Three Securitized Debt Trends We’re Watching
By Nick Rinaldi, Newfleet Asset Management/Virtus Fixed Income Advisers
Securitized debt sectors have seen a lot of action this year: U.S. consumer and office property delinquencies are on the rise, while mortgage rates soared to a 22-year high as investors reconcile themselves to “higher for longer” interest rates. So, what's our outlook for securitized debt? Here are three trends we're following.
This is an excerpt from NCPERS Summer 2024 issue of PERSist.
Securitized debt sectors have seen a lot of action this year: U.S. consumer and office property delinquencies are on the rise, while mortgage rates soared to a 22-year high as investors reconcile themselves to “higher for longer” interest rates. So, what's our outlook for securitized debt? Here are three trends we're following.
- While we think commercial mortgage-backed securities (CMBS) are still in the early innings of their credit cycle, we expect to see more interesting opportunities to invest in high-quality single-asset single-borrower (SASB) and conduit deals as foreclosures start to tick up. Tighter lending standards within the asset-backed securities (ABS) autos sector first implemented in 2023 are beginning to bear fruit, as we believe subprime auto deterioration has reached its peak.
Even with spiking mortgage rates, record low levels of housing inventory and low levels of mortgage delinquencies have bolstered this market. We think non-agency residential mortgage-backed securities (RMBS) demonstrate the best opportunity within housing due to their stable performance and attractive spreads. The CMBS sector continues to face challenging headwinds, including a looming maturity wall, reduced office demand, and an excess supply of multifamily housing. According to Real Capital Analytics, peak-to-trough valuations for office and multifamily are down 47% and 19%, respectively. That said, CMBS market valuations have rallied while spreads have compressed dramatically from year-end 2023. This signals that a floor may have been set on commercial real estate (CRE) valuations, and that CRE losses may not be as high as initially expected. On a year-to-date basis, new issue supply is up 184% as investors are comfortable putting dollars to work in conservatively underwritten deals.
Our Outlook: Expect to see a lot of extension modifications for maturing loans due to tighter credit conditions. In addition, look for an increase in downgrades as rating agencies evaluate current negative fundamentals.
- Floating rate coupons are extremely attractive in this higher-for-longer environment. U.S. consumer fundamentals remain strong. Unemployment (3.9%) remains near all-time lows, job openings (8.9 million) are near all-time highs, employment wage growth (4.2%) is nearly double the pre-pandemic growth rate, housing data remains robust, and the stock market is near all-time highs. Tighter underwriting for lower FICO borrowers also commenced in 2023. As a result, we think newer underwritten loans with lower debt-to-income ratios should produce lower losses going forward. Though delinquencies are worsening for all types of borrowers, the increase is more pronounced for lower-scoring FICO borrowers. That said, unemployment is still historically low at 3.9%.
Our Outlook: We're seeing a return to more normal credit metrics. However, we believe consumer credit should still perform well in a high 4% or even low 5% unemployment rate scenario.
- Despite affordability headwinds from higher rates, mortgage credit fundamentals still look solid, in our view. Though mortgage rates spiked from generational lows, threatening to dampen a hot housing market, the fallout has been relatively mild due to the ongoing housing supply shortage, which remains historically low and creates a floor for any potential price declines. Additionally, most homeowners were able to lock in rates over the last couple of years, creating low mortgage debt service levels. Meanwhile, mortgage delinquency rates are staying low. Homeowner equity levels have ballooned to nearly $30 trillion, and stringent underwriting has helped bolster performance. That, coupled with expected low levels of supply, makes RMBS valuations look attractive as a result.
Our Outlook: Higher mortgage rates and a subsequent fall in housing activity bode well for fundamentals and technicals for this sector. Credit quality remains healthy, while the non-qualified-mortgage market is issuing enough paper to remain stable. Overall, RMBS issuance is expected to be up 40% from 2023, allowing for many opportunities. RMBS spreads should track agency mortgage-backed securities with additional carry, allowing for outperformance.
A disciplined strategy offering exposure to undervalued securitized sectors may offer higher yield and carry at lower levels of volatility compared to corporate bonds of similar duration and credit rating.
Disclosures: Investing is subject to risk, including the risk of possible loss of principal.
This commentary is the opinion of Newfleet Asset Management. Newfleet provides this communication as a matter of general information. Portfolio managers at Newfleet make investment decisions in accordance with specific client guidelines and restrictions. As a result, client accounts may differ in strategy and composition from the information presented herein. Any facts and statistics quoted are from sources believed to be reliable, but they may be incomplete or condensed and we do not guarantee their accuracy. This communication is not an offer or solicitation to purchase or sell any security, and it is not a research report.
Bio: Nick Rinaldi is a senior managing director and portfolio manager of securitized products at Newfleet Asset Management, a division of Virtus Fixed Income Advisers, LLC (“VFIA”). Mr. Rinaldi is co-head of the securitized products team, specializing in asset-backed and commercial mortgage-backed securities.
About Newfleet Asset Management
Newfleet Asset Management, distinguished by its longstanding multi-sector approach, dynamic structural integration, experience, and culture of collaboration, has a proven track record of successfully navigating the fixed income markets to consistently generate excess returns over full market cycles.
To learn more about Newfleet Asset Management, please contact us at 877-332-8172 or visit www.newfleet.com.