- Fixed Income Portfolio Manager
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Key points
- While economic growth should continue to moderate, a soft landing for the US economy appears more likely.
- Securitized credit’s fundamentals are normalizing from strong levels; we see pockets of deterioration but few red flags.
- While we believe this remains an attractive environment for security selection, we expect performance across securitized credit sectors to vary by subsector and borrower type.
Macroeconomic conditions are moderating… has the Fed just come to the rescue?
We expect that US economic growth will moderate to below trend as the labor market softens, demand normalizes, and fiscal tailwinds fade. Financial conditions have tightened modestly, but the leading indicators we monitor do not suggest an imminent recession. Recent economic data signals growing evidence of less demand-pull and cost-push inflation pressures. As a result of these changes and amid its focus on the employment portion of its dual mandate, the US Federal Reserve’s (Fed’s) 50 basis-point policy rate cut delivered some relief. Going forward, bouts of volatility could generate greater idiosyncratic dispersion and create entry points to add exposure to securitized credit.
Fundamentals are normalizing for securitized credit borrowers
Fundamentals appear to be normalizing from very strong levels across most securitized sectors, though we observe some pockets of deterioration. At a high level, we do not see areas of significant concern outside of the well-publicized structural challenges impacting commercial real estate (CRE) and most acutely, the office segment. Residential housing dynamics remain robust overall, albeit with geographic dispersion. As the affordability gap between home ownership and renting grows (as rental prices begin to moderate), home prices should come under pressure. A material deceleration in price appreciation should be contained, however, since demand still greatly outweighs supply.
We expect consumer credit fundamentals to weaken modestly as some low-income-borrower cohorts work through the effects of credit overextension from lenders in 2021 and 2022. Further material degradation should be contained, given that lending standards are tighter, growth in consumer debt is slowing, and loan structures are generally more robust. Still, elevated borrowing costs and prices will continue to pressure the lower income/thin file borrower,1 who is already in a state of recession. Overall, strength of US household balance sheets, accumulation of net wealth (Figure 1), and the lock-in effect from a decade of low mortgage rates should temper the impact in other cohorts.
Figure 1
Within commercial real estate (CRE), price declines of close to 20% from their recent peak (according to Green Street’s Commercial Property Price Index) appear to have troughed. Limited transaction activity reduces transparency, however. We believe there is more pain to come in the office sector as long-term leases wind down. On a positive note, prices across most commercial mortgage-backed securities (CMBS) deals appear to be well ahead of balance sheet marks, thanks to repricing that has already occurred. This situation is presenting opportunities for bond buyers. Stable fundamentals persist in other property types (retail, hotel, and industrial), where capital remains intact. Although we expect near-term softness in the multifamily segment due to heavy supply, longer term, the sector remains on firm footing.
Fundamentals across most collateralized loan obligations (CLOs) have stabilized, but some tail risks remain. While rating downgrades in bank loans (the underlying collateral of CLOs) have stabilized in recent months, some issuers are struggling with declining interest-coverage metrics. Default rates have also moderated (2.1%), although when we capture distressed exchanges as part of the default calculations, we see more elevated levels (4.5%). We expect standard default calculations to remain low, as refinancing activity in the bank loan market pushes the maturity wall to 2026 and beyond. We also view the US$500 billion of available dry powder from private credit (according to Preqin) as a positive tailwind for the broadly syndicated market, as it provides attractive financing for the lower-quality loan cohort during times of market stress.
Technical backdrop leans positive
In asset-backed securities (ABS), new-issue supply has been heavy. This is because of both a pull-forward ahead of the US presidential election and a pullback in commercial bank lending, which has been replaced by offerings from finance companies and private credit. While the market has absorbed this heavy volume of issuance with minimal spread widening, spreads in high-quality ABS remain above their long-term median and are attractive relative to other high-quality investment-grade sectors. From here, lighter expected supply should provide a tailwind.
In CLOs, record supply has been met with spread tightening within AAA rated deals as newly created CLO exchange-traded funds (ETFs) and Japanese banks have fueled demand. We will be watching to see if this demand swings the other way, however, now that the Fed has begun to cut rates. Issuance in traditional CMBS conduits is scarce and provides little diversification across deals due to overlapping loan concentration. Year-to-date US CMBS issuance has been dominated by single-asset single-borrower issuance from one sponsor. As a result, concentration limits could become a concern for investors in this asset class.
Valuations remain attractive, but security selection is key
Spreads across investment-grade and below-investment-grade corporate credit sectors remain compressed relative to history, with limited potential for further tightening — although this narrowing is balanced by attractive all-in yields. Securitized credit spreads appear more attractive versus corporates with generally wider spreads for the same rating cohort and better upside/downside skew. That is to say, we see less capacity for further widening if our balanced view of the economy proves too optimistic. Securitized yields are also attractive given the shape of the curve, specifically amid higher short-end rates and the generally shorter duration of this asset class.
Overall, we see securitized credit as largely normalizing from recent strength, with some pockets of deceleration. By no stretch do see the sector falling off a cliff. In fact, we believe the current market environment is ripe with opportunities for active security selection in investment-grade and below-investment-grade securities for investors who can manage the illiquidity and sponsor risk appropriately.
1Thin-file borrowers have few accounts on their credit reports and thus generally do not qualify for the best rates and terms of loans.
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