Global Perspectives: Navigating U.S. securitized markets in an uncertain rate environment

Laura 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, Lara Castleton, and I am thrilled to be here once again, sitting with John Kerschner, U.S. Head of Securitized Products, and Nick Childs, Portfolio Manager on our Securitized Credit Team.

At Janus Henderson, we’ve invested in our fixed income securitized team. If you haven’t checked out our episode from October of last year, these gentlemen both lay a fantastic foundation in defining and demystifying the entire securitized market.

Since October, there’s been a lot of movement with rates, including at the end of last year, the market getting a little overexcited about rate cuts, and then at the start of this year the anticipation of rate cuts slowly being squashed.

So, John, I want to go to you first, because without a doubt, the number one question that we get when we do consultations with clients on portfolio construction is, “When are central banks going to cut and by how much?” Is that an important question?

John Kerschner: Well, it’s definitely an important question. There actually has been one central bank that’s already cut, Swiss National Bank cut, I believe it was last week. So, the process has already started. You are correct that coming into the year, the market got ahead of itself a bit, thinking there would be six or seven cuts, basically one at every meeting starting in March. And that has been pushed back, and now the market’s somewhere between two or three cuts. June maybe for the first cut, maybe not until July. But, interestingly enough, we still have three CPI [Consumer Price Index] reports before the June meeting. And the June meeting actually happens the morning … the afternoon of the CPI report. So, a lot of data still to come, so it’s a little bit unclear.

So, why is it important? Because the markets, and particularly rates and the yield curve, are going to reset themselves based on the path or the trajectory that the Fed [Federal Reserve] sets. That being said, I think investors get a little too wound up about that, because whether it happens in June or July or even September doesn’t really matter for most investors portfolios. I think what’s important is, first and foremost, the Fed is done raising rates, right? We know that almost for a certainty. And really what you should focus on is the path of cuts and then the terminal rate. And that’s the big unknown right now. Most people don’t believe that we’re going back to zero percent fed funds almost for sure. But whether that’s 2%, 2.5%, 3%, 3.5%, it’s somewhat unclear.

But I do think the Fed wants to start the process and go very slowly. They don’t like going at 50 basis points or even 100 basis points at a time. They want to cut once, get the process going. We can also talk about paring back the quantitative tightening that they’re doing and what that will do, because the Fed has multiple tools, but the biggest ones are obviously interest rate cuts and then the balance sheet that’s still very, very large. And so, I think they want to get the process going, probably two or three cuts this year and then maybe four or five cuts next year. And as long as that’s the case and there’s no big surprises, then investors should be OK.

Castleton: I should mention that we’re recording this in early April, so the market is changing very quickly, but having said that, gradual cuts this year, some more next year. Nick, how does that affect securitized markets? I’m assuming it wouldn’t affect every securitized sector uniformly.

Childs: No, certainly not. You know, one of the more nuanced things around securitized is that debt tends to be issued toward the front end of the yield curve. So, think zero to five-year – that’s where our debt is concentrated. And so, for us that becomes a fairly acute opportunity given the shape of the curve. So, we have a massively inverted cash-to-10-year note, as an example interest rate curve. We know the Fed’s going to cut at some point, and we know that interest rate curves have to be … they have to re–steepen at some point in time, right? That’s the natural order of things. So, to that end, for securitized, our market really does favor that. And I think one of the things that we talk a lot about clients with is, it might be traditional that a client kind of barbells their interest-rate risk. It’s certainly balance-sheet friendly to be long 30-year notes versus all your other areas of fixed income to get interest-rate risk in your portfolio. Today I think folks need to be mindful of that, because the curve shape, #1 and #2, we believe that neutral rate is going to be higher moving forward.

So, the two major areas of securitized, you have agency mortgages, these are government guaranteed assets. They’re on the longer side in terms of duration risk, particularly today given there are no major categories of borrowers that are refinanceable. And then you have the securitized credit side, which tends to be commercial real estate, so those are five-year debt obligations, but traditionally credit cards, autos … for those that have auto loans, you know the kind of terms of those. So, to that end, while the securitized credit is on that front end of the part of the curve, your mortgage, your agency mortgage area is a longer-duration asset. What a lot of folks don’t realize, agency mortgages strongly prefer a steepening yield curve. And that spread function, you will see a tightening function based on interest rates, based on a steeper interest rate curve.

Castleton: Right. Thank you. And so overall, it seems like we’re potentially facing a path where there’s less interest rate volatility, which is pretty attractive for most assets, including the securitized market. Is there anything you wanted to add, John, on the Fed balance sheet?

Kerschner: It’s interesting, there’s something called the MOVE Index, which is just a measure of interest-rate volatility. If people are familiar with the VIX, it’s a measure of equity volatility. It’s come down a lot. So, if you look at between basically the GFC [Global Financial Crisis] and COVID, it pretty much ranged between 40 and 100, averaged about 60, and then actually when Ukraine was invaded, went all the way up to 200. That’s a massive move. And it didn’t stay up there too long, but it stayed elevated, kind of in the 120, 130, 140 range, and the actual numbers don’t really matter, but just much higher than average. And that has actually been detrimental to mortgages, because mortgages have optionality in them, and so with volatility higher, that basically hurt the valuation of mortgages.

But now, as the Fed has gotten closer to cutting rates – and we’ve been telling investors this for a long time, probably the last couple of years, that once the Fed got close to cutting rates, that interest rate volatility would come down – and now it’s below 100. I think it got even in the 80s the other day… the last couple of days it’s popped up a little bit, but still below 100. And we do believe it’ll normalize, maybe not go all the way back down to 40, but 70, 80. And so, what this means is, it’s just easier to value a lot of securitized products because there’s a lot of optionality. Not just mortgages, but most securitized products have some kind of call feature. And if it’s easier to value, that means spread should come in. So that’s a very good sign, and the market hasn’t really priced that in yet. So that’s one of the reasons why, another reason why we’re so bulled up on securitized products.

Castleton: Something you walked through the last episode was just how much the securitized market in general is tied to the consumer. And so, that is one of the concerns, that the U.S. consumer in particular was a strong buoy to our economy last year, and there’s thoughts that that might come to an end here in 2024. Honestly, Taylor Swift only has so much content she can come out with after the Ambassador tour, so there already are some headlines coming out about rising delinquencies. John, going back to you, is that something that you’re concerned about?

Kerschner: So, we get this question all the time, because you see it in the news headlines, right? And the problem is, this is not univariate type issue, like, delinquencies up, delinquencies down. Why? Because when you look under the hood, it’s not an apples-to-apples comparison. So, what do I mean by that? If you’re just looking at, let’s say auto delinquencies or subprime mortgages, you’re assuming that not only the issuers are staying the same, but they’re issuing in the same amount, and then the borrowers are staying the same. And as it turns out, all three of those are different. If you think about … there’s many issuers in subprime auto market, probably 25 different issuers, and some of those are new, some of those have gone away, some of those are issuing more, some of those are issuing less. And so, when you’re just taking one slice of the market and saying, “Well, delinquencies are going up,” you’re not calibrating for all that, and that’s a problem.

Another thing that we’ve done a lot of work on is that FICO scores have gone up a lot, over 30 points since the GFC and over 10 points since COVID. And why is this? Well, COVID really helped because people got stimulus checks, they paid down their debt, and when they did that, delinquencies went down, and FICO scores went up. So, when we’re doing analysis, it’s not just looking at the net level of delinquencies or losses. We want to really understand what’s driving that. And that’s why, when you’re doing this type of analysis, you want to make sure it’s active and bottom-up fundamental. And that’s what we’re known for at Janus Henderson. Just knowing the issuers, knowing what’s going on, knowing what’s going on under the hood.

And by doing all that work, we learned very early on that what happened is, in 2022, a lot of issuers saw their books and said, “Oh, delinquencies are going down, defaults are going down, losses are going down.” Why? Because all these borrowers had extra money in their bank accounts. And so, these issuers were like, “Hmm, I didn’t give Joe Schmo that loan last year, but I’m gonna give it to him this year because he was kind of marginal last year, but he’s a little bit better this year.” And this happened with many issuers. And so, what happened is, 2022 is going to be one of the worst vintages we’ve ever seen.

Now, because we are doing this analysis, we saw that very early and kept our portfolios out of that vintage. What happened then is, as those defaults and delinquencies started coming in, spreads widened because the market got scared. But what we knew is that the issuers saw that as well and said, “Oh, we made a mistake in 2022, we have to tighten up our credit box,” and they did do that. And so, 2023 will be much better. So, last year and into this year, spreads got very, very wide because the market was behind, and yet the credit was actually much better under the hood.

So, I know it’s kind of a long-winded answer, but what you should take away from it is, usually the headlines don’t tell the whole story, and what you really want to be doing in this market is kind of the bottom-up fundamental analysis that we do every day.

Castleton: That’s great. And Nick, let me go to you, because bank loans is probably top of those headline risks in terms of rising defaults. And so, from a collateralized loan obligation, or CLO, how does rising defaults in bank loans – which, CLOs are securitizing bank loans … Does that worry you? How are you seeing that market play out?

Childs: Sure. I mean, in a lot of ways it has similarities to the consumer debt markets and the auto markets. If you go back to certain vintages of CLOs where you had … you know, the bank loan market, which was dominated by covenant light and easy lending. You then subsequently get a CLO with the asset base of covenant light and difficult debt. If you look at the CLO market today, what’s being issued, nearly zero covenant-light style assets, higher-quality CLO portfolios. So, we’re favoring the newer portfolios out there.

You know, one of the things in CLOs, though, is you have your AAA side, which is really incredibly remote from any real credit risk. So, there is some discrepancy or some variation in spreads and valuations, but we’re seeing a ton of variation in valuations down the stack. If you look at the triple B CLO benchmark, or you look at that market, we’re seeing bonds with 200, if not north of that, in spread … in valuation discrepancies, right? So clearly there’s an issue there, and that’s due to downgrades, so moving to triple Cs, as well as eventual default.

Castleton: I think important to also remind our audience as well, if for some reason there is a big pickup in bank loan delinquencies and defaults, the whole point of the CLO securitized structure and being able to choose your tranches [is that it] can help insulate you from a worst-case scenario. Is that not correct?

Childs: No, that’s exactly right. I mean, the best piece of securitized in terms of portfolio construction and building portfolios, is you can kind of, based on that underlying collateral, based on that underwriting, you can then go to the securitization market and kind of choose what risk-adjusted spread you’re looking to take across the capital structure. Again, AAAs are incredibly remote; they are AAA for a reason. They are not CDOs. So, you know, if we do have a series of downgrade waves, you know, in the end AAA is, in a way, favorite because they trade below par and they realize a rapid amortization of cash flows, which actually increases your total return expectation.

Castleton: Great, thank you both. So, I want to now move toward how we can think about implementing some of these ideas. Throughout our consultations when we are working with clients on their portfolios, we have started to see a little more of an uptick in high-yield bonds, for example. And I understand where that comes from. If you think about the high-yield universe, one, they’re providing much more attractive yields than they have been in a very long time. As an index, the high-yield credit quality has improved over time as well, and a lot of those bonds are still trading at par. So as a diversification away from core fixed income, for investors, that can be an attractive asset.

John, you are a portfolio manager on our Multi-Sector strategy, which can own high yield, securitized, government, etcetera. Do you find attraction in the high yield market, or is there something you favor over securitized right now?

Kerschner: It’s a good question. I I think a lot of investors have very short memories. Look, it’s been a really good couple of years for the high yield market, really kind of going back to COVID, because the Fed came out and supported the corporate credit markets. They said they were going to buy investment-grade corporate credit and even ETFs of the high yield market. In the meantime, they did basically nothing for the securitized market. So, if I ever meet Jay Powell, I’m going to ask him about that.

But it’s really been kind of a one-way train, tighter since then for the high yield market. And part of that is what you mentioned, how the index has gotten better since the GFC. It used to be about 40% of the high yield market was double B, now it’s closer to 50%. May not seem like a big change, but it actually is a pretty big change. At the same time, the high yield market keeps getting smaller. People don’t realize this, but coming out of the GFC, [high yield] was about $800 billion. I think it got up to about $1.7, maybe $1.8 trillion, and now it’s down to $1.3 trillion.

So, what’s happening there is two things. One, just upgrades, rising stars, which means you get upgraded from high yield into investment grade, but also a lot of private credit coming in and refiing some high yield names so that they go out of the public markets into the private markets. So the high-yield market isn’t that big, but there’s a lot of dedicated money for high yield. There’s like 100 different ETFs and 40-ACT funds that are just dedicated to high yield. So, you have all this money that has to buy high yield, and there are fewer bonds out there to buy. And so that’s been a pretty strong technical for high yield, so much so that now, when we talk about percentiles, when we’re talking about spreads … 100 percentile would be like all-time wides, like COVID, zero percentile would be all-time tights. High yield is kind of right around the 10th percentile, not at all-time tights, but getting very, very close.

And you can say, well, the economic environment’s pretty good and so that makes sense. But people forget …. I remember very clearly, [in] 2015 and ’16, the Multi-Sector Strategy was very new back then, it started in February 2014, and I was a securitized guy, and we were probably about 35%-40% of the portfolio in securitized and the rest in corporate credit. And back in 2015 we had an oil crisis, we had problems with China, and high yield widened a lot, and there was a lot of volatility. So right now, high yield is kind of low three hundreds, and all-time tights is about 275, depending on what index you look at. But normal spreads for high yield are about 400, and a shallow recession is probably 600 or 700, and during COVID [they] got out to 1,000 to 1,100. So, if you think about that, even if there’s a recession, and I’m not calling for a recession, but high yield spreads could widen two-, three-, four-hundred basis points, and that’s a huge amount of volatility.

So, I think people have to be cognizant of that, whereas in securitized, we can get very similar yields. So high yield yields right now are about 7.5% to 8%. We can get very similar yields with a portfolio that’s about 75% investment grade. And when we run our stress test, if the high yield market is down 10%, the securitized portfolio, with similar yield, again, would only be down about 3% or 4%.

Now these are, you know, stresses. I’m not saying this is exactly what’s going to happen, but it makes some sense, right? If you have a portfolio that’s 75% investment grade and securitized versus all high yield, not only is it going to be more liquid, but you would expect less drawdown risk. And so, that’s why we are so bulled up on securitized.

Castleton: And that I think that resonates with investors too, who are looking at getting almost over 4% from just lending to the government. It you’re going to take some risk outside of that, it does make sense to go to where your spread compensation is giving you attractive downside buffer potentially…

Kerschner: That’s exactly right, and like Nick mentioned, a lot of securitize sits at the short end of the yield curve, and the yield curve’s inverted now. So, you’re getting that extra risk-free rate as a starting point for securitized. Now, a lot of high yield is relatively short as well, but not as short as most securitized.

Castleton: And let me go to you too then, Nick. So, you mentioned at the beginning, of the securitized universe, the MBS space is the more interest-rate sensitive space, so more of a duration component for investors’ portfolios. And so, they look at that within government and investment-grade credit as an opportunity to get some defensiveness within their portfolios. Do you see a similar dynamic in terms of investment-grade credit versus mortgage-backed securities right now, in finding more attraction over one or the other?

Childs: Yeah, similar to high yield, in that conversation you have IG credit at that tenth percentile in terms of spread. So, not all-time tights but very, very tight, while you have agency mortgages around 75th percentile. So, when we look at agency mortgages versus IG credit, and that basis, as we would say, or that spread in a relative sense, we’ve really never been this cheap in my career. Now you can argue, you know, a few months ago we were cheaper, but just more generally that trend continues.

The great thing about agency mortgages, or the great thing about securitized broadly, is when you’re running an equity portfolio alongside a high-yield portfolio or an investment-grade corporate portfolio, in the end you have corporate risk. If you look at the high yield index and you strip duration out, 98% correlations to equities. So, are you really diversified by adding high yield or corporate credit versus equities? Yes, you are from an interest rate sense, but not from an underlying fundamental sense. Whereas you look at agency mortgages, there you have a government guaranteed asset that’s as cheap as it’s ever been to IG credit.

And what’s really interesting is that, traditionally, agency mortgages lose duration to lower interest rates. And why is that? We all know we try to refinance when rates are lower. Well, today, you have 95% or so of borrowers that have no incentive to refinance and won’t have any incentive to refinance for another 300 basis points in rate. So, to that end, you have that duration, you’re not going to lose that interest-rate duration as you go lower, and you’re getting a similar duration to the Agg (Bloomberg U.S. Aggregate Bond Index) with no credit risk.

Castleton: Thank you. So, I’m going to allow one more question to both of you. What are investors potentially missing out on by hiding out in money markets? Where could they be looking to go? Well, I guess you’re excited…

Kerschner: So yeah, we get this question a lot for the last year and a half or maybe even longer, and I get it, right? Short-term or risk-free rates were at zero for so long. So, people were just used to getting zero on money markets or CDs or, you know, their checking accounts for sure, and T Bills, and then, all of a sudden, the Fed starts raising rates and now you can get, let’s just say, 5%, round number. And so, I was in Europe last year and I met this family, and the guy was a doctor, and he found out I was in finance, and he’s like, “Oh yeah, I have this ladder of T Bills and I just keep rolling and I get 5%.”

And I’m like, OK, it sounds good, but there are ways to do better with taking just a little bit more risk. AAA CLOs are yielding about 150 to 200 basis points more, and they’re AAA. Yes, there’s a little bit more risk, call it like 1% or 2% of volatility if there’s some kind of dislocation. But most people can weather that, right? Like, you can take a drawdown of 1% or 2% and not really be that affected.

So, you’re leaving a lot on the table by going totally risk free. And I get that some people want that, like, come hell or high water, I want to know that I’m safe and I can sleep well at night. But you know, the funny thing is, when we tell them this, you go get a CD from a bank and let’s just say they pay you 5% or whatever it is. Guess what the bank does with your money? It takes that money and goes and buys AAA CLOs and it pockets the, call it 200 basis points, difference.

So, I think the mistake that most investors make is they think they can time the markets, and it’s incredibly difficult, I would say impossible. And why is that? Because people think, “Well, I’m just going to put it in cash.” And then they’re always like, when the time is right, or when I think it’s, the market’s going to turn or rates are going to rally or stocks are going to rally, I’ll put it in something else.

Well, look what happened at the end of last year. I mean, the 10-Year [Treasury] got out to 5% and within a few weeks it was down to 4%, or even 380 [basis points]. And no one really saw that coming, right. And I’m sure 99% of investors who thought they were going to see it coming didn’t. And then stocks just went nuts and rallied. And so, we all know there’s so many papers out there and studies that say, long-term, cash is not a great investment. Now, I get you might want to have some cash for expenses and things like that, but long-term, cash is not a great investment, and it’s incredibly hard to time the markets. And if you’re willing just to take a little bit more risk – and we can demonstrate how little that is – you can get more yield. So, it’s opportunity cost: You’re missing out by just parking in cash, when the vast majority of investors don’t need that 100% safety that a T Bill will give them.

Castleton: Thank you, John, for that. And I think I’m going to wrap up with you, Nick. Not everybody plays in the securitized space that much. What should investors be looking for when looking for a good securitized manager?

Childs: Sure. I think number one, you really have to look at the team. It takes years, if not decades, to really master the space. Everything from understanding cash flows to understanding the underlying borrowers or collateral to being a bit of a legal, professional legal person in terms of underwriting deal documentation. So that’s really important.

Number two, I’d be very wary of a firm that hasn’t dedicated a significant amount of resources to data and technology. Our process in doing securitized well, in our opinion, at least from a philosophy sense, requires a strong background in quantitative analysis.

And then number three, if you’re going to ask a smart question, ask people what they’re avoiding. You know, one of things about securitized is you don’t want to buy it in – at least in credit terms, right? – you don’t want to buy it in a passive sense. I mean, look what happened to office space. I think everybody’s read those articles, right? So, the smart question I think would be asking folks, what are you avoiding and why? And I think, no matter what period in time I can remember, there’s always been areas of securitized that we’ve avoided.

Castleton: Great answer and thank you both again. Hopefully we can sit down in six months time and revisit the securitized market in the future. It was helpful to get a walkthrough of the market today. We’re in a very ultra-sensitive economic environment. Seems like a lot of areas of the securitized space have and can provide good diversification and risk-adjusted yield for investors.

And thank you for tuning in. We hope you enjoyed the conversation and got some ideas and just more confidence in how you can approach today’s ever-changing landscape.

For more information from Janus Henderson, you can download other episodes of Global Perspectives wherever you get your podcasts. Or visit janushenderson.com.

I’m Laura Castleton. Thanks, and see you next time.

10-Year Treasury Yield is the interest rate on U.S. Treasury bonds that will mature 10 years from the date of purchase.

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

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

Cboe Volatility Index® or VIX® Index shows the market’s expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500® Index options and is a widely used measure of market risk. The VIX Index methodology is the property of Chicago Board of Options Exchange, which is not affiliated with Janus Henderson.

A covenant-lite loan is a type of financing that is issued with fewer restrictions on the borrower and fewer protections for the lender.

Credit quality ratings are measured on a scale that generally ranges from AAA (highest) to D (lowest).

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.

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.

J.P. Morgan CLO AAA Index is designed to track the AAA-rated components of the USD-denominated, broadly syndicated CLO market.

JP Morgan CLO BBB Index is designed to track the BBB rated components of the USD-denominated broadly syndicated CLO market.

Monetary Policy refers to the policies of a central bank, aimed at influencing the level of inflation and growth in an economy. It includes controlling interest rates and the supply of money.

The MOVE index, or Merrill Lynch Option Volatility Estimate Index, is a market-implied measure of bond market volatility. The index calculates the implied volatility of U.S. Treasury options using a weighted average of option prices on Treasury futures across multiple maturities (2, 5, 10, and 30 years).

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.

Tranches are segments of a pool of securities that are divided up by credit rating, maturity, or other characteristics.

Volatility measures risk using the dispersion of returns for a given investment.

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.

An inverted yield curve occurs when short-term yields are higher than long-term yields.