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Market View

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.

 

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