ABS and CMBS: The Reopening Impact
Good morning, my name is Adam Castle. I’m a portfolio manager focusing on securitized products here at Lord Abbett.
Interstitial: Economic and Market Backdrop
Right now, it's a very interesting time; there's immense optimism in the markets. We are well on our way to rolling out a vaccine which is picking up steam domestically. The case count for COVID-19 is declining every day. And we are starting to see jobs come back. In addition to that, the Fed has been remarkably quick to act over the last year and they've expanded their balance sheet to an unprecedented level—really, in our lifetimes and not seen since the Great Depression.
And on top of it all we just have experienced another stimulus bill sizing up to $1.9 trillion that has been pretty front-loaded. We're expecting it to have a very meaningful impact in 2021 and probably early next year on the lower income segments of U.S. households, which should be very meaningful for getting this economy restarted.
Despite all of this, you know, great progress that we're seeing fundamentally and the accommodation from monetary policy, the markets have had a pretty challenging month. [B-ROLL: Financial market images.] There's been an immense rotation within asset classes to adjust to this set of circumstances. And we're positioning for this rotation to continue.
So what am I really talking about? There's been a huge move from high quality assets and Treasuries out to deeper credit to deeper value things that are more levered to the economic reopening. This has led to an increase in interest rates, and generally things that are very high quality and had been very tight in spread and have fallen slightly out of favor.
So, as we think about what that means, if you consider all of the circumstances in play, manufacturing PMIs are at a post GFC peak. Alternative data that we've tracked suggests that we are approaching an inflection point in employment. It's likely that in the official data unemployment takes a meaningful pick-up over the next month. And when you consider the size of stimulus, it's really no wonder that the markets are getting concerned about inflation. We're starting to see interest rates, not only have they started to increase out the curve, but even in the intermediate part of the yield curve, we are seeing pressure, and we expect that to continue in the near term.
Interstitial: ABS/CMBS: The Current Environment
So regarding securitized products, specifically the rotations that are occurring, we expect that to pervade into the securitized markets. One thing that we are positioning for is for strength in commercial mortgage backed securities and CLOs, and in consumer asset backed securities. While at the same time we're expecting the momentum positive momentum in residential mortgage backed securities to slow down. If you think about what was really a winner during the pandemic, it was the U.S. housing market. Home prices are at extremely high levels, the demand for housing is elevated and the supply is depressed. All the while, [mortgage] underwriting standards have been pretty tight. What that's led to is an incredible outperformance in residential mortgage backed securities.
And we think that momentum, there will be in favor of sectors that are more leveraged to the return of normalcy. Whether that's consumer loan securities, such as auto, student, or credit card loan or commercial mortgage backed securities and collateralized loan obligations.
Within each asset class in securitized we're also expecting there to be credit curve compression. This week we began to see under performance of AAA and AA [rated] tranches while seeing outperformance of non-investment grade and lower-rated mezzanine tranches, further reflecting this this view of reflation and of [investors’] optimism and desire to reduce duration and reduce interest rate risk while maintaining credit risk.
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Asset-backed securities (ABS) are collateralized by a pool of assets such as loans, leases, credit card debt, royalties or receivables. An ABS is similar to a mortgage-backed security, except that the underlying securities are not mortgage-based.
Collateralized loan obligations (CLOs) are a form of securitization where payments from multiple middle sized and large business loans are pooled together and passed on to different classes of owners in various tranches. A CLO is a type of collateralized debt obligation.
Commercial mortgage-backed securities (CMBS) are secured by mortgages on commercial properties rather than residential real estate. The underlying loans that are securitized into CMBS include those for properties such as apartment buildings and complexes, factories, hotels, office buildings, office parks, and shopping malls.
Securitized products are pools of financial assets that are brought together to create a new security, which is then divided and sold to investors.
Tranches are segments created from a pool of securities—usually debt instruments such as bonds or mortgages—that are divvied up by risk, time to maturity, or other characteristics in order to be marketable to different investors.
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