforming loan subsectors. However, delinquencies on non-QM loans have risen, and continued heavy supply could work against spread tightening.
As noted, we see the best relative value in ABS, a sector whose shorter spread duration should limit downside risk compared with other credit sectors if we experience a broader risk asset sell-off. Within the sector, we see opportunities in synthetic prime auto bonds, which are issued by banks looking to unload risk on their loan books. We also favor discount‑priced whole-business securitizations, subordinate prime auto bonds, and senior and subordinate equipment and auto dealer floor plan ABS. We are warier of areas like bank credit cards, solar financing, federal student loans, and consumer loans.
In CMBS, we favor new issue conduit deals, with a preference for more senior paper. These offer diversified collateral, and more recent issues benefit from enhanced underwriting and less office exposure compared with seasoned conduit bonds. We had been looking to avoid the retail sector, as shopping malls face secular challenges and store closures have increased. However, a favorable financing environment and investor demand have improved the quality of assets, lifting our view. Within retail, we prefer smaller, open-air shopping centers over enclosed malls and favor properties featuring grocers and other needs-based providers over discretionary shops. We had liked the lodging and industrial subsectors, but the team recently downgraded their view to neutral. Many strong lodging bonds have been refinanced, which was a key element of our investment thesis and limits further upside. And the industrial complex has seen heavy issuance, very optimistic underwriting assumptions, and low debt service coverage ratios.
RMBS should benefit from continued home price appreciation, and fundamentals appear fine. Lower rates should lift the prices of discounted bonds, valuations have recently improved in some areas, and there are specific bonds that offer solid return potential and potentially less downside risk from more interest rate volatility. On the downside, we expect a glut of issuance to remain a headwind, a large rate rally would be negative for more recently issued bonds that are priced at premiums, and U.S. election uncertainty could trigger volatility. Within the sector, we are biased toward higher quality, but we like seasoned single-family rentals across the quality spectrum. And we see opportunities in discounted bonds backed by hybrid adjustable rate mortgages in different market segments.
Lastly, in CLOs, we continue to like senior AAA rated tranches. AA rated bonds are screening as less expensive versus comparable investment-grade corporate bonds but more expensive than AAA CLOs. We do see some value in A rated CLOs for portfolios that can accept the higher risk. And we believe that BBs are the area of the CLO capital structure most vulnerable to deteriorating bank loan fundamentals and are an area we are currently avoiding.
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, US Core Plus Bond, US Core Bond, and US Investment Grade Core Bond Strategies. Chris is the cochair of the Investment Advisory Committees for the Total Return Fund, Total Return ETF, and New Income Fund and a member of the Investment Advisory Committees for the Short Duration Income Fund, Global Multi-Sector Bond Fund, QM U.S. Bond Index Fund, QM U.S. Bond ETF, GMNA Fund, Dynamic Credit Fund, and Mortgage-Backed Securities Multi-Sector Account Portfolio. He is 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 member of the Investment Advisory Committee of the GNMA Fund and manages the Mortgage-Backed Securities Multi-Sector Account Portfolio. He also is a member of the Investment Advisory Committees of the Short-Term Bond Fund, Global Multi-Sector Bond Fund, Inflation Protected Bond Fund, Limited Duration Inflation Focused Bond Fund, New Income Fund, Total Return Fund, and the U.S. Treasury Funds, Inc. 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.
1 Credit spreads measure the additional yield that investors demand for holding a bond with credit risk over a similar-maturity, high-quality government bond. Option-adjusted spreads are adjusted for any early repayment options that issuers may have. Past performance is not a reliable indicator of future performance.
2 Excess returns measure the performance of a bond relative to a similar-duration U.S. Treasury security.
3 Duration measures the sensitivity of a bond’s price to changes in interest rates. Bonds with longer duration have higher sensitivity to changes in interest rates.
4 Source: Bloomberg Non-Agency CMBS Agg Eligible Index.
5 Source: Bloomberg US Aggregate ABS Index.
6 CLOs are securitized portfolios of bank loans structured into slices, or tranches, of varying credit risk. An outside firm manages the portfolio of loans.
7 Source: J.P. Morgan CLOIE Post-Crisis Index.
8 CRTs are a type of RMBS issued by Fannie Mae and Freddie Mac but with credit risk borne by private investors. They can incur losses if enough homeowners in a pool of mortgages default on their loans.
9 Source for ABS, CLO, CMBS, and RMBS issuance totals: J.P. Morgan. All totals in U.S. dollars as of July 12, 2024.
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