Corporate credit offers tight spreads and a broad consensus—might the complex crosscurrents of securitized products be more interesting?

Back in November, we turned our spotlight on securitized products, picking them out as a particularly attractive corner of the credit market.

Investors are moving back into higher-rated fixed income after years of comparative neglect, and we noted that asset- and mortgage-backed securities (ABS and MBS) offered diversified risk exposures, together with relative value caused mainly by technical supply-and-demand factors.

Since then, the ICE Bank of America U.S. ABS and CMBS Index is up around 5%. It has continued to perform positively in the new year even as bond yields have gone back up. Indices of collateralized loan obligation (CLO) debt tranches are also up strongly.

While the average ABS and CMBS spread has come down from around 190 basis points to 150, that is still 50 basis points more than comparable investment grade corporate bonds. We continue to see relative value here, but we also think securitized products represent the more interesting opportunity set.

Debates

The consensus on corporate credit is pretty emphatic. Spreads are tight and volatility is low for widely accepted reasons. Balance sheets are robust. And because balance sheets are robust and yields are relatively high, new supply is muted.

In contrast, some heated debates continue in the securitized world.

For example, there is a lot more end-consumer exposure here, from credit cards and auto loans to timeshares and cellphone contracts. U.S. retail sales have been strong as household balance sheets continue to benefit from a booming labor market, slowing inflation and record homeowners’ equity—but there are plenty of voices warning about the depletion of consumers’ excess savings.

Also, a mix of fixed- and floating-rate securitizations creates a channel for the big macro debates to affect relative value in the sector (as well as the potential to use it to hedge bond portfolios against “higher-for-longer” rates).

Most visibly, questions remain as to how the slump in commercial real estate might play out, as property valuations reset and interest costs rise. This is creating some opportunity within offices, the epicenter of the slump, but we also see it opening up value in the 70% of commercial mortgage-backed securities (CMBS) that are not secured by offices.

Finally, the securitized-products opportunity set is broadening and diversifying still further.

We believe one key example can be found in MBS. High rates have slowed the pace of mortgage refinancing, which has reduced the risk of prepayments for MBS investors and squeezed the supply of first-lien loans for securitization. However, it is also triggering an uptick in securitizations that include second-lien mortgages, which is creating more scope for additional yield, spread and credit-selection alpha, in our view.

Supply-and-Demand Dynamics

We have written a lot about how technical supply-and-demand dynamics are likely to move fixed income markets more than fundamentals this year, now that we have reached peak rates. But here, too, the dynamics are arguably more complex and interesting in securitized products than in corporate bonds.

The busy issuance calendar of 2021 – 22 and the drop in new issuance in 2023 were characteristic of credit markets in general.

But counterbalancing the lack of new issuance in securitized products was the fallout from the mini-banking crisis of spring 2023. That took banks, historically the main holders of the asset class and particularly of MBS, out of the market as they nursed their stricken balance sheets. It also resulted in tens of billions of dollars of securitized products, taken over from SVB and Signature Bank by the Federal Deposit Insurance Corporation, being sold back into the open market later in 2023.

For now, banks are still mostly on the sidelines of the ABS and MBS markets, leaving them to asset managers. We think this could mark a longer-term shift in the buyer base, from buy-and-hold to more market-sensitive investors. Right now, we believe it is one of the supply-and-demand factors contributing to the relative-value opportunity in the sector.

Complex Crosscurrents

As investors return to larger fixed income allocations, we think securitized products will almost inevitably attract some of the flows—at the very least, as segments of flexible and core multi-sector credit funds.

That should help bring demand back in line with supply over time, in our view, and ultimately bring spreads back in line with those for corporate credit, where the same complex crosscurrents are simply not at work.

Fixed income investors are understandably focused on central bank policy at the moment, but more than that is going on in the market. We think securitized products are among the places where value is on offer and active management can be additive.