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Written by: Jeffrey T. Katz and Gordon Li, CFA | TCW
Inflection points come fast and furious in the twilight hours of a cycle, and the market’s erratic tendencies were on full display last quarter. Though risk assets broadly continued to extend their upward march for much of the quarter on the belief that the economic outlook is rosy, the market held on to such convictions with a noticeable nervous edge. Indeed, all it took was a smattering of mixed economic news the first week of August to set off a rout in the stock market, a blowout in credit spreads, and a significant rally in rates. While the subsequent rebound in spreads left risk assets largely unscathed, the shift in sentiment for rates was clear: “higher for longer” is out, “demand for duration” is in.
For securitized assets, the weeks that followed were marked by the unraveling of the “carry” versus “total return” trade, a reversal that is perhaps best exemplified in the performance of agency mortgage-backed securities (MBS). The conventional 30-year par coupon has fallen from roughly 6.0% in late June to under 5.0% today, a 1-point swing in a quarter. As rates have rallied between 50 and 100 basis points (bps) across the yield curve since April, the “duration effect” – along with positive technicals and shifting investor sentiment on prepayment speeds, convexity risk, and terminal rates – has led to the significant outperformance of discount-dollar-priced profiles. Excess returns for Fannie 2.0s and 2.5s surged over 2% since the end of May and are now leading this year’s excess returns in the coupon stack, trouncing the higher coupons that have struggled to tread water. Indeed, the comfort of carry in higher coupons evaporated rather quickly as the higher-for-longer narrative faltered and prepayment risk reemerged.
Agency MBS Par Coupon and Current Coupon Spread
Source: Bloomberg
Excess Return by Conventional 30-Year Cohort
Source: Bloomberg
In non-agency MBS, similar dynamics have prevailed. Seasoned lower coupon collateral, housed in bonds priced in $80 and $90 dollar handles across prime jumbo and non-qualified mortgage (non-QM) sectors, has caught a second wind. These bonds, with longer durations, have benefited the most from the rally in rates and a speedy repricing of prepayment assumptions – a sharp reversal from below-turnover-floor expectations held just a year ago. For such deeply discounted profiles, any incremental increase to speed assumptions presents significant upside potential via pull-to-par convexity. As primary mortgage rates fell close to 1% last quarter, the market repriced these bonds to faster prepayment speeds, with long-term conditional prepayment rate assumptions increasing by 1% to 2%, translating to a nominal spread pickup of between 20 and 30 bps. At the same time, growth in closed-end second lien and continued strength in non-QM supply has given investors in mortgage credit ample opportunity to take on high quality bonds backed by strong housing fundamentals and priced at healthy spread pickups to agency MBS risk.
On the subject of supply, the blazing pace of issuance that has led off 2024 has shown no sign of slowing in recent months. If anything, the seemingly insatiable demand from investors has further emboldened issuers to open the taps. The commercial mortgage-backed securities (CMBS) market saw a thawing in credit availability for office properties, along with ongoing supply in hospitality and industrial deals, for certain tier-1, higher-quality assets. With over 70% of single-asset/single-borrower deals this year coming in the form of floating-rate structures, the turn in rates has driven a scramble for fixed-rate bonds, especially for subordinated tranches. Indeed, BBB-rated fixed-rate conduit spreads have compressed from close to 800 bps at the start of the year to around 450 bps in September, with tranches reaching over ten-times subscription levels as investors’ demand for duration easily outpaced the barrage in supply. In collateralized loan obligations (CLO), low liability costs and deep investor demand (further buoyed by the ETF bid) has precipitated a record amount of refinance/reset issuance that accounted for roughly 60% of total supply this year and reshaped the market. As a result, only 26% of CLOs today have exited reinvestment, compared to an expected 50% a year ago, while the maturity profile of deals has also extended with a fifth of the market maturing in more than four years.
2024 CMBS Issuance and Spread Levels
Source: Barclays
Refi/Reset Volume Extended the Maturity Profile of CLO Deals
Source: Deutsche Bank
Asset-backed securities (ABS) issuance tells a similar story, with ongoing momentum in “esoteric” sectors. Last quarter saw the expansion of digital infrastructure and whole business supply, along with the notable return of aircraft deals – a sector that bore the full brunt of a global pandemic and geopolitical turbulence in recent years. All in, esoteric deals accounted for about 20% of this year’s record ABS issuance as sponsors sought to lock in favorable funding terms on the back of tighter spreads and strong investor appetite for bonds. As rates have fallen and spreads have compressed, much of recent issuance has moved into premium territory, elevating refinance risk in freely callable bond structures. Rather than exercising caution in the face of prepayment risk inherent to bonds priced far above par, investors have thrown caution to the wind by justifying these higher prices by pricing bonds “to maturity” instead of “to worst.” Yet another example of exuberant investors valuing assets to “best case” scenarios!
As exemplified by the August experience – which saw the stock market sell off 6% and corporate excess returns1 fall 1.2% in the span of a week – the prevailing paradigm for risk pricing is built not on the foundations of fundamentals but on the shifting sands of sentiment. Against this backdrop, our process in securitized investing remains resolute: capturing high quality spread and total return potential in bonds backed by strong fundamentals and bulletproof structures. Indeed, such a value-driven portfolio is better positioned to weather the volatility that accompanies a turn in the credit cycle and then produce asymmetric upside as risk pricing normalizes.
1 Bloomberg U.S. Corporate Bond Index