Last week’s small but unexpected undershoot in U.S. inflation erased almost all traces of another Federal Reserve rate hike from futures markets. The exuberant response across fixed income and equity markets suggests many investors took that as a signal to start thinking, at least, about life beyond cash: interest rate risk, credit risk, equity risk.
We continue to exercise patience. Markets have been convinced that this hiking cycle is over a handful of times already, only to be disappointed.
Fixed income yields are attractive, in our view, but pricing could continue to be volatile. Central banks may or may not be done with hikes, but for some months now, we have seen a dampening of their impact on the market. In their place, technical forces, especially supply of and demand for paper, have become the key dynamic—a theme we believe will continue into 2024.
Is there a place in fixed income where carry and income allow investors to stay patient, and where the technicals are especially favorable? We believe so, and we think that place is securitized products.
Diversification and Relative Value
In our view, securitized products look attractive across multiple sectors, maturities and risk profiles. We like two characteristics in particular: their diversification and their relative value.
For investors concerned about the impact of the economic slowdown on corporate bonds, securitized products offer diversification into more consumer-oriented debt (from credit cards and auto loans to timeshares and cellphone contracts) and more unusual corporate sectors (such as telecommunications infrastructure, aircraft and equipment leasing).
Fundamentals are softening as higher rates begin to bite, but U.S. consumer spending remains quite resilient (witness last week’s retail sales data). Also, household balance sheets continue to benefit from a still-healthy labor market, modest debt burdens, slowing inflation and record homeowner equity, underpinned by a resilient housing market supported by low inventories and favorable demographics.
While commercial real estate is experiencing headwinds as property valuations reset and interest costs rise, we believe diversification can help here, too. More than 70% of commercial mortgage-backed securities (CMBS) are secured by non-office properties tied to sectors such as housing, travel and supply chain logistics, which have proven buoyant.
Despite this backdrop, heavy issuance in 2022 met an investor exodus from fixed income that disproportionately affected securitized products. As a result, in addition to diversification, the sector now offers attractive relative value.
While BBB corporate bonds trade with an average spread of around 190 basis points, BBB auto-loan securities offer a 250-basis-point spread and equipment lease securities trade at 350 basis points, both with about half the duration. AAA student loan securities offer a 150-basis-point spread versus 100 basis points for A rated corporates.
This was why all areas of the securitized credit market maintained their overweight view in our latest Fixed Income Outlook.
But there is one sector with a “very overweight” view: U.S. agency mortgage-backed securities (MBS). Here, we like both the fundamentals and, especially in the case of new, “current-coupon” MBS, the valuations.
We think that part of the fundamental story here is the resilient consumer and housing dynamics mentioned above. In addition, one of the sector’s key risks—early or faster-than-scheduled prepayment, which usually erodes both annual carry and yield to maturity—remains muted.
Prepayments tend to be more common when rates are low and falling and borrowers can refinance at lower cost. Right now, most are happy to stick with the lower rates they are currently paying. They may need to repay early if they are moving home, but it is precisely the prospect of having to refinance at higher cost that has been slowing existing home sales.
Moreover, in the current environment, prepayments can even be positive for the investor because the borrower repays the par value of the loan while many recently originated MBS are trading at discounts to par.
The Buyer Base Has Shifted
Recently, current-coupon MBS spreads have widened to approximately 170 basis points. Why is the market so cheap, given the strong fundamentals?
As with the rest of the securitized market, we think this is largely about the technical backdrop. Again, it is a story of heavy issuance through 2021 and 2022 that the market struggled to digest. But with agency MBS there is an added twist, as the buyer base has shifted dramatically away from banks (which tend to be overwhelmingly buy-and-hold investors) to asset managers (where they are available for sale).
That shift was amplified by the mini-banking crisis earlier this year. Initially, many banks shied away from buying additional MBS, as the meaningful price declines in their existing portfolios affected internal risk assessments. On top of that, in April, it was announced that some $83 billion in MBS seized by the Federal Deposit Insurance Corporation from the stricken SVB and Signature Bank were instead to be sold into the market in a “gradual and orderly” manner.
While the program did proceed in an orderly way, banks were the single largest holder of MBS; putting them on the sidelines was always going to put a cloud over the sector. There are few signs that banks wish to get MBS back on their balance sheets; nonetheless, this cloud may be lifting as the broader market begins to transition itself away from a buy-and-hold market to a greater free float. Moreover, new issuance in 2023 has been just 25 – 30% of 2021 and 2022 levels, so a technical tailwind could be building.
For a long time, U.S. MBS were simply not attractive. In a low-yield world, it was among the lowest-yielding paper.
Today, a combination of strong fundamentals and very supportive technical supply-and-demand dynamics makes it, in our view, one of the most interesting sources of carry and income in the entire fixed income market. As cash rates peak but longer-dated bond markets remain volatile, MBS and securitized credit in general may be one place to clip generous coupons and await broader fixed-income market stability and equilibrium.
In Case You Missed It
- U.S. Consumer Price Index: +3.2% year-over-year and unchanged month-over-month in October (Core CPI increased 0.2% month-over-month 4.0% year-over-year)
- Eurozone Q3 GDP (Second Preliminary): -0.1% quarter-over-quarter
- Japan Q3 GDP (Preliminary): -0.5% quarter-over-quarter
- U.S. Producer Price Index: -0.5% month-over-month in October and +1.3% year-over-year
- U.S. Retail Sales: -0.1 % month-over-month in October
- NAHB Housing Market Index: -6 to 34 in November
- Eurozone Consumer Price Index: +2.9% year-over-year in October (Core CPI rose +4.2% year-over-year)
- U.S. Building Permits: rose 16K to 1,487K in October
- U.S. Housing Starts: rose 1.9% month-over-month in October
What to Watch For
- Tuesday (11/21):
- U.S. Existing Home Sales SAAR
- Wednesday (11/22):
- FOMC Minutes
- U.S. Durable Goods Orders
- Thursday (11/23):
- Eurozone Purchasing Managers’ Index
- Japan Consumer Price Index