Securitised credit: boring is the new sexy

You know that markets have changed when investors are excited about T-bills. These conservative short-term debt instruments are offering yields of more than 5.5%. Boring is the new sexy indeed!

Two years ago today, almost to the day, we said that change was coming. We expected a material re-assessment of accommodative central bank policy in light of inflation and economic strength. As a result, we were steadfastly avoiding any long positions in US 2-year Treasuries.

In the subsequent two years, much has changed. Financial markets have seen dynamic gyrations and marked volatility, especially around interest rates. Bond strategists, who outnumber equity strategists six to one, have been waiting for rate cuts… and like Samuel Beckett’s Godot, they aren’t coming.

What we see is what we’ve seen for some time: a US economic market underpinned by the pillars of consumer wealth, high employment, sound corporate earnings and low leverage. This, combined with the US debt structure which is mostly fixed-rate, longer-term debt, means a US economy with little sensitivity even  to large increases in short-term interest rates. We also believe it is this combination of economic strength and debt structure that has resulted in a market that has misunderstood these facts, or a market that is now trading from cost and simply looking the other way.  

Outside of the US, we see other developed markets as having more sensitivity to short term interest rates as well as greater sensitivity to a sea change in global inflationary dynamics. The divergence in developed market economies creates dynamic and differentiated moves in risks, in interest rates and across currencies.

This backdrop will underpin a market likely to prove meaningfully different to what we’ve been through over the last two decades; namely one with periodic bouts of high volatility.  

Given that, if I told you that by benefitting from some inefficient markets we could generate 7-8% income with a “boring” strategy with little exposure to interest rate changes, a low exposure to credit spread moves and a low exposure to idiosyncratic risk, would that be of interest?

Where is this opportunity?

1. Sectors where major strategic buyers are now required to change gears.

The Federal Reserve (and other central banks) is unlikely to continue crowding out other investors as it shifts to policy withdrawal. Banks in the US and elsewhere must shift gears as they reckon with regulation (Basel III) and higher capital requirements. These two elephants (Fed and banks) have been the largest buyers of Agency Mortgage Backed Securities (MBS) and of highly rated (AAA) securitised credit for many years. Opportunity, therefore, lies in the sectors where banks and the Fed have represented the majority of the buyer base, but do so no longer.

As a fun fact, US banks own nearly one-third of all outstanding US AAA-rated collateralized loan obligation (CLO) securities.

While Basel III does treat AAA CLOs fairly well, it’s an example of a market where banks have been persistent portfolio buyers. This is true in other securitised sectors like Agency MBS,  AAA MBS,  and AAA Asset Backed Securities.

Notably, banks do not generally buy corporate debt for their portfolios. As such, a pull-back by the banks creates a disproportionate opportunity in securitised credit. Much like the familiar private market story in direct lending or real estate, the absence of banks has now created a similar opportunity across high quality securitised credit.

2. Outside of the “easy” traditional flows.

For more than 12 months, the combination of volatility, significant mark-to-market changes and concerns about the timing of private market valuation changes, has resulted in inertia. Many investors have not felt comfortable making material asset allocation changes due to volatility or cost-basis. This means flows follow the path of least resistance; standard fare. Autopilot drives down the S&P 500 Index or Aggregate Bond Index highway. Route IG (investment grade corporate bonds), like Route 1, is well-traveled but likely less smooth at today’s levels of valuations and there are more appropriate and sophisticated play books for this market.

Uncertainty is real. With the vast majority of US mortgage debt established in the standard 30-year fixed rate mortgage, the sensitivity of the homeowner to interest rate changes is very low. Likewise the prepayment function of the existing mortgages is likely not well-predicted by models relying on historical data from a very different era. Again, this creates opportunity.  

We see the MBS market as historically cheap (and history for us is more than 20 years, going back before the central bank buying of agency MBS).

Agency MBS is guaranteed (implicitly and explicitly) by the US government and as such it represents a non-credit risk premium. With the majority of the market at a discount dollar price, the ”convexity” (relationship between prices and yields) of the sector is very different than what most are familiar with. That is opportunity.

Diversification three ways:

1. Diversity of pools. Securitised credit was conceived to create granular pools with hundreds or thousands of underlying receivables. Diversity, and reduction of the risk of the obligor was the key tenet. That is valuable today
2. Diversity of credit risks. Credit beta is not focused on corporate risks. You have consumer (with a range to choose from, we would choose the most boring, or the prime consumer), you have housing (where equity is very high), you have equipment (often in short supply). The diversity in asset class fundamentals offers credit exposure diversification that is beneficial in an environment that may have inflation for some time. You can allocate across corporate, consumer, real asset or financial exposure. You can do this across regions.
3. Diversity in risk premium. Credit risk, prepayment risk among them.

A major advantage is the balance between yield, spread and risk. Today with our favorite T-bill at more than 5.5%, all yields are high.  

In some sectors the additional spread premium is a paltry addition, or percentage of the total yield, for the additional risk. What’s more, the balance between income and the exposure to changes in rates or spreads is incredibly powerful in securitised credit.

The Fed and the bank pull-back creates a favourable situation: income is high and the potential range around that income can be low. The most attractive opportunities are higher in quality and shorter in tenor. This creates the highest income (inverted curve) and the most reduced sensitivity to any spread widening (low credit spread duration) and the most reduced sensitivity to interest rate increases. This is possibly one of the most interesting and unique opportunities.

1. Securitised product has a multi-class structure. By virtue of payment rules, amortizing loans and seasoning, you can find a very wide range of shorter tenor cash flows, or low duration cash flows. The most attractive opportunities have short credit spread duration (1.5-2.5 yrs), little interest rate sensitivity (often floating rate), high income (6.5%-8%), and high ratings (AAA,AA).
2. The high (income) and low (sensitivity) profile is attractive. Earning near 8% income with no effective duration and two years of spread duration, means that even if yield spreads were 150 basis points (bps) wider, the cashflow would still break even to our beloved T-bill. For a liquid opportunity, this is one that merits a close look.

With pro-inflationary trends like the 3Ds of deglobalisation, decarbonisation and demographics, the likelihood that the market misreads signals and remains volatile is high. Boring is most assuredly the new sexy.

Benefitting from a pull-back by the banks and the Fed, in well-secured, diversifying income, seems the optimal manner in which to participate in today’s tremendous income opportunity.

While private market opportunities also certainly exist that benefit from these bank-driven dislocations, securitised credit or Agency MBS are critical tools in a liquid portfolio to navigate this new regime.