Capital IdeasTM
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Fixed Income
Xavier Goss
- The excess yields available from investment-grade and high-yield corporate bonds are beginning to attract “crossover” investors.
- Asset-backed securities look attractive in the current rising interest rate environment given their shorter duration.
- Including securitised credit in a fixed-income portfolio could provide diversification benefits due to its lower correlation with corporate credit.
- Security selection will likely be the key to alpha generation for securitised credit in the coming years.
As the risk of recession looms large over financial markets, how will securitised credit fare? It’s a growing area of bond markets that has become an important anchor of some actively managed, fixed income portfolios. Portfolio manager Xavier Goss discusses the reasons he remains optimistic on several areas of this market despite some near-term challenges.
The economic outlook is mixed
The US Federal Reserve (Fed) is obviously looking to bring inflation under control, which means we will likely see the economy slow down and unemployment go back up. But while tightening financial conditions should be a headwind, US consumers have remained strong because of wage inflation and low unemployment, as well as the subsidies they received directly from the government. Therefore, even if the US heads into a recession, consumers are starting from a much better position than they were in the lead-up to the global financial crisis.
Overall, it is not a bad time to be looking at fixed income broadly. With the backdrop of rising unemployment and slower growth, I do expect defaults to increase from current low levels, but relatively tight underwriting standards and a stronger US consumer should help mitigate downside risk. Additionally, the excess yields available from investment-grade (BBB/Baa and above) and high-yield corporate bonds are beginning to attract “crossover” investors who are dipping their toes into fixed income. There is a lot of cash in the system and new issuance is low. This could provide a nice backstop for the securitised market.
1. Asset-backed securities provide income and diversification
Securitised credit today is a large and diversified sector. At one end of the spectrum, you have asset-backed securities (ABS), comprising consumer credit such as student loans and auto loans. At the other end, you have commercial mortgage-backed securities (CMBS), backed by loans on a variety of assets such as industrial warehouses, office buildings and retail malls. The securities are segmented into different credit ratings, depending on the level of collateralisation (i.e. the value of the assets backing the loan) and/or their position in the capital structure.
Today, in the portfolios I manage, the largest relative exposure in securitised credit is to asset-backed securities backed by consumer loans. I am optimistic about the continued strength of US consumers’ balance sheets. Given where we are in the financial cycle, I prefer taking shorter duration credit risk in consumer loan sectors as opposed to longer duration commercial assets. ABS look attractive in this rising rate environment as they tend to have significantly shorter duration (meaning they are less sensitive to interest rate fluctuations). These assets have tended to be good diversifiers and income generators for portfolios.
US consumers remain strong despite economic headwinds
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Past results are not a guarantee of future results
Data from 1 January 2003 to 30 June 2022. Sources: New York Fed Consumer Credit Panel, Equifax
In the coming years I expect there will be significant divergence in performance across sectors. This should increase the opportunity to generate alpha through security selection. Bonds backed by subprime auto loans are a good example of asset-backed securities that have shorter duration and increased credit risk, depending on the originator of the loans. This is an area where credit research can add substantial value.
Risk factors you should consider before investing:
- This material is not intended to provide investment advice or be considered a personal recommendation.
- The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment.
- Past results are not a guide to future results.
- If the currency in which you invest strengthens against the currency in which the underlying investments of the fund are made, the value of your investment will decrease. Currency hedging seeks to limit this, but there is no guarantee that hedging will be totally successful.
- Depending on the strategy, risks may be associated with investing in fixed income, emerging markets and/or high-yield securities; emerging markets are volatile and may suffer from liquidity problems.
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