August 2023 / INVESTMENT INSIGHTS
Perspectives on Securitised Credit
Second Quarter 2023
- Securitised markets maintained the positive momentum that transpired following March’s banking system distress.
- Supply technicals remained highly supportive, but fundamentals are gradually worsening, and valuations have become more fair than cheap.
- We saw the best opportunities in high‑quality ABS and CLOs, had a balanced opinion of RMBS, and remained cautious on CMBS.
Securitised credit markets maintained positive momentum in the second quarter that began in early April following March’s banking system distress. Concerns about banking system health gradually faded as no additional major institutions failed, and emergency liquidity measures introduced by the Federal Reserve had their desired calming effects. Investor confidence was also boosted by a last‑minute resolution to the debt ceiling standoff in Congress, thereby avoiding a US government default; slowly declining inflation data; and surprisingly resilient growth, even in the face of sharply higher interest rates. The improved sentiment supported demand for risk assets broadly, benefiting securitised assets.
The Fed hiked the fed funds rate in May; paused rate hikes in June following 10 consecutive increases, as policymakers hinted they would; and then tightened once more in late July. The July move raised the policy rate to a range of 5.25% to 5.5%, its highest level since early 2001. Fed Chair Jerome Powell was elusive with forward guidance, emphasizing that future policy actions will be data‑dependent with inflation still elevated but gradually progressing toward the Fed’s comfort zone.
After dropping in March, Treasury yields subsequently rebounded across the curve, led by the more policy‑sensitive front end, keeping key sections of the term structure deeply inverted. Treasury market volatility remained quite high when viewed from a longer‑term perspective but declined significantly from its pinnacle in mid‑March, when bank failures threw markets into a frenzy. The moderation in rate volatility and signs that the Fed was at or near the end of its tightening cycle were positive factors for more interest rate-sensitive areas such as non‑agency residential mortgage‑backed securities (RMBS).
RMBS Led Other Sectors in Q2
The diverse and difficult‑to‑benchmark RMBS sector generally produced the strongest total returns of major securitised credit sectors. Returns for RMBS were broadly robust—a welcome respite following significant rate‑driven challenges last year. Credit risk transfer (CRT) securities and nonqualified mortgage (non‑QM) bonds, particularly lower‑rated tranches, generated some of the strongest returns, aided by supportive macro and technical backdrops.
Collateralized loan obligations (CLOs) also generated solid total returns despite the move higher in Treasury yields, aided by their near‑zero duration profile. Indeed, the prospects for yet another rate hike before year‑end helped revive demand for floating rate assets, which had begun to fade earlier in the year when investors anticipated that rate cuts could soon be necessary if banking system stress worsened. Similar to the RMBS sector, lower‑quality slices of CLO deals bested the performance of higher‑quality tranches, though performance in the sector was broadly positive. Overall, the CLO index rose 2.43% for the quarter, adding to year‑to‑date gains.
Commercial mortgage‑backed securities (CMBS) produced mixed results as the sector continued to face a flurry of negative headlines highlighting growing stress in the commercial real estate (CRE) market. Office buildings attracted the most negative attention, and negative developments for specific properties led to increased dispersion in performance and idiosyncratic risk, making careful security selection more critical. Non‑agency CMBS in the Bloomberg US Aggregate Bond Index, which consists of only fixed rate debt, produced negative total returns (‑0.50%) with Treasury rates rising. But the CMBS index recorded positive excess returns, driven by AAA rated bonds, which outperformed similar‑duration Treasuries by 0.86%. By contrast, BBB rated CMBS underperformed Treasury counterparts by 1.44% as investors remained wary of areas offering less structural defences against losses on underlying loan collateral.
Asset‑backed securities (ABS) ended the quarter with modest absolute losses of ‑0.12% as their lower duration made them more inoculated from rate increases. But excess returns for ABS were positive, surpassing duration‑matched Treasuries by 0.58%. In contrast with the CMBS market, performance for ABS was relatively balanced across the ratings spectrum. Investors saw fundamentals slowly deteriorating but not to a degree that would threaten the fortitude of ABS structures. Student loan debt experienced meaningful credit spread tightening in Q2. Auto loans—both prime and subprime—also tightened, as did credit card and high‑quality equipment deals. Rental cars and container‑backed bonds were among the weaker performers.
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