Schroders: Securitised credit and asset-based lending

The conditions framing 2018 will persist into the New Year, governing value through 2019, namely:

1. Federal Reserve (Fed) interest rate policy and quantiative easing (QE)
2. Persistence of regulation of banks and insurance companies globally
3. Lack of affordable housing supply

The Fed is the first major provider of QE to substantially reverse course. While QE and low interest rates have supported investment returns, it has also led to many markets becoming crowded. However, securitised credit, excluding agency mortgage-backed securities (MBS, guaranteed by government-sponsored entities), has received far less benefit and is less exposed to an unwinding.

Securitised credit offers a respite from overcrowded corporate credit, as – other than agency MBS – it sits outside of major benchmarks and does not feature in exchange traded funds (ETFs).

Securitised’s strong 2018

Securitised was one of the best performing credit sectors in 2018. The table below shows how various sectors compare with traditional government, corporate and high yield bonds. It benefited from a combination of limited supply, high spreads, strong fundamentals, and more conservative lending standards. Tighter banking regulation is behind that last point. All of these conditions look set to persist in 2019.

However, securitised markets have recently seen some of the yield spread compression that has occurred across the credit universe. This has even happened in some private markets. The illiquidity premium has declined, especially within markets for larger loans or trades that are more scalable. Today, investors must work harder to identify markets that are inefficient or offer more material compensation for risk.

Regulation of banks and insurance companies has been critical to strong performance. Regulations, such as Solvency II and Basel III (and soon IV), have resulted in pressure on banks and created opportunities to access a diverse set of assets. Investors have been able to step in and replace community banks in real estate transactions and new opportunities have emerged to finance capital relief transactions for the banks. We do not see regulatory relief in sight and expect these inefficiencies to continue to create opportunity next year.

Agency MBS: an attractive diversifier

The nearly $8 trillion agency MBS sector is one in which net supply is increasing. With heavy bank regulation in the US, the bulk of US mortgage financing still sits under the government umbrella. The Fed itself is also a substantial owner of agency MBS through its QE programme. However, it is running down this portfolio, which is increasing net supply and cheapening prices.

Agency MBS offer value now that we have reached the monthly cap in the Fed’s “run off” programme. Additional support comes from the current mortgage rate being higher than the bulk of the outstanding mortgage market (the coupon on the index), which mitigates extension risk. We view agency MBS as an attractive diversifier against traditional corporate credit risk and expect that to remain true next year.

With boosters like the Trump tax package, the US economy has grown more than other developed markets in 2018. The US consumer is strong, household balance sheets are healthy, and debt service costs (mostly fixed-rate) remain low. These factors are all strong fundamental supports for US asset-backed securities (ABS) and MBS.

CLO clouds gather

At more than $1.3 trillion outstanding, the market for leveraged loans is a growing example of a crowded market. Half of the US leveraged loan market is financed via collateralised loan obligations (CLOs) and this is one of the markets where we see clouds on the horizon.

Typical investor protections, such as loan covenants, have been shed. This is already resulting in below-average recovery rates when loans default. We believe that investors are not compensated for this increasing risk and should remain in the most senior levels of CLO capital structures. Additionally, external pressures could increase refinancing demand, while limiting refinancing options for outstanding leveraged loans; a typical precursor to higher default rates.

Continued demand for floating rate assets

One of the conditions creating demand for leveraged loans is increasing US interest rates. Their floating-rate nature has provided credit exposure without detrimental exposure to rising interest rates. We believe this will continue to play a part in 2019.

Floating rate exposure is also a feature of much of the global securitized credit market, excluding agency MBS. In addition, assets like consumer ABS and MBS are backed by loans from sectors that are more regulated and have not re-leveraged as dramatically as the corporate market.

US rental housing as a defensive asset

Mid-term elections in the US are settled, with the House and Senate controlled by different parties. US legislative changes such as tax plans or regulatory shifts are hence now much less likely. This reduces the chance of constrained residential mortgage lending abating.

This time around, the US lending landscape excludes the “affordability products” prevalent prior to the financial crisis. The vast majority of existing home loans are now fixed-rate. As such, existing mortgagors are unlikely to be challenged should mortgage rates rise.

Affordability, for a new home buyer; however, makes for significant headlines given the importance of housing as a basic need for nearly everyone. On one hand, rising home prices, as we’ve seen over the last several years, increase homeowners’ equity and provide protection for investors in earlier securitisations. On the other hand, with low supply of homes and rising mortgage rates, new home-buyers may be priced out. With lower availability of smaller square footage housing or affordable apartments, home prices in many markets are likely to be well supported. But something has to give as mortgage rates rise and we believe demand for rental housing is likely to increase. We view this as an important trend to monitor and a potentially defensive asset to own or lend on.

Contrasting fortunes for auto and student loans

Other types of lending, such as auto lending, have seen standards tighten and the benefits of recent declines in oil prices. We see this sector as priced fairly, even given the increased leasing activity seen in recent years.

In contrast, student loan debt has been the growing pariah of the consumer debt space, likely driving some of the delays in household formation and home buying. This continues to be a sector where we see higher levels of political risks.

US resilience in 2019

Despite some risks, we generally expect US ABS and MBS to have a lower correlation to downdrafts than other markets and continue to exhibit more attractive return per unit of duration, or price volatility. That said we still highlight the potential for changes in areas where credit or pricing has got ahead of itself, such as for leveraged loans or more subordinated commercial mortgage-backed securities

We expect the Fed will focus on the consumer, housing and inflation as decision tools when evaluating rates. As a result, we are expecting asset prices to remain stable and performance reasonable in 2019, albeit below 2018 levels.

Die hierin geäußerten Ansichten und Meinungen stellen nicht notwendigerweise die in anderen Mitteilungen, Strategien oder Fonds von Schroders oder anderen Marktteilnehmern ausgedrückten oder aufgeführten Ansichten dar. Der Beitrag wurde am 17.12.18 auch auf schroders.com veröffentlicht.