Will 2020 Be the Year of Securitized Credit?
Corporate credit has had a very good year. Record‑low interest rates have encouraged firms to issue huge amounts of debt, which has been eagerly snapped up by yield‑thirsty investors. At the end of November, the Bloomberg Barclays US Corporate Bond Index had returned 14.8%, an impressive recovery from its 2018 loss of 2.5%. However, about two‑thirds of the strong returns were driven by the significant decline in government bond yields, leaving corporates vulnerable if government yields reverse part of their fall. Additionally, investment-grade corporates are not cheap: With spreads around the 20th percentile of their historical range, there are fears that the sector could be hit if there are any jitters over the global economy.
In our global multi‑sector and diversified income bond strategies, we recently diversified some of our corporate exposure into securitized debt instruments, which pool together contractual debt such as residential mortgages, commercial mortgages, car loans, student loans, and credit card debt. The securitized debt sector has benefited over the past 10 years from consumer deleveraging and more robust structuring and currently has generally higher credit ratings than corporate debt. It also offers attractive spreads and short duration profiles, should provide some protection against a rise in government yields. What’s more, the securitized debt sector has historically displayed a moderate correlation to corporate debt and other risky assets, making it an attractive avenue for diversification and reducing overall portfolio volatility.
Non‑agency residential mortgage‑backed securities (RMBS) look particularly interesting. The correction in the U.S. housing market in 2006–2007 was one of the major causes of the global financial crisis; but since then, U.S. households have undergone a tremendous amount of debt reduction. The rebuilding of the RMBS sector is still in its infancy, but the combination of relatively low leverage, beefed‑up protections, and high compensation per unit of credit risk will likely gradually attract more investors seeking to diversify away from corporate debt. Overall, we prefer non‑agency RMBS to agency RMBS (which are government‑guaranteed securities, meaning there is no credit risk) because they have lower convexity risk, meaning their prices tend to fluctuate less when interest rates change.
In the commercial mortgage‑backed securities (CMBS) sector, single asset single borrower (SASB) loans are interesting. SASB transactions involve the securitization of a single loan, which is typically collateralized by one very large, exclusive property or a small pool of properties. These loans tend to have very low leverage and are generally high in quality and offer some very solid deals, even at lower credit‑quality levels.
Collateralized loan obligations (CLOs)—portfolios of leveraged loans that are securitized and managed as funds—have been in the news a lot recently. In recent months, yields on BBB and BB rated CLOs have rocketed, while those on similarly rated corporate bonds have dropped, creating the widest spread between the two asset classes since 2016. We recently added some exposure to CLOs, but we are double‑ and triple‑checking our fundamental analysis. Leveraged loan defaults are expected to rise next year, so lower‑rated CLOs may be more vulnerable than their credit ratings would suggest. Higher‑rated (e.g., AAA) CLOs, which should be safe from the leveraged loan storm, are also interesting, though they come with worse liquidity than a typical corporate bond.
Key Risks—The following risks are materially relevant to the strategies highlighted in this material:
Transactions in securities of foreign currencies may be subject to fluctuations of exchange rates, which may affect the value of an investment. Debt securities could suffer an adverse change in financial condition due to ratings downgrade or default, which may affect the value of an investment. Investments in High Yield involve a higher element of risk.
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