Opportunities and Risks in U.S. Securitized Markets

Jarad Vasquez: I’m Jarad Vasquez, senior portfolio manager and co-head of the Core Fixed Income team here at Allspring Global Investments. I’m with Mira Park, senior portfolio manager of the Investment Grade Income team here at Allspring, and you’re listening to On The Trading Desk®. Today, we’re talking about opportunities and risks in U.S. securitized markets and why fixed income is the top opportunity listed in our recently published 2024 investment outlook. Thanks for being here, Mira.

Mira Park: Hey, Jarad. Yeah, thanks for having me.

Jarad: As I mentioned before, in Allspring’s recently published investment outlook, the number one highlighted opportunity is that fixed income is likely to provide compelling investment opportunities in the next year. Mira, can you give us your two cents on why this might be the case?

Mira: Absolutely. It’s been a pretty astounding 525 basis points of rate hikes over the past almost two years from the Fed (Federal Reserve). And it would appear that they are finally done tightening. In fact, as of this past week’s Fed meeting, it looks like the Fed is pretty strongly setting up for a pivot into dovish, or easing, policy next year based on their view of moderating inflation and growth. So, as you know, Jarad, we’ve been espousing this for several months now here at Allspring. But this is the time to allocate to fixed income, and more specifically, with longer durations out the curve in order to capture and maximize on the bond capital appreciation that we think we’ll see this year. So, that’s something you really can’t do if you’re sitting on cash with no duration, as tempting as those front-end yields are. And just a quick illustration of this using some simple bond math. If you take a bond portfolio today, with, say, a duration of yielding 5.5% and you think about returns over the next 12 months, well, you’ve got your 5.5% of income return. And then, let’s just assume rates fall by a pretty soft assumption of 50 basis points next year as the economy softens. So, that’s two and a half points of additional price appreciation. So, you’re looking at 8% total returns over the next year. And I think that’s pretty compelling for bond investors.

Jarad: Yeah. Another point on top of that is that you have a pretty good volatility picture across spread products within this space. And with that, an active bond manager can actually get you additional yield through security selection. And you could probably get 75 to 100 basis points over that 8% that you’re talking about, which really starts to put this space and this investment opportunity in this sector at a very, very compelling point versus any other sector out there. I think the real reason we’re here, though, Mira, is to talk about securitized products and kind of the opportunities there. Maybe we can get into a little bit of your insight into how compelling the yields are across structured products and things that you’re looking at.

Mira: Well, as you know, Jarad, our team works with many income-oriented entities. So, we’re working with insurers, endowments, banks. So, we do tend to focus quite a bit on the private label structured product universe where there’s a credit risk component and you can pick up additional spread. Think ABS, CMBS, CLOs (collateralized loan obligations). Now, CMBS, or commercial mortgage-backed securities, is kind of going through its own fundamental secular issues right now. So, we’re a little bit more wary of risk there at the moment. But we do continue to see great opportunities in sectors like ABS, or asset-backed securities, to lock in highly attractive yields currently. And I would say, not only are they nominally attractive yields, but really attractive when looked at on a risk-adjusted basis. Whether that risk is volatility of returns, risk-based capital, or just rating stability, we would argue that ABS compares quite nicely to other fixed income sectors along any of those measures. But to answer your questions on yields, in the commercial sectors of the ABS market, such as small to mid-size equipment, data centers, shipping containers, even certain parts of the whole business spectrum, we’re currently seeing yields of roughly 5.75% to 7.5%, even approaching 8% if you look at the most illiquid, esoteric parts of the market. So, the yields for the investment grade space are really compelling. And on top of that, I would say it’s an area where we’re broadly comfortable with the fundamentals. We like the robust structuring and there’s a lot of diversification to be had. And Jarad, I know that your team tends to focus more on core fixed income. What are you seeing in terms of the opportunities in agency mortgages?

Jarad: Yeah, I think agency mortgages are a pretty unique opportunity right now relative to where they’ve been over the past decade. MBS (mortgage-backed securities) spreads are as attractive as they’ve ever been against credit and IG (investment grade) credit. And there’s a couple of reasons for that. You’ve had the Fed in the market really pushing those spreads tight and taking the volatility out of that market over the last few years. And with them exiting, it’s really kind of opened the door for those spreads to widen and start to look more attractive versus other sectors. For the first time in my career, we don’t have really a kind of de facto buyer in that space. You go back 15 years, 20 years, you had the agencies that really kept OSs and spreads tight there. After that you had banks, you’ve had REITs (real estate investment trusts), and then you’ve had the central banks. And now they’re all kind of gone. So, it’s really real money and asset managers that are setting the prices in that space right now. And what that’s doing is it’s allowing those spreads to become more attractive versus other parts of the core index. On top of that, you have a very good volatility picture. And with the move in rates that we’ve had, you actually have more tradable coupons in the agency mortgage space than we’ve had in a very, very long time. If you go back to 2018, there were three coupons that made up 85% of the MBS index in the 30-year space. Right now, you have 10 or 11 tradable coupons. So, what that does is it allows you a lot more opportunities for security selection and an experienced active manager can take advantage of that in these types of markets. Along with that, you have a really attractive prepayment picture. You have slow prepayments for a lot of the MBS space. But you’ve had a lot of mortgages created in the last year, year and a half that are closer to in the money. So, you have stories that can be taken advantage, both from a refi perspective and from an extension protection perspective. So, there’s a lot to do in that space right now, on top of the fact that you’re still getting a 5% to 6% yield for what’s essentially a government bond. You don’t have to worry about credit with agency mortgages. You’re more worried about that refi component and a large part of the agency mortgage space is really in the money. So, that’s not really a big risk. I think that’s part of the reason that we really like this space right now. It’s our favorite sector across our team. But I think it’s going to look good for the next year or two. And I think it’s one of the good spots that you can step into because you do get a little bit of duration, as you were talking about earlier, so you can take advantage of those falling yields if the Fed starts to move the other direction. But there’s also just a tremendous amount of security selection opportunity where a manager can really start to give you some extra alpha, on top of those 5% to 6% yields. And you get to that point, all of a sudden, you’re 6%, 6.5% for a government bond. That starts to look attractive versus anything.

Mira: So, what about more broadly, when you’re constructing core fixed income portfolios, what is your team’s current view on other risks in the market or more specific portfolio construction thoughts that you guys have right now?

Jarad: When I look at the risks that are out there and I think about the economy in general, there are risks for growth, for our economy slowing down, and for how reactive the Fed’s going to be, depending on the data we’re seeing. Inflation is moving in the right direction, but we’re far from done on that. And I think the Fed has been very clear in stating that. So, there are risks to the economy in general. And when you think about where credit is trading, there are reasons for why it’s trading where it is, but it’s relatively tight relative to some of these other parts of the market. I think for us, one of the risks that we’re thinking about as we look at that outlook is liquidity. And when things become questionable and you have uncertainty in the market, liquidity is a major risk and it’s a major technical risk. And by staying up in quality and staying in the structures that you stay in, Mira, and that we stay in, where you have liquidity in the market if you need it, I think that’s a risk that probably gets undervalued a little bit. And I think it’s something that our team is looking to make sure that we’re able to take advantage of as we see liquidity get priced into the market, if we see some of these bigger moves, whether they’re lower or higher in interest rates. Speaking of risks, I think one risk that I think a lot of people are curious about right now, and I think you’re probably the right person to take this on, Mira, is the ongoing developments in commercial real estate, particularly the risks that office CRE is facing.

Mira: Yeah, that was definitely a big market topic in 2023 and will continue to be, in our team’s view. So, right now, we have this challenge of a secular decline in office usage. And it’s playing out at the same time that we have borrowing costs at very high levels, historically high levels. And so, the impacts on commercial real estate, or CRE, and CMBS and securities is ongoing, as you just said. It is a slow-moving sector. We would say that we’re really only in the third inning of kind of seeing these issues in office CRE play out. So, let’s just start with the quote-unquote bad news or the risks on the horizon. We do have a decent amount of office CRE loans reaching maturity next year, about $30 billion coming due in the United States. And that’s versus the $10 billion that we saw this year. And the financing environment, as I said, remains tough right now. Not only are interest rates high, but cap rates are rising on a lag to interest rates. And so, all this is happening while there continues to be uncertainty over building tenancy and the long-term usage of office spaces. So, the valuations on CMBS bonds tied to these loans, currently, even if you look at Class-A properties in New York City that are 90% occupied, great locations, they’re actually being pretty heavily penalized by the market until there’s certainty of refi and/or like this full runway of long-term tenant leases. On the good news side, we are starting to see interest rates come down. And so, at least we have some clarity that rates are unlikely to keep rising, which gives lenders and special servicers more confidence to finance or extend loan maturities. Along those lines, special servicers do continue to work with borrowers in extending loans, extend and pretend, as necessary until we get into cleaner air in, say, a year or so. Lastly, we’re seeing consistent progress and return-to-office. Manhattan, by some reports, is now as high as 75% RTO’ed. And even here in San Francisco, more recently, which is a tech heavy city, we’ve jumped to 59% on our highest occupied days. We think that as the labor market loosens, this may persuade even more workers to return to the office in future months. All that said, we do think there’s going to be more headlines ahead. As you know, these loans reach maturity next year. There will be more price volatility, but that does create opportunity for investors, right? So, the low hanging fruit in our mind would be bonds off of strong properties or pools of properties that might get swept up in any dislocation and spreads over the next several months. So, Jarad, with the time that we have left, do you want to share any final thoughts for our listeners about riding the curve in fixed income into 2024?

Jarad: I think that absolute yield levels for high quality, intermediate, and core fixed income-type sectors is just really attractive right now. We’ve talked about some of the yield levels that you can get with high quality. And I think when you couple that with the volatility and the security selection opportunities that are out there that you can take advantage of with a good active manager, I think IG high quality fixed income is the most attractive it’s been relative to other sectors and other parts of the market than we’ve seen in a long time. Do you have any final thoughts?

Mira: I echo your excitement about 2024. I think it’s going to be a great year for bond investors. And I think both of us would wish our clients and our listeners happy holidays.

Jarad: Absolutely. And thank you, Mara, for being with us here today and sharing your insights.

Mira: Great to be here.

Jarad: And for our listeners, thank you for joining us here On the Trading Desk®.

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