Look to securitized markets for alternative sources of yield

The impressive performance of corporate credit markets to start the year has prompted many investors to begin seeking out alternative sources of yield and total return in the global fixed income markets. One sector that has been garnering increased attention is the nearly $13 trillion global securitized market, which includes residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS) and asset-backed securities (ABS). While we believe that securitized assets broadly appear attractive today, the size of the market and the variety of unique subsectors it encompasses requires investors to be very discerning when evaluating the opportunities and risks in the sector. Below are some of our Mortgage and Securitized Team's favorite sectors, as well as those we believe warrant some caution.

Agency RMBS: Relative valuations remain compelling vs. other high-quality options

Mortgage spreads have tightened by ~40 basis points since late last year after bond markets began pricing in a less-hawkish Federal Reserve. That said, we can't forget about the 120 bps of spread widening we experienced from October 2021 through October 2023, which was driven by a combination of quantitative tightening, regional banking pressures and heightened interest rate volatility. We expect the latter two of these headwinds to subside through the end of the year, and with agency MBS spreads still trading roughly 40 basis points wider than long-term averages, the sector remains attractive.

Source: Bloomberg. As of 5/31/24. Agency MBS: Fannie Mae Current Coupon MBS Spread and BBB Corp: ICE BofA US BBB Corporate Index Spread. The index performance is provided for illustrative purposes onlyand is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results.

For yield-buyers, absolute yields in the agency MBS market should be enticing, as the current coupon MBS yield is above 6% and near its highs since 2007, and relative value buyers should be even more excited, as spreads in this U.S. Government-guaranteed sector are ~30 bps wider than BBB-rated corporate bond spreads. We continue to find value in specified pools of high-coupon MBS, where we are targeting stories with a lower likelihood of refinancing, and we also think attractive opportunities exist in the CMO market, where we can find much wider spreads than in similar-duration low-coupon MBS.

Non-Agency RMBS: Strong prospects given stable housing market, strong employment and low rates on outstanding mortgages

The non-agency RMBS market continues to perform well in 2024 amidst a favorable backdrop for both technicals and fundamentals. Demand remains strong and continues to outpace new issuance, while delinquencies and default rates have hovered around historic lows thanks to more conservative loan underwriting post-Financial Crisis. Home prices in the U.S. are up nearly 50% since the onset of the pandemic, yet we expect them to remain stable given the severe lack of homes available for sale.

Source: Bloomberg. As of 3/31/24.

While non-agency RMBS valuations vary widely by subsector, they remain generally attractive today, especially when considering the industry backdrop. Absent a steep decline in mortgage rates, new origination should remain light due to challenging home affordability, and this supports market technicals. Meanwhile, stable household balance sheets and a strong employment market each support borrower credit. The combination of strong fundamentals and favorable technicals is positive for residential credit.

CMBS: Rent growth has peaked and higher financing costs are stressing commercial real estate

Like many other segments of the securitized market, commercial mortgage-backed securities have performed quite well this year, yet we are generally in agreement with today's negative sentiment on the sector and believe caution is warranted. The spike in rates and the resulting higher financing costs have pressured all parts of the CMBS market, but we are most wary of office CMBS. As many companies have been able to reduce their physical footprints in response to an increasingly flexible, hybrid work environment, the office sector has experienced the brunt of that negative impact in the form of rising vacancies and falling rent growth.

Source: Bloomberg. As of 3/31/24.

While risks remain in the CMBS market, there are select opportunities to take advantage of in adjacent sectors, such as the single-family rental market. Single-family rental properties have benefited from the aforementioned favorable housing market technicals, while high underlying mortgage rates have made it more affordable for many borrowers to rent rather than own, keeping vacancies low.

ABS: Consumer ABS appear rich, especially given expectations for a weakening consumer into year-end

The ABS market has had a similar experience as the non-agency RMBS market this year, as strong demand has more than offset an increase in supply, pushing spreads tighter. Overall, we remain cautious on consumer ABS and have instead been favoring business-oriented ABS. While household balance sheets are starting from a strong position, we expect them to weaken as pandemic-related savings have been depleted and student loan payments have resumed. This is already starting to show in the form of rising credit delinquencies, most notably among lower-income borrowers, causing us to tread carefully with regards to lower-rated consumer ABS. Instead, business-oriented ABS, which include small business loans, aircraft ABS, etc., appear much more attractive given the wider spreads offered by these securities.

Source: Macrobond. As of 2/28/24.

Source: Macrobond. As of 10/31/2023.

Bottom line: To repeat a phrase that has become increasingly popular in recent years - there is once again income in fixed income - and we would argue that the securitized markets offer some of the most attractive risk/reward opportunities in fixed income markets today.