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Market View

Fixed Income: What You Need to Know about ABS and CMBS

August 19, 2019
1277 Views

Structured credit products offer the potential for effective portfolio diversification—and attractive valuations versus other asset classes.

 

In Brief

  • Short maturity asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS) have historically generated consistently higher returns than short maturity Treasuries.
  • CMBS and ABS offer the potential for effective portfolio diversification given their low correlation to many other widely held asset classes.
  • Structured credit products such as ABS and CMBS have a domestic orientation, exhibiting less sensitivity to potential weaknesses overseas relative to large multinational corporations.
  • Finally, certain ABS investments provide exposure to a strong fundamental consumer backdrop while CMBS have recently offered attractive relative value versus comparably rated corporate bonds, in our view.

 

Fixed-income investors have acquired greater familiarity with government and corporate bonds than securitized products—securities typically based on pools of various types of contractual debt obligations—potentially making them reluctant to invest in these strategies. We believe securitized products, also known as structured products or structured credit, may offer potential benefits to fixed-income portfolios managed by investment professionals with the appropriate expertise.

More specifically, securitized products are fixed-income instruments whose repayment is supported by the cash flows of relatively illiquid assets, such as mortgages, auto loans or credit card receivables. In our view, securitized investments offer a wide field of opportunity, spanning a broad range of sectors, issuers, structures and risk profiles.

In this Market View, we’ll take a look at two widely known examples of structured products—asset backed securities (ABS) and commercial mortgage-backed securities (CMBS)—and the characteristics that may make them useful additions to fixed-income portfolios.

Keywords

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.

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.

ABS, CMBS May Offer Diversification Benefits
Securitized products offer a few key differentiating features relative to comparable fixed-income assets such as corporate bonds, including:

  • Structural flexibility: Securitized products offer greater ability to select desired duration, payment characteristics, and credit risk compared to other fixed-income sectors.
  • Structural protections: Vehicles such as ABS and CMBS offer embedded protections which are intended to reduce credit risk.
  • Diversification of performance drivers: Securitized products offer exposure to underlying collateral that is difficult to gain exposure to otherwise, such as credit card receivables, and commercial real estate.

These three features enable securitized products to display historically low correlation to more traditional asset classes (see Chart 1).

 

Chart 1. ABS, CMBS Offer Relatively Low Correlation to Other Asset Classes
Correlation data from July 1, 1999–June 30, 2019

Source: Morningstar. ABS represented by the Bloomberg Barclays U.S. Asset-Backed Securities Index. CMBS represented by the Bloomberg Barclays U.S. CMBS Investment Grade Index. U.S. investment-grade corporate bonds represented by the Bloomberg Barclays U.S. Corporate 3-5 Year Index. U.S. high-yield corporates represented by the ICE BofAML U.S. High Yield Index. REITs represented by the GPR 250 REIT Index. Leveraged loans represented by the Credit Suisse Leveraged Loan Index. Emerging market sovereign bonds represented by the JPM Government Bond Index-Emerging Markets (GBI-EM) Global Diversified. Developed and emerging market stocks represented by the MSCI ACWI (All Country World Index) ex-U.S. Index. U.S. stocks represented by the S&P 500® Index. Stocks are subject to greater risk and market volatility, while bonds are subject to greater risk of default and interest rate volatility.

Past performance is no guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees and expenses, and are not available for direct investment.

 

Other Potential Advantages of ABS and CMBS
Asset-backed securities and commercial mortgage-backed securities historically have offered unique potential benefits for fixed-income portfolios beyond diversification. We have identified specific areas of opportunity in each:

Asset-backed securities: Consumer-linked ABS are financial securities collateralized by a broad spectrum of consumer receivables such as credit card receivables, auto loans, and student loans. Exposure to these securities can potentially provide:

  • An attractive return profile versus other high quality asset classes, such as U.S. Treasuries. In fact, as of June 30, 2019, short-maturity investment-grade ABS had outperformed short-maturity U.S. government bonds in 92% of rolling five-year periods since 1997, according to data from Morningstar.
  • A greater focus on the U.S. economy compared to corporate bonds. In our view, consumer-linked ABS, as a U.S.-focused asset class, are less likely to exhibit sensitivity to trade war concerns, variability of international revenue streams, and broader weakness in market and economic conditions outside the United States than the broader U.S. corporate bond category.
  • An attractive alternative to investing in conventional corporate debt. As we noted earlier, key areas of the ABS sector are linked to the U.S. consumer. As Lord Abbett director of strategic asset allocation Giulio Martini has noted, the fundamental backdrop for the U.S. consumer appears solid, as evidenced by a low unemployment rate, rising wages, increased saving rates, and conservative consumer debt levels. As shown in Chart 2, U.S. consumers have deleveraged significantly since the 2008–09 financial crisis, while corporations have used lower rates to take on additional debt to finance share buybacks and M&A activity.


Chart 2. U.S. Leverage Trends May Lend Support to Consumer-Linked ABS
Debt-to-income ratio for households vs. net debt-to-EBITDA for corporations (December 31, 2000 – December 31, 2018)

Source: Federal Reserve, BEA, J.P. Morgan. 

 

Commercial mortgage-backed securities: CMBS are collateralized by mortgages on income-producing commercial and multifamily properties. CMBS can be categorized into two main types: a diversified loan portfolio (conduit) or a single-asset/ single-borrower loan involving the securitization of a single loan typically collateralized by one large property or loans collateralized by a group of properties owned by a single borrower. CMBS exposure can potentially provide:

  • Exposure to the commercial real estate sector in lieu of direct investment in property.
  • Outperformance on the short-end of the curve relative to U.S. Treasuries. As of June 30, 2019, short-maturity investment grade CMBS had outperformed short-maturity government bonds in 95% of rolling five-year periods since 1997, according to data from Morningstar.
  • Like ABS, a greater focus on the United States.
  • Attractive relative value across the credit spectrum relative to like-rated investment-grade corporate bonds, as shown in Table 1.

 

Table 1. CMBS Recently Offered Attractive Valuations versus Comparably-Rated U.S. Corporates
U.S. CMBS and corporate bond spreads versus U.S. Treasuries by rating category, as of June 30, 2019

Source: Bloomberg. CMBS=Commercial mortgage-backed securities. In this instance, spread represents the respective difference in current yields (expressed in basis points; one basis point equals one-one hundredth of a percentage point) of rating-specific segments of (i) the Bloomberg Barclays U.S. CMBS Investment Grade Index and (ii) the Bloomberg Barclays U.S. Corporate Bond Index versus U.S. Treasuries.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees and expenses, and are not available for direct investment.

 

Summing Up
As investors weigh the latest twists and turns in the U.S.-China trade conflict, they may wish to consider the potential advantages of including U.S.-focused securitized products as part of their fixed-income allocation. ABS and CMBS can potentially provide diversification benefits, a domestic focus, and attractive return profiles. While structured products offer investors an opportunity to gain exposure to assets that would, on their own, be illiquid, undiversified, or require a large capital investment, investors should still consider utilizing the expertise of investment professionals with the experience and resources needed to invest in this segment of the fixed-income market.

 

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. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. 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. Moreover, the specific collateral used to secure a loan may decline in value or become illiquid, which would adversely affect the loan’s value. 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. The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. No investing strategy can overcome all market volatility or guarantee future results.

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.

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.

Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes. Although U.S. government securities are guaranteed as to payments of interest and principal, their market prices are not guaranteed and will fluctuate in response to market movements.

A bond yield is the amount of return an investor will realize on a bond. Though several types of bond yields can be calculated, nominal yield is the most common. This is calculated by dividing the amount of interest paid by the face value.

Correlation is a statistical measure that describes the strength of relationship between two variables. It can vary from 1.0 to -1.0.

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 credit quality of the securities in a portfolio 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. High yielding, non-investment-grade bonds involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities.

The Bloomberg Barclays Asset-Backed Securities (ABS) Index is the ABS component of the Bloomberg Barclays U.S. Aggregate Index. The Asset-Backed Securities (ABS) Index has three subsectors: credit and charge cards, autos and utility. The index includes pass-through, bullet, and controlled amortization structures.

The Bloomberg Barclays U.S. CMBS Investment Grade Index measures the market of U.S. agency and U.S. non-agency conduit and fusion CMBS deals with a minimum current deal size of $300 million. The index is divided into two subcomponents: the U.S. Aggregate-eligible component, which contains bonds that are ERISA eligible under the underwriter's exemption, and the non-U.S. Aggregate-eligible component, which consists of bonds that are not ERISA eligible.

The Bloomberg Barclays U.S. Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. Total return comprises price appreciation/depreciation and income as a percentage of the original investment.

The Bloomberg Barclays U.S. Corporate Bond Index measures the total return of the investment-grade, fixed-rate, taxable corporate-bond market. It includes U.S. dollar-denominated securities publicly issued by U.S. and non-U.S. industrial, utility, and financial issuers. The Bloomberg Barclays U.S. Corporate 3-5 Year Index is a subset of the broader index.

The Credit Suisse Leveraged Loan Index is designed to mirror the investable universe of the U.S. dollar-denominated leveraged loan market.

The GPR 250 REIT Index is a subset of the GPR 250 Index and covers all companies having a REIT-like structure. This in combination with the consistently applied rules for company inclusions results in the GPR 250 REIT Index being a sustainable representation of the global Real Estate Investment Trust market.

The ICE BofAML US High Yield Index tracks the performance of US dollar denominated below investment grade corporate debt publicly issued in the US domestic market. Qualifying securities must have a below investment grade rating (based on an average of Moody’s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, at least one year remaining term to final maturity as of the rebalancing date, a fixed coupon schedule and a minimum amount outstanding of $100 million.

Source:  ICE Data Indices, LLC (“ICE”), used with permission. ICE PERMITS USE OF THE ICE BofAML INDICES AND RELATED DATA ON AN "AS IS" BASIS, MAKES NO WARRANTIES REGARDING SAME, DOES NOT GUARANTEE THE SUITABILITY, QUALITY, ACCURACY, TIMELINESS, AND/OR COMPLETENESS OF THE ICE BofAML INDICES OR ANY DATA INCLUDED IN, RELATED TO, OR DERIVED THEREFROM, ASSUMES NO LIABILITY IN CONNECTION WITH THE USE OF THE FOREGOING, AND DOES NOT SPONSOR, ENDORSE, OR RECOMMEND LORD, ABBETT & CO. LLC., OR ANY OF ITS PRODUCTS OR SERVICES.

The JP Morgan Government Bond Index-Emerging Markets (GBI-EM) Global Diversified is a comprehensive global emerging markets index that consists of regularly traded, liquid fixed-rate and domestic currency government bonds.

The MSCI ACWI (All Country World Index) ex-U.S. Index is a subset of the MSCI ACWI Index.  The MSCI ACWI (All Country World Index) Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The MSCI ACWI Ex-U.S. Index with Gross Dividends approximates the maximum possible dividend reinvestment. The amount reinvested is the entire dividend distributed to individuals resident in the country of the company, but does not include tax credits. The MSCI ACWI Ex-U.S. Index with Net Dividends approximates the minimum possible dividend reinvestment. The dividend is reinvested after deduction of withholding tax, applying the rate to non-resident individuals who do not benefit from double taxation treaties. MSCI uses withholding tax rates applicable to Luxembourg holding companies, as Luxembourg applies the highest rates.

The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

The information is being provided for general educational purposes only and is not intended to provide legal or tax advice. You should consult your own legal or tax advisor for guidance on regulatory compliance matters. Any examples provided are for informational purposes only and are not intended to be reflective of actual results and are not indicative of any particular client situation.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

The opinions in 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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