ABS and CMBS: Assessing Opportunities Amid the U.S. Recovery | Lord Abbett
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Market View

We believe selectivity will be key in identifying attractive values among securitized products such as ABS, CMBS, and CLOs.

Read time: 4 minutes

The last Market Views covering structured products (April 6 & 13, 2020) were published during a time when the market environment was quite different, to put it mildly. We used the opportunity to address reader questions about how the structure of asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS) could potentially provide protection to investors amid the onset of pandemic-fueled economic weakness and market volatility. (Indeed, the structured products sector recovered well in 2020 along with the broader fixed-income market.)  

With the dramatic turnaround in U.S. economic prospects and market fundamentals that has occurred in the interim, we thought it was time for a fresh update on the asset class.

Vaccines, Stimulus, Inflation, and Rising Rates

But first, let’s examine the current backdrop. Markets have expressed optimism over the past couple of months centered on two major factors, only one of which is viewed as an unambiguous positive.

First, the great global vaccine rollout continues. While suffering fits and starts in some parts of the world, in the United States progress has been relatively steady, with eligibility broadening as vulnerable demographics clear through the system. Without question, any strides towards a long-hoped-for post- COVID-19 world are to be greeted with open arms on many levels—positive economic impact being but one.

The second is another round of stimulus spending, courtesy of the American Rescue Plan (ARP) legislation recently signed into law by President Biden. Here, the market’s assessment appears to be mixed. The good: The bill is front-loaded to deliver maximum impact in the near term for qualifying businesses and individuals, extending $1,400 payments per individual to those making less than $75,000 per year or households making less than $150,000 per year for a total of $410 billion in assistance. In addition, an extended unemployment program, consisting of a $300 weekly supplement to jobless benefits through September 6, provides an additional $246 billion in support.  Coupled with series of tax credits aimed at lower-income households, the ARP provides a 20% boost in after-tax income to the lowest-earning 20% of households, according to a Tax Policy Center estimate cited in a recent Wall Street Journal article. 

And the bad? Markets are also focused on another potential outcome to such an enormous infusion of capital into the economy, namely that it may prove inflationary in an environment that already has seen its fair share of potential warning signals.  On March 18, the monthly Manufacturing Business Survey compiled by the U.S. Federal Reserve Bank of Philadelphia showed respondents forecasting a sharp increase in activity for March, indicating that an already notable, broad-based recovery in the manufacturing sector may be picking up steam—something we can all cheer. However, prices paid for materials used in manufacturing also jumped sharply. (See Figure 1.)

 

Figure 1. Philadelphia Fed’s Manufacturing Survey for March Points to a Sharp Rise in Activity…
Philadelphia Fed manufacturing survey, July 31, 1970–March 18, 2021

 

… But Sends a Sobering Signal on Inflation
Prices-paid component of the Philadelphia Fed manufacturing survey, July 31, 1970–March 18, 2021

Source for both charts: U.S. Federal Reserve Bank of Philadelphia manufacturing Business Survey released March 18, 2021. For illustrative purposes only.

 

While the latter datapoint may not get much notice from the U.S. Federal Reserve, given the lack of longer-term evidence that such price increases eventually prove to be more broadly inflationary, it nevertheless adds grist for the mill for those who see the pressure steadily rising. Those worries became evident earlier this year as yields rose on high-quality fixed income, particularly U.S. Treasuries and high-grade corporate bonds.

Implications for Structured Products

Given these factors, and given that we believe rates will continue to rise in the near term, albeit in a modest way, we have chosen to focus the structured portions of our portfolio in a “barbelled” fashion, that is, emphasizing exposure to the top and bottom of the credit stack.1 Our view is that the market is still being overly punitive in pricing lower-rated tranches of ABS, CMBS, and collateralized loan obligation (CLO) deal structures that we consider of good quality, given the notable improvement in lower-end consumer balance sheets likely resulting from the U.S. stimulus programs.

And while we believe that the market’s rotation into investments that are more highly leveraged to economic expansion will continue and become broader, we are taking a highly targeted approach—one that requires a high degree of both structural and credit expertise to implement effectively. Put simply, while securitized products should benefit from the current environment, an indiscriminate program of buying risk across these markets offers significant downside, in our view.

Specifically, we expect strength within the CLO, CMBS, and consumer ABS spaces broadly, but again, with significant variation between individual structures and tranches within them. Structures within the ABS space offering exposure to consumer and auto loans, credit cards, and student loans should be particularly well positioned to benefit from the slow return to normalcy and post-pandemic world, in our opinion.  For a specific example, Figure 2 shows some of the steady improvement in key metrics for auto loans over the past year.

 

Figure 2. 2021 Brings a Less-Stressed Auto-Loan Sector
Year-over-year percentage change, January 2020–January 2021

Source: Lord Abbett Internal Indices, Intex. Data are latest available. A subprime auto loan is a type of loan used to finance a car purchase that's offered to people with low credit scores or limited credit histories. Prime auto loans are offered to borrowers with higher credit scores and stronger credit histories. Default rate=Three-month constant default rate (CDR), the percentage of loans within a pool of auto loans in which the borrowers have fallen more than 90 days behind in making payments to their lenders. Severity=The amount of loss associated with each default as a percentage of the defaulted balance. For illustrative purposes only.

 

On the flip side, we expect residential mortgages, which have been a major beneficiary of high home prices, high demand, and depressed supply, to flag, given robust momentum in the space through the pandemic as a “Covid winner.”   

Summing Up

While investors are counting on a strong “grand reopening” for the United States, the pace of recovery may be uneven among economic sectors, and many businesses will face changed circumstances in a post-pandemic world.  To identify and capitalize on opportunities within structured products, we believe a flexible, actively managed approach—one backed by teams with deep experience in credit research and security valuation—may be ideally suited to the current environment.

We would like to thank Yifan Wang, Investment Analyst, for her contributions to this article.

 

1A credit stack refers to the capital structure of a securitized product such as an ABS, CMBS, or CLO. In such a structure, the AAA-rated class amortizes first before any of the junior (lower-rated) classes, which only begin to amortize once the AAA class is paid off. The same principle applies down the capital stack with the junior classes amortizing only after more senior (higher-rated) classes have been paid off.

 

A Note about Risk: The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. High-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. Lower-rated bonds may be subject to greater risk than higher-rated bonds. No investing strategy can overcome all market volatility or guarantee future results.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This Market View may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

A so-called barbell strategy involves investors purchasing short-term and long-term bonds, but not intermediate-term bonds. The particular distribution on the two extreme ends of the maturity timeline creates a barbell shape. The strategy offers investors exposure to high yielding bonds with potentially limited risk.

basis point is one one-hundredth of a percentage point.

Credit enhancement: Structured financial products such as asset-backed securities and commercial mortgage-backed securities derive their value from underlying assets such as mortgages or credit card receivables. Some of those assets are riskier than others. For such investment products, credit enhancement serves as a cushion that absorbs potential losses from defaults on the underlying loans. Structured products are issued in classes, or tranches, of securities, each with its own credit rating. The tranches are categorized from the most senior to the most subordinated, or junior. Credit enhancements are attached to the highest-rated tranches, giving their buyers priority in any claims for repayment against the underlying assets.

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 (also known as structured products) are pools of financial assets that are brought together to create a new security, which is then divided and sold to investors. 

Spread is the percentage difference in current yields of various classes of fixed-income securities versus Treasury bonds or another benchmark bond measure. A bond spread is often expressed as a difference in percentage points or basis points (which equal one-one hundredth of a percentage point). The option-adjusted spread (OAS) is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is adjusted to take into account an embedded option. Typically, an analyst uses the Treasury securities yield for the risk-free rate.

Credit ratings: The credit quality of securities referenced herein is assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor's, Moody's, or Fitch, as an indication of an issuer's creditworthiness. Ratings range from 'AAA' (highest) to 'D' (lowest). Bonds rated 'BBB' or above are considered investment grade. Credit ratings 'BB' and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer's ability to pay interest and principle on these securities.

The information provided herein is not directed at any investor or category of investors and is provided solely as general information about our products and services and to otherwise provide general investment education.  No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as Lord, Abbett & Co LLC (and its affiliates, “Lord Abbett”) is not undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity with respect to the materials presented herein.  If you are an individual retirement investor, contact your financial advisor or other non-Lord Abbett fiduciary about whether any given investment idea, strategy, product, or service described herein may be appropriate for your circumstances.

The opinions in this Market View are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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