Short Credit: Timely Views on ABS and CMBS

Lord Abbett experts offer their perspective on the investment prospects for these securitized asset classes.

Amid the ongoing market volatility, Lord Abbett investment professionals have stayed in close contact with advisors and investors to provide timely perspective on recent events and their impact on portfolios. On March 24, Lord Abbett Partner and Portfolio Manager for Fixed Income Kewjin Yuoh, Investment Strategist Joseph Graham, and Director of Product Strategy Stephen Hillebrecht held a webinar for professional investors on developments in the short duration credit space, with a special focus on the performance of—and potential opportunities in—liquid and securitized products such as commercial mortgage-backed securities (CMBS) and asset-backed securities (ABS). Here, we summarize our experts’ views through their answers to investor questions.

To start off, please walk us through some of the dislocations in the short duration credit markets over the past few weeks.

Joseph Graham: In some ways this has been a classic liquidity run on short-term markets. Some features of it are typical of investors’ search for liquidity during times of market stress and some features are relatively new. One thing that's typical is the inversion in credit markets along maturities. We've seen very short term bonds trade wide relative to long-term bonds. That's somewhat typical in a time like this because investors are ordering bonds based on dollar price and selling bonds with the highest price in an effort to limit the losses they may take on their sales.

Even certain instruments that historically have been very resilient to default from economic shocks have come under pressure. Things like auto leases of luxury car manufacturers in an ABS structure, or, in the investment grade corporate space, the short term debt of well capitalized home improvement companies, have traded at extraordinarily wide spreads. We think that has little to do with default risk and more to do with investors’ thirst for liquidity. 

One thing that we think is new during this particular liquidity run has to do with market structure changes that happened in the decade since the 2008-09 financial crisis—especially bank balance sheet reduction and risk retention rules. These changes altered the landscape, leaving banks with a reduced role as an intermediary that can hold risks. That has left asset managers scrambling for liquidity during the current market stress.

How has the market for these instruments responded after previous periods of extreme volatility?

Stephen Hillebrecht: We've seen earlier episodes involving significant short term price volatility in short-term investment grade bonds—once again, the 2008-09 financial crisis offers a good example and that experience has provided a lesson, in our view. If you are able to avoid credit issues—and credit research capabilities play a big part here—there is the potential for a strong recovery in prices as markets normalize. And with these recent price declines, we're seeing valuations we really haven't seen in some time, which present some compelling opportunities, in our view.

What is some of the potential impact of the U.S. Federal Reserve’s (Fed) policy moves on March 23?

Kewjin Yuoh: The Fed’s previous actions—150 basis points (bps) in rate cuts, the $1.5 trillion repo market financing, the commercial paper funding facility, money market fund support—are all tools taken from the 2008-09 playbook. Of course, these moves didn’t immediately reverse market sentiment. But we think what the Fed did on March 23 was actually much more relevant because of the opening of the $300 billion exchange stabilization fund (ESF). Granted, that is a small starting amount. But in terms of signaling, this was a first step in helping potentially turn the tide of investor sentiment. With the ESF, the Fed created a platform to purchase corporate securities in the primary and secondary markets—and that hadn't been done before. And these were specifically focused on those shorter duration or shorter maturity corporate securities that were investment grade—issues that were part of the liquidity stress mentioned earlier. We'll find out more specifics in the next few days, but we think this is a big deal because it shows that the Fed is paying attention to the problem.

The Fed also instituted the term asset lending facility, which is specifically focused on asset-backed securities. Higher quality securitized products, including ABS, are a very strong source of liquidity relative to other asset classes. We do believe that the Fed will take additional steps through additional modifications to these programs because they have said that they will do “everything” to support the correct and proper functioning of the marketplace. What we really need now, however, is for the fiscal picture to improve.

Tell us more about the current landscape for ABS and CMBS.

Yuoh: In assessing the Fed’s recent actions, it is clear to us that there is a lot of focus on the consumer. That is absolutely what's driving the CMBS and ABS markets right now, in our view. When you look at commercial real estate that is directly influenced by consumer spending, hotel and entertainment properties come to mind. Of course, there is a significant impact within retail as well, although malls had already come under pressure probably about two years ago based on existing retail trends.

We expect office and industrial commercial properties to be relatively stable. Multifamily housing, specifically apartment buildings, should benefit from the Fed's actions to purchase agency commercial mortgage backed securities—remember, agency CMBS are dominated by multifamily properties. That would be a property type that would potentially benefit in the near term, in our view.

What is your current approach to these asset classes?

Yuoh: In terms of how we are using securitized products within our short duration vehicles, generally we are focusing on investment grade, high quality assets, where we see a spread premium for the complexity of the assets. One particular opportunity may be assets that underperformed during the 2008-09 financial crisis. We think that underperformance may have shaken out a lot of investors from securitized products and to us, those assets afford us a premium in terms of spread. Think about what happened to CMBS during the 2008-09 crisis. When we buy ‘AAA’-rated CMBS, the structure of the security is the most important aspect in the sense that there is collateral for the loans made to commercial real estate borrowers. But to the extent that any of those loans default and have a loss, those losses first impact those investors who have gone down the rating spectrum. We are involved in the higher quality and higher rated assets within these securitizations, which have a high degree of credit enhancement. So an ‘AAA’-rated CMBS during the 2008-09 crisis generally had approximately 30% credit enhancements. This basically meant that within the commercial real estate loans, 30% of losses could be absorbed before the AAA security was actually hit with the principal loss. Post-financial crisis, not a single AAA CMBS took a loss. Unlike securitized products backed by residential mortgages, which suffered significant credit issues in 2008-09, investors in highly rated CMBS and consumer ABS did not experience defaults.

What about now? When you look at the different types of CMBS that we purchase for our portfolios that are ‘AAA’-rated, current credit enhancement ranges between 30% and 65%. Now granted the speed with which this has happened in terms of the economy slowing down and the likelihood that the cash flows available to meet lease payments, are changing on a dime. But are we currently worried that ‘AAA’-rated CMBS securities are potentially going to take a principal loss? No, we're not.

Could you give us the “elevator pitch” version of your investment case for structured products?

Hillebrecht: In terms of the fundamental story, and the fundamental outlook for these specific securities and securitized products as a whole, if you've done your fundamental research correctly, and take the highest quality assets, you should potentially be well positioned for the markets ahead.

Register for a webinar on March 26 with Lord Abbett Director of Fixed Income Steve Rocco on the current high yield market—and the opportunities we see there.