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Written by: Chandler Nichols | Advisor Asset Management
Credit markets have recently offered meaningful returns and income; however, credit spreads are signaling stretched valuations. Meanwhile, we think “higher for longer” is likely to remain as strong economic signals commence paired with the inauguration of a new U.S. president seeking to shift the fiscal and geopolitical landscapes.
Investors will have to assess how these macro factors impact fixed income markets. Duration management remains a critical consideration in the new year as U.S. 10-year Treasury yields have actually increased by 100bps (basis points) since the Federal Reserve (Fed) started cutting interest rates on 09/18/2024.1 Higher quality, securitized assets may be an intriguing segment of the market to potentially lower one’s risk profile while achieving elevated relative value and income potential.
Key Takeaways
- Credit markets are showing signs of being overvalued as recent spread tightening paired with macro-level uncertainties remain as a new U.S. president is set to enter office.
- Asset-backed securities (ABS) have historically offered attractive income prospects relative to their corporate bond counterparts.
- Consumer trends remain healthy, bolstering the case further for consumer-oriented asset-backed security exposures.
Fixed Income Market Credit Spreads Have Tightened Significantly
The U.S. economy proved that it can still thrive during periods of elevated interest rates and compressed credit spreads have reflected this. The Federal Reserve’s “higher for longer” stance raises the question as to how much longer this can continue. Elevated borrowing costs may increase the strain on corporate balance sheets, particularly for high-yield issuers with lower credit quality, as there is an expectation for roughly $1.5 trillion in new corporate bond issuance during 2025.2 As rates stay elevated, the market may begin to price in wider spreads and fixed income investors should account for a potentially slower pace of rate cuts.
Asset class representations are as follow: Investment Grade US ABS, ICE BofA AA-BBB US Asset Backed Securities Index; 1-3 Year US Investment Grade & HY Corporates, ICE 1-3 Year US Corporate & High Yield Index | Past performance is not indicative of future results.
From a fiscal standpoint, the Trump administration is likely to tackle tax reform from the get-go. The Tax Cuts and Jobs Act expiring at the end of 2025 would result in roughly $4 trillion in tax increases for the start of 2026.3 Therefore, continuing this reform while exploring tariffs and de-regulation as ways to generate additional government revenue and maintain above trend growth are expected to be key initiatives.
While the macro backdrop is certainly different from when President Trump first took office, ABS maintained their tighter credit spread profile through most of his first term. It’s important to note that the aforementioned tax law was originally passed at the end of Trump’s first year as president too.
Asset-Backed Securities Offer a Relative Value Opportunity
Asset-backed securities are securitized fixed income securities backed by a pool of loans or leases taken on by consumers or corporate businesses. Organized into tranches and segmented by risk profile, the higher the tranche, the higher the credit quality. Structured with embedded protections such as overcollateralization and excess spread checks, the asset class is enabled to potentially offer a more robust credit profile relative to corporate credit counterparts.
ABS tends to offer lower duration profiles too, due to the short-term nature of the underlying loan pools. For example, credit card balances are revolving and frequently replenished while auto loans typically have terms ranging from 3-5 years.
With a notch higher in credit quality, the income potential for ABS has been historically higher than that of corporate credit, investment grade and high-yield issuances included. Currently, the yield spread between the two sectors favored ABS and was trading in-line with its 10-year median at the end of 2024.
Asset class representations are as follow: Investment Grade US ABS, ICE BofA AA-BBB US Asset Backed Securities Index; 1-3 Year US Investment Grade & HY Corporates, ICE 1-3 Year US Corporate & High Yield Index | Past performance is not indicative of future results.
The Current Macro Environment Bolsters the Case for Consumer-Based ABS Exposure
Moreover, ABS tends to benefit from the resilience of certain sectors, such as housing or consumer finance, where underlying fundamentals have been resilient despite elevated interest rates. Even as total household debt hits new highs, consumer debt as a percentage of disposable income is still trending below its historical median.4 Furthermore, the unemployment rate has been relatively modest and below its 40-year median as well.5
Final Thoughts: ETF Flows Signal a Strong Demand for Securitized Fixed Income Exposures
The U.S. ETF (exchange-traded fund) industry had a banner year in 2024, breaching $10 trillion in assets under management (AUM) with over $1 trillion of net new assets.6 Both are a first for the U.S. ETF industry. Amongst the asset raise is an ever-growing fixed income ETF market that absorbed 27% of total 2024 flows, currently flexing $1.8 trillion in total ETF AUM.7,8 Breaching $16 billion in new asset flows over the last 12 months, securitized debt ETFs have surpassed both investment grade and high yield bond ETF flows over this same timeframe as investors are seeking to diversify multi-asset portfolios further.9
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1FRED, measured from 09/18/2024 through 01/08/2025
2Goldman Sachs (2024, October 23) Companies may issue $1.5 trillion of US bonds in 2025
3Thomson Reuters Tax & Accounting (2024, September 13) What to know about TCJA expiration
4Dumas, Breck (2024, December 30) US credit card defaults soar to highest level in 14 years
5FRED, measured using monthly data from 11/1984 through 11/2024.
6Roy, Sumit (2025, January 02) 2024 ETF Inflows Topped $1.1T, Shattering Previous Record
7Ibid.
8AAM using data from FactSet, measured from 01/08/2024 through 01/08/2025
9Ibid.