Perspective - Markets
Outlook 2020: Securitised credit
Signs of consumer stress mean securitised credit investors should be especially alert to quality and liquidity in the coming year.
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- With a record number of global bonds carrying negative yields, and policy accommodation to remain high, we expect demand for securitised credit to remain strong.
- Securitised credit issuance has been slower and yields are still more appealing than in other credit areas
- We view the US – more so than the UK or Europe - as having the most attractive fundamentals in the consumer lending, residential housing and real-estate lending markets.
In 2019, securitised credit delivered stable, low volatility returns owing to fundamental support and accommodative interest rate policy from global central banks. In 2020, central bank policy slack is set to remain and a substantial amount of global debt yields zero or below. We believe investors will continue to seek returns from sectors outside aggregate bond benchmarks.
Lower supply and better value
In 2019 the majority of credit sectors saw risk premiums reduce substantially, leaving many sectors near historic lows. The search for yield in a low return environment has left many sectors in a state of over-valuation. The credit recovery has also been uneven, featuring periods of yield spread widening as events such as trade wars challenge the economic recovery. As such, we expect to see pockets of leverage continue to expand in sectors which have been - and which will remain - a focus of capital allocation.
Amongst credit allocations, the securitised sector remains the furthest from the historically tight levels. We have also seen far less expansion in securitised credit markets than has been witnessed in the corporate markets. We began 2019 with a theme of “Main Street vs. Wall Street”, reflecting our preference for consumer credit versus corporate. We believe the trend persists, and a number of sectors with consumer credit are preferable, particularly in terms of leverage.
US corporate credit, being at a 15-year high in debt levels, appears later cycle than the consumer, where debt service coverage is as strong as it has been in 40 years. Consumer, housing and real estate credit in the asset backed (ABS), mortgage backed (MBS) and commercial mortgage backed securities (CMBS) market have all performed well. Delinquency levels in most sectors are at the low end of their historical ranges. With stable returns, reasonable yields, and controlled issuance, the securitised sectors have offered an attractive diversifying opportunity versus traditional credit allocations.
Cracks are appearing in the “lower end” of consumer debt
In 2020, we expect the “consumer over corporate” theme will continue to perform, but recognise that it will be a year of “differentiation”. Differentiation recognises that higher quality, lower leverage assets offer protection in a “later cycle market”, where cracks are slowly beginning to emerge. For example, amongst consumers, asset rich, higher net worth consumers have outperformed. This can be seen in the very low levels of super-prime credit card charge-offs (debts creditors deem unlikely to be repaid), prime auto delinquency and housing delinquency. Lower net worth consumers - those that do not qualify for a home loan - tend to be over leveraged. This can be seen in the weaker delinquency performance of subprime auto loans, where delinquency has been rising, even with declines in unemployment.
Unsecured installment loans (personal consumer loans) and student loans have also seen weaker performance, with their more debt-burdened borrowers. There are also pockets of leverage in other sectors. Large cities like LA, San Francisco, NY, Boston, Chicago, Washington, DC have seen substantial competition for real estate capital, and are likely to have a bigger problem down the road with more excessive loan leverage. Some CMBS deals now have delinquency rates of 2.5% to 3.5%, which is a high level, not expected to be seen prior to the loan maturity.
Lastly, the collateralized loan obligation (CLO) market has seen the concentration of CCC-rated deals increase with leveraged loan downgrades. With many CLOs approaching the CCC level - that impacts collateral triggers - some mezzanine classes are approaching a potential interest payment deferral.
Prioritise quality and liquidity, and favour the US
With some cracks on the horizon, we are maintaining a higher quality, best-in-class bias, allocating to deep, liquid markets. This should allow us to differentiate among sectors and securities and to own credits protected by strong fundamentals, better collateral, or senior structure. We believe that most interesting among the potential distressed opportunities are BBB and BB-rated CLOs, where investors have already begun to see price declines and number of auctions.
Globally, we view the US markets as having the most attractive fundamentals in the consumer lending, residential housing and real-estate lending markets. While Brexit now looks more likely to be orderly, the overall economic health in the UK and Europe seems to be a little behind, from a GDP growth perspective. Consumers in the UK and Europe seem to have less confidence than their US counterparts. That being said, we do see a benefit to global diversification across our global best ideas strategies covering securitised credit.
We believe diversification and evaluating all risks is important in a later-cycle, more idiosyncratic market. We also believe in benefitting from some of the illiquidity premiums available where banks are withdrawing as the typical provider of lending and borrowers are looking for financing. If we can find markets where banks have been asked to reduce leverage (like real estate lending), where regulation has limited the expansion of credit (such as in residential housing), and if we can find specific areas where banks had less competition (such as smaller balance loans, retail loans or loans with terms longer than 10-years), we are likely to be able to earn a incremental return while taking less risk.
Finding areas within asset-based lending or securitised credit, where risk is fairly priced and volatility can be managed to lower levels, is our focus in 2020.
You can read and watch more from our 2020 outlook series here