Investment Insights

Securitised credit can be an important

diversifier in bond portfolios

December 2022

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Securitised credit can be an important

diversifier in bond portfolios
Key takeaways
• The excess yields available from investment-grade and high-yield
Xavier Goss corporate bonds are beginning to attract “crossover” investors.
Portfolio Manager • Asset-backed securities look attractive in the current rising
interest rate environment given their shorter duration.
• Including securitised credit in a fixed-income portfolio could
provide diversification benefits due to its lower correlation with
corporate credit.
• Security selection will likely be the key to alpha generation for
securitised credit in the coming years.

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 As the risk of recession looms large over financial markets, how will securitised
credit fare? It’s a growing area of bond markets that has become an important
anchor of some actively managed, fixed income portfolios. Portfolio manager
Xavier Goss discusses the reasons he remains optimistic on several areas of this
market despite some near-term challenges.

The economic outlook is mixed

The US Federal Reserve (Fed) is obviously looking to bring inflation under
control, which means we will likely see the economy slow down and
unemployment go back up. But while tightening financial conditions should be a
headwind, US consumers have remained strong because of wage inflation and
low unemployment, as well as the subsidies they received directly from the
government. Therefore, even if the US heads into a recession, consumers are
starting from a much better position than they were in the lead-up to the global
financial crisis.
Overall, it is not a bad time to be looking at fixed income broadly. With the
backdrop of rising unemployment and slower growth, I do expect defaults to
increase from current low levels, but relatively tight underwriting standards and a
stronger US consumer should help mitigate downside risk. Additionally, the
excess yields available from investment-grade (BBB/Baa and above) and high-
yield corporate bonds are beginning to attract “crossover” investors who are
dipping their toes into fixed income. There is a lot of cash in the system and new
issuance is low. This could provide a nice backstop for the securitised market.

1. Asset-backed securities provide income and diversification

Securitised credit today is a large and diversified sector. At one end of the
spectrum, you have asset-backed securities (ABS), comprising consumer credit
such as student loans and auto loans. At the other end, you have commercial
mortgage-backed securities (CMBS), backed by loans on a variety of assets such
as industrial warehouses, office buildings and retail malls. The securities are
segmented into different credit ratings, depending on the level of
collateralisation (i.e. the value of the assets backing the loan) and/or their
position in the capital structure.
Today, in the portfolios I manage, the largest relative exposure in securitised
credit is to asset-backed securities backed by consumer loans. I am optimistic
about the continued strength of US consumers’ balance sheets. Given where we
are in the financial cycle, I prefer taking shorter duration credit risk in consumer
loan sectors as opposed to longer duration commercial assets. ABS look
attractive in this rising rate environment as they tend to have significantly shorter
duration (meaning they are less sensitive to interest rate fluctuations). These
assets have tended to be good diversifiers and income generators for portfolios.

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 US consumers remain strong despite economic headwinds

Past results are not a guarantee of future results

Data from 1 January 2003 to 30 June 2022. Sources: New York Fed Consumer Credit
Panel, Equifax

In the coming years I expect there will be significant divergence in performance

across sectors. This should increase the opportunity to generate alpha through
security selection. Bonds backed by subprime auto loans are a good example of
asset-backed securities that have shorter duration and increased credit risk,
depending on the originator of the loans. This is an area where credit research
can add substantial value.
Private student loans in the US are another example. Credit risk on these loans
has come down marginally because of US President Joe Biden’s move to
provide debt relief to educational loan borrowers, though the programme is
being challenged in court. Private student loans are, of course, not being
forgiven by the government, but it is common for students to have both a federal
loan and a private loan. However, the debt relief on the federal loans should
lighten the overall debt load, thus the credit risk on private loans should be
lower. If the programme receives approval to go ahead, it would likely provide a
further catalyst for the sector.
Overall, the portfolios I manage are about a year-and-a-half to two years short
spread duration versus their benchmarks. (Spread duration is a measure of how
the price of an asset moves in relation to its credit spread.) I believe financial
conditions will tighten further, and as a result, structured credit spreads need to
widen from current levels. I try to keep the investment portfolios I manage
balanced between income generation and total return. So, while the market is
tilting toward a risk-off stance, I want to own a decent amount of assets that
provide a strong revenue stream.
Even with the Fed tightening aggressively, I do not expect US unemployment to
spike significantly in the next 12 to 18 months. So, if I am buying a bond that
matures in two to three years, I am comfortable taking on slightly higher credit
risk given the shorter maturities.

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 2. Select opportunities in CMBS despite retail headwinds
Commercial mortgage-backed securities are a different story from consumer
ABS. These assets are longer duration in nature and closely tied to gross
domestic product (GDP) growth and corporate profits. I currently favour the
more senior part of the capital structure in CMBS. In a slowing economy, I don't
really want to own long-duration intermediate-risk (mezzanine) tranches as they
tend to be more vulnerable to slowing GDP growth.
While I remain cautious on CMBS overall, there are some corners of the market
that still look attractive. In terms of the underlying collateral of these bonds,
warehouses for companies like Amazon and other large retailers, data centres
and industrial buildings have held up better, but there is still a lot of uncertainty
in the office and retail sectors. Some companies are bringing their employees
back to the office five days a week, which should be positive for CMBS. But it is
impossible to project what the office sector will look like in the coming years.
Lower office attendance has also meant less foot traffic in commercial city
centres, which can be a headwind for retail. But even if the reopening brings
more people into stores, the retail sector is still facing the same challenge it has
faced for years with people shopping more online.
I see better opportunities in commercial mortgages in single-asset, single-
borrower (SASB) deals, where instead of the bonds being backed by a broad
portfolio of commercial real estate, it's just one asset or a small handful of assets.
The majority of deals, by total volume, coming to market this year have been
SASBs. This is representative of a shift in investor preferences. Single-asset
borrower deals are also easier to analyse than a traditional CMBS that contains
multiple underlying assets. Currently, in portfolios I manage, the CMBS sleeves
are almost equally split between SASBs and more traditional conduit deals
backed by multiple properties.

Single-asset CMBS have gained significant market share

Past results are not a guarantee of future results

Data as at 13 October 2022. Sources: Capital Group, Bloomberg

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 3. Managing risk in non-agency residential mortgages
In non-agency residential mortgage-backed securities (RMBS) assets, I currently
prefer credit risk transfer securities, which are US government-originated loans
that have been offloaded to the private sector. I think the biggest potential
headwinds in this sector are extension risk and a moderate increase in
delinquencies as unemployment increases. With rising interest rates, borrowers
are likely to extend their mortgages. Borrowers who received loans or refinanced
their existing mortgages during the pandemic when rates were below 3% are
unlikely to prepay any time soon. Relative to asset-backed securities, mortgage-
backed securities need much greater management of duration and convexity
risk.
I am also starting to look out for deteriorating underwriting standards. Broad
market underwriting standards appear to have returned to pre-COVID-19 levels
as certain lenders look to increase origination volumes to meet loan demand.
However, as financial conditions tighten, I expect we will see significant
bifurcation in terms of what loan originators will do.
Savvy originators are likely to tighten their underwriting standards, or at least
keep them consistent and be willing to let their origination volume go down as a
result. On every call that our analysts and I have with originators, we ask about
their underwriting standards and their origination volumes. If their volumes are
up in the last year, it is an immediate red flag.
Originators that have steady backing from long-term investors tend to accept
that their origination volumes can decline 20% or more given current financial
conditions. I expect any weakening of standards to first appear in private equity-
funded issuers since many commercial banks have maintained a more
conservative stance.
Given this backdrop, I strongly believe that security selection will be a key driver
of results in the coming years. We have a team of analysts that aims to sort the
good originators from the bad ones.

US home sales have declined amid rising mortgage rates

Past results are not a guarantee of future results

Data as at 15 September 2022. Source: Refinitiv Datastream

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 4. Highly selective on CLOs
One of the key benefits of having securitised credit in a diversified fixed-income
portfolio is that it has a lower correlation with corporate credit. You can generate
similar returns while getting decent diversification. Right now, I’m looking for
relative value opportunities along the same lines I mentioned before: shorter
duration credit in consumer loan sectors.
That's manifested itself in the portfolios I manage in an overweight position in
consumer ABS. I am also looking to build a position in collateralised loan
obligations (CLOs), although I am highly selective and opportunistic when
investing in these securities. I think there is going to be an opportunity in CLOs,
but for now there are a lot of technical headwinds. Valuations are relatively high
and there are a significant number of loans sitting on dealer warehouse lines,
which have not yet been securitised. US and Japanese banks, which have
historically been large investors in CLOs, are also dramatically reducing their
demand due to recent changes in the regulatory environment for US banks.
Meanwhile, a strong US dollar is reducing demand from Japanese banks. That
leads me to believe spreads are likely to grind wider in the coming months.
Given the above technical backdrop, potential purchases in the future will be
very slow and deliberate.

5. Fundamentals are supportive of securitised credit

While an economic slowdown always increases risk, I am less worried about
forced selling by leveraged investors than I have been in past cycles. Many
securitised credit investors have been cautious on the market since the start of
2022 and are holding significant cash positions.
It is probably one reason why credit spreads have held up relatively well despite
the recent sell-off in equities. Another factor supporting structured securities is
that there is just not a lot of supply coming to market. New issuance in the
corporate sector is down around 30% year-over-year; structured products supply
is lower by around 50% relative to the prior year.
While the risks emanating from a weakening economy cannot be ignored, the
securitised credit market appears to be in a pretty good spot overall from a
fundamental perspective. I expect overall credit fundamentals to weaken, but
security selection will be the key to alpha generation in the coming years. There
will be ample opportunities to utilise our deep credit analysis to add value for
clients.

Xavier Goss is a portfolio manager at Capital Group. He has 18

years of investment industry experience and has been with Capital
Group for one year. He holds a bachelor's degree in economics
from Harvard University. He also holds the Chartered Financial
Analyst® designation. Xavier is based in Los Angeles.

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