Global Perspectives: The outlook for securitized as Fed commences rate-cutting cycle

Lara Castleton:Hello and thank you for joining this episode of Global Perspectives, a podcast created to share insights from our investment professionals and the implications they have for investors. I’m your host for the day, Laura Castleton. And today we’re doing our biannual securitized update, reviewing what’s going on in the macro environment, talking about the various opportunities and updates in each securitized sector and what opportunities may lay ahead. To do that, I’m joined by John Kerschner, U.S. Head of Securitized Products at Janus Henderson, and John Lloyd, Head of Multi-Sector Credit Strategies. Gentlemen, thank you both for being here.

John Lloyd: Thanks for having us.

Castleton: Since we last recorded in April, there is a lot that has happened in the market. And I want to go to you first, John. We are timestamping this in October after a hotter-than-expected monthly jobs report, worse-than-expected jobless claims number, hotter-than-expected inflation print. So I think the one thing that has continued since the last recording is the market is very sensitive to every data point. How do we make sense of this? Where do you see the path of the Fed rate cut cycle and just the economy broadly?

John Kerschner: Yeah. So, we’ve had a backup in rates since the hotter-than-expected payroll number, and the market was actually pricing in more Fed cuts than the Fed itself. And now we’re back to the market being in line with the Feds. So, we have about five and a half cuts for next year priced in or through next year priced in. The terminal rates are largely aligned as well. If you remember, the Fed, in their last summary, economic projections moved up their terminal rate to 2.9%. And if you look at kind of the the forward curve, that’s roughly where the market is pricing in the terminal rate as well. And I think there’s a couple things we’ll be watching.

Obviously, even with the hot payroll number, a lot of the employment data that we’ve been seeing has softened and come in, has been coming in a little bit softer minus that one data point. And inflation is still trending down. Even in the inflation data today, one of the stickiest components we’ve seen in CPI, the rents component, has finally started to soften. So I think the important message for the market today is the Fed is going to be data dependent and is focused on their dual mandate and the second part of the mandate now, which is unemployment. And I think the market probably has it right now that we’re going to be in a Fed cutting [cycle], probably 25 basis points a meeting at this point, unless there’s a shock to the economy.

Castleton: So that sounds like it’s setting up the soft-landing backdrop pretty nicely. Would you agree with that?

Kerschner: I would agree with that.

Castleton: OK, well, let’s turn to you, John. I realize both of you are John, I should start calling … We’re going to call you Kersch and you Lloyd for for clarity, for people just listening. OK. So Kersch, securitized update … obviously securitized markets are much more tied to the consumer. We just talked about how a soft landing is perhaps on the table. What’s the update on the health of the broad consumer?

Kerschner: Yeah, overall, it’s better than you might believe reading the mainstream press. One thing maybe people realize, don’t realize, is if you look at the consumer in three different layers, so high level, medium level, low level, the high-level consumer is obviously doing very well. Why? You know, if you have a stock portfolio, stocks are very close to all-time highs, if not at all-time highs. And most, you know, high-level consumers are getting raises there, they have jobs, they’re wanting to spend … a lot of people traveling overseas because the dollar is very strong because the fed funds rate has been relatively high compared to a lot of other central bank rates. So, it feels pretty good, quite frankly, if you’re at the upper end, and that makes up about 55% of spending out there. Middle, you know, still probably decent because unemployment is relatively low. That middle is about 30%.

It’s the low-end consumer that people are most concerned around about, right? Because inflation is real. And I think there’s this misnomer from low-end consumer that inflation will turn into deflation, right? Like prices will actually start coming down. And for most places, that’s not going to happen, right? It’s just, inflation will slow down, prices will still go up, but just at a slower rate. But the low-end consumer is still only 15% of this economy. So not to write them off completely, but it’s not as important as the high-end consumer.

Goldman [Sachs] actually has a very good rubric to look at this. They break down the consumer into six different areas: spending, employment, income, wealth, debt, and confidence. And they measure each of these on a percentile basis, with lower being worse off, actually. And what you see, like some of these factors are very, very high. Like wealth is 98^th percentile. That’s from the stock market, obviously debt at 93^rd percentile. That’s because so many people paid down their debt during COVID because they didn’t have anything else to spend it on. Spending’s 59^th percentile. So not as as high, but still decent. Employment, 66^th percentile, that’s still very, very good.

Areas that are not so good are income; that’s because of inflation and confidence. And part of this is just, you know, reading in the mainstream press about what’s going on with inflation, things like that. And that affects people’s confidence. But the overall score is still 60^th percentile. So not gangbusters, but above average. And that’s how we would score it as well.

Castleton: Right. That’s a really helpful backdrop from the consumer. I think too often we just get the blanket, here’s the consumer exactly, which is not helpful when you’re in the securitized market exactly. So that breakdown was really helpful, just seeing that they’re broadly positive from a high-level perspective. But that nuance is really important, and we’ll get into the implications of that to the securitized sectors before we do that.

If I go to you, Lloyd, multi-sector credit strategies, you have the flexibility to go into many areas of the market. How are the spreads shaping up in the securitized versus corporate credit market? Are they still attractive today, and how do you view that relative trade going forward?

Lloyd: Yeah, it’s changed a little bit. So, if we were sitting here 18 months ago, we would have told you there was a pretty major opportunity in the securitized market versus the corporate market. I think the view has changed since then. We’ve seen securitized spreads tighten. So now we believe we’re in this carry type of market. The benefit of securitized is it’s still trading wide relative to its history, still trading wide versus corporates. So we think we’re getting better risk-adjusted carry in the securitized market. And just some examples of that, you can buy a CLO [collateralized loan obligation] AAA security, so highest rating out there, AAA, and you were seeing spreads in the primary [market] of around 100, and 35 basis points. And you’re looking at the IG [investment grade] corporate market trading in, you know, the 89 basis-point area right now. So a lot more spread.

And just remind anybody who’s listening, the IG corporate market is largely triple B as well, a big component of that. So higher rated, better spread. Do we think that’ll continue to tighten? We think there is some tightening potential on the margin, but even if you’re just sitting there in a carry environment, you’re getting better risk-adjusted carry in the securitized markets, and that’s true across ABS [asset-backed securities], gas, mortgages, residential credit, kind of all the sectors versus IG and and corporate high yield and loans.

Castleton: Right. We did start this over a year ago. So that story has been consistent, of securitized spreads being attractive, and interesting to hear the update that while it still is, that gap may narrow over the next coming six to 12 months. So that’s why it’s important to have that flexibility of somebody there that’s able to evaluate this on a daily basis. Exactly. Yep, great update there. So thank you.

Let’s dig into some of these more specific stories in terms of implementation for listeners. I want to frame it around just from like a duration perspective. If we just break out these asset classes first starting just on the ultra-short end, which, CLOs you just mentioned, Lloyd, one of the bigger components here at Janus Henderson. So Kersch, if I go to you, how are CLOs shaping up today, and why should investors continue to own something that is still short duration when the Fed is cutting interest rates?

Kerschner: Yeah, it’s a very good question. We get this question a lot from investors these days. Look, the nice thing about CLOs is, like John Lloyd mentioned, they’re still pretty wide spread, so they’re still giving you pretty decent yield, right? The Fed has cut, but only 50 basis points. Now, that will come down as the Fed cuts, but historically triple-A CLOs, and this comes with a big caveat because past performance is never a guarantee your future, but historically AAA CLOs have outperformed cash by about 100 to 150 to 200 basis points. And we’ve seen that over the last couple of years.

And so obviously cash yields will come down as well as the Fed starts cutting, and there’s still close to, depending on who you talk to, $6.5 to $7 trillion in money market funds. And so we still think that most people have a place in their portfolio for something that’s cash or cash-plus for those short-term kind of payments they have to make, or spending. And quite frankly, no one really knows. I mean, yes, the Fed will probably start to cut rates more after their 50 basis-point cut last meeting, but no one really knows how far they’ll cut. And so, if they cut, you know 100 basis points or even 150 basis points, you’re still getting, you know, kind of a 5% to 5.5% yield, whereas the 10-year Treasury is like 4% or a little bit above 4% today. So it still looks good on a relative basis to a lot of other longer-dated fixed-rate fixed income.

And then one final point, one other reason we really like triple-A CLOs, and this is a little bit of a nuance point, is net issuance is actually negative at the triple-A level now; gross issuance will be very close to all-time highs this year. 2021 was the biggest year of issuance, and CLOs coming off a very low issuance year obviously in 2020. So gross issuance is very high, but a lot of these are refis or resets of old deals. And so, net issuance, because you have a lot of refi-ing investors in CLOs, are getting a lot of cash back. Normally investors as an aggregate about $5 billion, they’re getting now about $20 to $25 billion back a quarter, and that gets reinvested back in the CLO market. And we obviously have one massive new investor in the CLO market that didn’t exist four years ago and barely was accounted for anything a year ago, and that was the CLO ETFs. There are now 19 CLO ETFs. It’s amazing. Some of those haven’t launched yet, but they’re coming. But lot of demand from CLO ETFs, and we think that’s going to continue, right?

Castleton: OK. So, great outlay on the short end of the curve, especially that opportunity with money market rates obviously have started to come down. So that 150 basis-point, hopefully, over money markets, great opportunity on the short end, still makes sense in portfolios.

Lloyd, let me go to you. As investors are looking to lock in some duration and some of this yield for longer, agency mortgage-backed securities are one of those ways to do that. And if you look at duration in general, you’ve got your Treasury sovereign debt, you’ve got your corporate credit debt, you’ve got agency mortgages as the main buckets. How is the landscape with agencies changing as of late, and what’s the opportunity there going forward?

Lloyd: So, our view is agencies are probably the best way to lock in duration. And I do want to start, in preface, one thing about locking in some duration as well going forward is with the Fed put in play, like I commented, and then focusing on unemployment as much as inflation. If we don’t have this Goldilocks scenario, you can see rates cut pretty rapidly to support the economy, right? So, it’s important to have that insurance in your portfolio. And a second point there is, it’s also our view as core CPI gets below 3% that rates will start being negatively correlated to spread risk and equity risk. So those are two kind of thematic reasons to think about adding and extending duration in your portfolio, especially as we’re getting to a Fed cutting cycle now.

Why are agency mortgages one of the best places to put duration in there? Well, I’ll start with almost, you know, 87% of the index is out of the money, meaning it’s not re-financeable right now, and the mortgage market does worry about convexity, prepayment risk. And so that’s a really positive sign. So you’ll capture that duration as rates fall. A second point with why we like mortgages is the mortgage spread right now is on the wider side relative to corporates, and we get asked, why did that happen? Well, the Fed went from doing QE [quantitative easing], where they were an indiscriminate buyer of mortgages at any level, to QT [quantitative tightening]. We had bank failures last year where they sold … the FDIC took over all their held maturity books and available for-sale books and sold those into the market. So we had a massive supply gut come onto the market that widened out spreads.

And then generally speaking, mortgages don’t like rate vol [volatility] as well, and rate vol’s been really high. So with the Fed cutting, we believe rate vol will come down. We’re kind of through that supply glut of the bank selling, and the Fed is actually getting much closer to ending QT as well. So the setup is really good for mortgages and the valuations versus corporates. You almost have to go back to the GFC [Global Financial Crisis] to see it as wide as it is today. So we think there’s still room for spread tightening on top of the duration you’re getting from the mortgage market.

Castleton: Great. So as a way to get in that Agg-like or that core defensive ballast and fixed income, agencies is a really sweet spot to overweight.

Kersch, if I go to you, there are still many investors that are looking for that non-Agg-like exposure, what they might miss in just the general benchmark, ABS is one of the largest buckets within the securitized space. Can you just talk to some of the fun and unique opportunities you see there? Maybe also some things to be wary of.

Kerschner: Right. And I think if you’re following the mainstream press, there’ve been a lot of articles about how delinquencies are going up and defaults are going up and, you know, to be cautious on this sector. You know, I already made some points on the consumer, but I think it’s a little bit of misnomer because what they’re comparing it to is, you know, the 2021 experience where any measure of consumer health was at all-time best levels. You know, whether it’s defaults at all-time lows, delinquencies at all-time lows, bankruptcies at all-time lows, you know, kind of the amount people had as far as savings or in their checking account was at all-time highs. And that’s obvious, right? Because government was giving out money, most people were very smart about it. They saved some, they spent some, they paid down debt with some. And so now we’re kind of ticking back up to a more normal range.

But if you look at actually subprime auto, so these are, you know, pretty low on the FICO score. Consumer is usually 660 FICO and below, it’s about a third of our country. And you look over the last, you look at delinquencies or defaults on a year-on-year basis, delinquencies are down 19 basis points and defaults are actually down 29 basis points. So it’s not a huge change, but this kind of narrative of, like, delinquency and defaults are way up, it’s not actually true when you look at, you know, under the hood, no pun intended … actually, pun intended. So, when you really get into the details, you see that. And another point that a lot of people don’t realize is, when you look at some of that data, it’s just Fed data for the entire, let’s say auto loan market, that’s $1.6 trillion. The auto ABS market is only just a bit above $200 billion. So you’re looking about like one-eighth of the entire market out there is actually securitized. And then under that, kind of $200 to $250 billion that’s securitized.

We obviously do a lot of due diligence, bottom-up fundamental work. There were a lot of new issuers, you know, coming out of the GFC, kind of the mid-teens going into COVID and some of those new issuers have not done very well. So you have to know what’s going on. You can’t just buy the market, and it really speaks to active management in these spaces.

Castleton: What are some of the areas that you’re most excited about with?

Kerschner: So, I think maybe the poster child for most excited is data centers. They’re issued both in ABS and CMBS [commercial mortgage-backed securities] because they are commercial real estate in some respects, but they have kind of a, you know, a corporate, whoever the tenant is, aspect to it. So that’s more ABS, but the numbers around data centers driving the AI growth are just astounding. And you’ll hear it from our equity research team as well. You’ll hear from the corporate credit team. But the most outstanding stat I saw was, like the next five years, the amount of new energy we need in this country equates to what Japan puts out currently. I mean, it’s just it’s hard to wrap your head around how much is needed.

And, you know, these are not like warehouses you can put up in two months; they’re, you know, complicated type structures. And obviously you need the power and it’s unclear where some of that power is going to come. There’s more talk around nuclear energy, if that comes online, bringing like gas-fired plants back online, things like that. But bottom line is, this isn’t going away, right? Like you talk to our equity brethren up on floor 7, they will give you all sorts of stats of how AI is just still in the early innings. I believe this. I do think it’s going to be kind of revolutionary. And so how that filters down to us on the 6^th floor, you know, we’re just lowly bond guys, but like we like these areas that are new, they’re different, you have to understand the fundamentals. We think we have a leg up on that. But maybe most importantly, because they’re new, they trade very cheaply to a lot of different asset classes out there. So, we can buy data centers, investment grade-rated, 300 off, something like that. And like John Lloyd mentioned, the index is what? What is it now?

Lloyd: 89.

Kerschner: 89.

Castleton: OK, great. And speaking of real estate, Lloyd, talking about the CMBS market, there’s been hopes that lower rates will be more supportive of one of the hardest-hit sectors in the securitized market. How do you see the broad CMBS market shaping up? Are there still some secular trends that are painful for that space, as you would hear on the headlines?

Lloyd: Yeah, I think you really have to divide that market up. You know, having some Fed cuts will help on the margin. The unfortunate thing though is most of the office real estate, a couple Fed cuts aren’t going to do it. It’s really a thematic issue that’s hitting that sector, of you just have less people that are in office in person on a regular basis. You have very high vacancy rates. So, you really need something to change there to save a lot of that, call it class C, class B office space in many of our cities. So I don’t expect the Fed rate cuts to offset some of the pain that’ll come in that market. But it does create a lot of opportunity for investors who are active managers and can do due diligence into the market.

And you know, John mentioned one of the themes with data centers, you’ll get those issued in the CMBS market as well. Industrial warehouse has been an area that we’ve played, and think about that thematically, it’s the Amazonification of the world, and we still don’t have enough industrial warehouse space. So it’s a gross space, and those spreads are coming, you know, very cheaply in that market because of the turmoil of office hospitality. We’ve seen some really good deals there, you know, where we can buy Four Seasons investment grade in the 300-type spreads for marquee, you know, Four Season properties, right? So, you can really focus on, you know, kind of trophy assets and get really good yields or really good themes within that market as well.

Castleton: Great. Well, I’m getting a theme across the entire securitized landscape is that when we talk spread, the compensation over, for risk-taking outside of the risk-free rate, they seem to be wider across the board and securitized, probably because there’s a lot more due diligence that needs to be done within those sectors. But that leaves a plethora of opportunities for investors to look outside of the more traditional sovereign corporate credit markets. Again, that might not always persist if we look out in a year, but for now that play is very much happening.

So I want to end, Kersch, with you. Just the securitized market, one of the biggest, what are some of the things you see next for that market in general?

Kerschner: Yeah. I mean, I think there’s been a lot of talk about private credit. Obviously, our CEO, Ali Dibadj, has been out there talking about how we want to buy or get into private credit. We bought Victory Park [Capital]; it closes I think at the end of this year. They are a smaller player, but very interesting. They do a lot of consumer credit, and one area that we have aligned with them on is litigation financing. This has been … it was coming to the public markets, and we were very big players in it kind of right before COVID, and now it’s gone more private credit. And what this is very simply is, if you think about there’s a big class action lawsuit and the court system moves very slowly, right. So there comes a time where they know they’re going to win the case, but the money hasn’t been paid out yet. And sometimes that can take months or even years to happen. And so, think of, you have a class action lawsuit with 10,000 people that are going to get paid out. Those people want their money sooner rather than later, and they’re willing to pay a premium for it. So, there are people that have started these companies to, you know, offer them the money ahead of time, obviously at some kind of haircut, and then they will securitize that knowing that the money’s coming. And the nice thing about it, it really has nothing to do with the economic cycle. That’s why it performed so well during COVID. As long as the courts were open, this sector would continue to pay investors. And yes, the courts all went remote, but they stayed open. And so it’s just this very niche business. It’s not huge, but again, it’s very interesting because of the non-correlation and how low, you know, delinquencies, their defaults have been, because once you know a settlement’s gonna be paid, eventually it will be paid.

So that, that’s just a sector that we were very involved in several years ago and then we kind of went away, and we’re like, OK, what’s going on here? And now we kind of know, it’s like, firms like Victory Park, they’re now kind of giving money to these issuers privately. And so we’re very excited to work with them where we can take their expertise, our expertise and combine it.

Castleton: Very interesting. And that’s definitely a space I’m hearing more from clients on, is the private market. So we’re investing a lot there. Appreciate you laying out those examples. And for the update today on the securitized market, when the economy is uncertain, there’s volatility, every data point is confusing, it’s useful to rely on some strong fundamental stories, and you both laid out some really compelling ones today. So thank you for that.

We hope you all enjoyed the discussion. For more insights from Janice Henderson, you can download other episodes of Global Perspectives wherever you get your podcasts, or visit janicehenderson.com. I’ve been your host for the day, Laura Casselton. Thank you. See you next time.

“Agg” refers to the Bloomberg U.S. Aggregate Bond Index is a broad-based measure of the investment grade, US dollar-denominated, fixed-rate taxable bond market.

Basis point (bp) equals 1/100 of a percentage point. 1 bp = 0.01%, 100 bps = 1%.

The Bloomberg US Mortgage Backed Securities (MBS) Index tracks fixed-rate agency mortgage backed pass-through securities guaranteed by Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC). The index is constructed by grouping individual TBA-deliverable MBS pools into aggregates or generics based on program, coupon and vintage.

Carry is the excess income earned from holding a higher yielding security relative to another.

Credit Spread is the difference in yield between securities with similar maturity but different credit quality. Widening spreads generally indicate deteriorating creditworthiness of corporate borrowers, and narrowing indicate improving.

Credit quality ratings reflect the lower rating received from Standard & Poor’s and/or Moody’s. Not rated securities are not rated by S&P or Moody’s but may be rated by other rating agencies. Ratings are measured on a scale that ranges from AAA (highest) to D (lowest).

Duration measures a bond price’s sensitivity to changes in interest rates. The longer a bond’s duration, the higher its sensitivity to changes in interest rates and vice versa.

Forward curve represents the expected future prices of a security over different points in time, as determined by current market conditions. It reflects market participants’ consensus on how these prices will evolve, influencing investment and hedging decisions.

Quantitative Easing (QE) is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market.

Quantitative Tightening (QT) is a government monetary policy occasionally used to decrease the money supply by either selling government securities or letting them mature and removing them from its cash balances.

A yield curve plots the yields (interest rate) of bonds with equal credit quality but differing maturity dates. Typically bonds with longer maturities have higher yields.