U.S. securitized: The price you pay determines the value you get

Judging by relative spread levels, corporate and securitized markets are not in agreement on either the state of the U.S. economy or the risk inherent in credit markets.

As shown in Exhibit 1, while securitized spreads are trading around their 10-year average levels or wider, corporates are trading near their all-time tightest levels. Quite simply, securitized assets are being sold to investors at a significant discount to corporates.

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Thankfully, in our view, investors need not make a pinpoint prediction about the future of the U.S. economy to gain from this situation but can rather seek to take advantage through a simple relative value trade.

In our view, the pricing disparity between corporates and securitized may potentially give investors the opportunity to increase returns through higher yields, while also mitigating risk.

Should the U.S. economy cool more than expected, we think securitized sectors are likely to outperform, as corporate spreads may experience a starker repricing. On the other hand, if the soft landing continues to unfold, we believe securitized could outperform as their spreads have more room to tighten, potentially providing an additional tailwind to returns.

As shown in Exhibit 2, buying securitized assets at today’s valuations offers investors the potential for higher returns, with lower dispersion, versus their pricier corporate counterparts. Notably, the potential total return in most securitized sectors would remain positive if spreads widened to their 10-year extremes. This is due to a combination of higher coupon income, which helps to cushion the effects of price movements, and the fact that securitized sectors are trading nearer their 10-year wide levels.

By focusing on finding value in spreads, we believe investors may optimize the efficiency of their portfolios and earn higher yields without necessarily taking on greater credit risk.

Investors who are sitting in cash could potentially lock in higher yields with only incrementally higher risk by incorporating securitized assets in their fixed income portfolios. Similarly, investors with corporate-heavy bond allocations may benefit from diversifying into securitized to earn potentially attractive yields, while also standing to gain on a relative basis should the pricing mismatch between corporates and securitized normalize.

IMPORTANT INFORMATION

Fixed income securities are subject to interest rate, inflation, credit and default risk.  The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa.  The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.

Securitized products, such as mortgage- and asset-backed securities, are more sensitive to interest rate changes, have extension and prepayment risk, and are subject to more credit, valuation and liquidity risk than other fixed-income securities.