Amid soaring inflation and dislocated markets, it may feel like investors are in the midst of a storm. Yet one corner of the fixed income market stands out for its potential for resilient returns across scenarios: senior securitized credit.
Recent spread-widening has created one of the most attractive entry points for the sector since the great financial crisis. Opportunities can be found across a variety of asset classes – including high quality senior bonds backed by pools of commercial mortgages (CMBS), non-guaranteed residential mortgages (RMBS), corporate bank loans (CLOs), and other consumer receivables (ABS).
Senior bonds rank first in repayment priority in their respective capital structures, and the credit is supported by subordination, overcollateralization, and excess interest paid by the collateral beyond debt service and other costs. This structure offers insulation from collateral underperformance. In addition, technical factors should support valuations going forward – valuations that we believe are attractive from both a historical and relative-value perspective.
Spreads on senior securitized bonds rated AAA now range between 160 basis points (bps) and 230 bps over the swap curve. This represents a widening of about 110 bps since the start of the year, while corporate bonds rated single A have widened only by about 70 basis points – or just 50 bps if the financial sector is excluded. In fact, spread levels in select AAA securitized products are now on average within range of those witnessed following the initial COVID shock in 2020 (see chart below).
Senior securitized credit spreads look attractive
The moves in spreads year to date have not been driven by broad changes in credit quality. Rather, they reflect broader risk sentiment that has been exacerbated by idiosyncratic features of securitized markets – more limited liquidity and lack of a dedicated buyer base. In addition, some bank participants have been sidelined by capital constraints, portfolio extensions, funding cost volatility, and drawdowns.
Even though the performance of consumer loans, mortgages, and corporate bank loans is tied to the same macro uncertainties as the broader economy, the structuring of senior securitized credit provides a degree of insulation from left tail risks. Overall levels of credit enhancement are scaled based on the historical performance of the collateral and the sensitivity of losses to broader macroeconomic changes, including those in employment, economic growth, and inflation. For example, many senior commercial mortgage-backed securities (CMBS) in the single-asset single-borrower sector have loan-to-value ratios of 25% to 30% – implying that the value of the underlying real estate collateral would need to decline by over 70% before senior bonds would be impaired. Historically, these levels of credit enhancement have tended to provide more than adequate mitigation of default risk.
We expect senior bonds with strong levels of credit enhancement to remain insulated from downgrade and default risk – a critically important attribute during this period of uncertainty. In addition, these securities are self-liquidating by nature as underlying borrowers pay back principal on mortgages, loans, etc., reducing dependence on the future state of capital markets for timely repayment.
Technicals also favor the sector because supply is limited. In our view, the pricing of senior securitized credit relative to the underlying assets is not sustainable, and we expect it to self-correct in a way that supports valuations. With higher interest rates and historically wide securitized credit spreads, the cost of financing for loan originators and aggregators has increased materially year to date. Thus, for the economics to continue to make sense for deal sponsors, senior spreads need to tighten and/or the rates on underlying loans needs to increase correspondingly.
If this does not happen, it would mean more expensive loan terms, which should generally translate to lower origination volumes as fewer borrowers elect to take out more expensive financing. We are already seeing this transpire in residential mortgages, commercial mortgages, refinanced student loans, and bank loans. Lower origination volumes should translate to lower supply in ABS, CMBS, CLO, and residential MBS issuance – thus providing technical support for the asset class, in our view.
Window of opportunity
High quality securitized spreads are ranging between 160 bps and 230 bps, levels reached only three times since the great financial crisis – during the European debt crisis in late 2011, the market turmoil of late 2015 and early 2016, and briefly in 2020 before the Fed stepped in to stabilize markets. Should the forward curve be realized, investors could potentially achieve high quality yields of 5% to 6% for the next three to five years as bonds gradually amortize.
For more on this topic, read our recent blog post, "After Historic Market Moves, Outlook for Bonds Improves."