Global Perspectives: Demystifying securitized fixed income

Lara Castleton: Hello and thank you for joining this episode of Global Perspectives, a Janus Henderson podcast created to share the insights from our investment professionals and implications that they have for investors. I’m your host for the day, Lara Castleton, head of U.S. Portfolio Construction and Strategy.

A few weeks ago, I took a deep dive into the entire fixed income market in today’s landscape with the head of our U.S. fixed income strategy, Seth Meyer, and Portfolio Manager John Lloyd. Today, we’re going to dissect the securitized subset of the market with John Kerschner and Nick Childs. John is the head of our U.S. securitized products at Janus Henderson and Portfolio Manager, and Nick Childs is Portfolio Manager on our securitized credit team. Gentlemen, thank you for being here.

John Kerschner: Thanks, Lara.

Nick Childs: Thanks for having us.

Castleton: Securitized, what is it, John? Besides just the sector that wins the trophy for the most acronyms out there…

Kerschner: We definitely do that.

Castleton: Can you give us just a brief history for our listeners here today? What is securitized, history of, etc.?

Kerschner: Yes, surely. We’re talking about bonds, and there are basically three major types of bonds. First, government bonds; that’s pretty self-explanatory. Governments tend to spend more than they’re taking in taxes. They have to borrow the rest. In U.S., we have about $24 trillion, which is an incredible lot. But about $24 trillion of Treasury securities. Then you have corporate debt. Most big companies issue bonds in order to finance acquisitions or new plants and equipment, things like that. That’s about $10 trillion.

And then pretty much everything else falls under the securitized umbrella. Securitized includes mortgages, commercial mortgages [CMBS] – commercial real estate, asset-backed securities [ABS], which can be everything from autos, to credit cards, to student loans, to all sorts of other things: timeshares, shipping containers, data centres, fast food franchises. Anything with a cash flow that can be quantified and put in a securitization will fall under ABS.

And then finally, last but not least, are CLOs, which are collateralized loan obligations. Those are taking corporate loans and putting them in a securitization. All of securitization is about $15 trillion, about 50% more than, actually, corporate debt. And the overriding theme, besides the acronyms, is basically taking a pool of loans. Mortgages, you’re just taking mortgage loans. Asset-backed loans, let’s just say you’re taking a bunch of auto loans.

CMBS, you’re taking a bunch of commercial real estate loans. CLOs, corporate credit loans. And you’re basically putting them into a securitization. That just means you’re aggregating these loans. You’re getting a rating agency to put a rating on it. There’s a bunch of legalese that goes around it as far as rules. And all those cash flows from that pool of loans then get divided up into different layers of risk. Sometimes they’re called tranches; we’ll just say layers. And then those different layers of risk are sold to people like Janus Henderson. And you can have anything from AAA, obviously lowest risk, usually lowest amount of yield or income, all the way down to B or even what they call an equity or a residual tranche, which can be a similar type [of] risk-return to equities.

Securitization’s actually been around a lot longer than people think. Mortgages have been around since the early ‘70s. CMBS came about after the S&L [savings and loan] crisis back in the early ‘90s. CLOs and ABS, also late ‘80s, early ‘90s. We’re talking 30, 35 years. For mortgages, it’s closer to 50 years. Been around for a long time. But I started my career, in investment management, in mid ‘90s, right at the start, and still here today.

Castleton: A lot of our listeners probably remember 2008. And they go back to that, and they think about that point in time as scary. I think throughout the rest of this time, I’d like to demystify a lot of that as we talk about some of these sectors. You already talked about these sectors have a lot more history than maybe we remember. They have their different underlying capabilities, opportunities. I want to dive into those more granularly, and that’s your challenge for today.

Nick, before we get into specific sectors, let’s just level-set what has broadly happened in the securitized market. 2022 was not a great year; year of the great rate reset. How did securitized overall fare during that time?

Childs: That’s a great question. I’d separate securitized into two major asset classes: Agency mortgages, these are government guaranteed. You’re looking around $9 trillion in size. A very, very large market. And then what we would bucket securitized credit. This is the asset-backed securities, commercial securities, etc. As far as agency mortgages are concerned, these are longer duration in nature. And pretty much everything went wrong in the agency mortgage market, both from a macro perspective as well as from a supply and demand technical perspective.

From a macro perspective, everybody knows the movement in interest rates, the movement in volatility, all of this is hugely negative for mortgages. And you’re talking around six years of interest rate risk. Huge drawdowns, particularly relative to history. And from an excess return perspective, or how mortgages fared versus Treasury, is even worse. From a supply-demand perspective, you have to realize we were undergoing quantitative tightening.

The Fed [Federal Reserve] was no longer buying mortgages. We had banks, insurance companies all not buying mortgages as we moved higher in rates. This is a very institutional product, as you can see. And lastly, money managers. Money managers, given the rate move in fixed income, saw the worst outflows since the Global Financial Crisis.

As far as securitized credit goes, securitized credit has performed incredibly well from an absolute return standpoint. Securitized credit – again, asset-backed securities, CLOs, collateralized loan obligations, our securities, our bonds – tend to be short-term in nature. And what does that mean? That means we have lower interest rate risks into the higher rate move. Given that it’s mostly a short-duration asset, it’s performed really, really well. That said, the tail end of that is the supply-demand technical in securitized credit, while nowhere near as abundant as agency mortgages, has been pretty similar. A lot of supply relative to corporate credit has hurt spreads from a relative basis. And while from an absolute return basis they’ve performed quite poorly, when you look at them in a relative value sense versus corporate credit or other areas, they look incredibly cheap. And when you look at general expected total returns, as well as certainty of total returns, that short-duration asset with really high yield levels today seems incredibly attractive.

Castleton: Is it safe to say then that the securitized credit on the short end of the curve held up relatively well, MBS, maybe not as much? But relative to just investment-grade or high-yield credit markets, how did they fare from a spread perspective?

Childs: The reality is, high yields actually performed incredibly well. When you think about the high-yield market, in terms of probability in forecasting recession, high yield doesn’t really see a recession coming. When you look at securitized credit, on the other hand, our space is definitely pricing in more of a hard landing, which makes it great from a relative value perspective.

If auto loans are being created or credit cards are being created or people are buying homes, we have supply. In high yield or corporate credit, institutions and corporations can decide when to issue, why to issue, etc. And when you rewind the clock, corporate debt has been pushed out and termed out. Through that 2022 and into 2023 period, there was a lot of choices and decisions where corporations didn’t have to issue credit and otherwise issue debt or put supply into the market. Very different than our marketplace.

Kerschner: Can I just add to that? One other point is that, when COVID happened, the Fed came out and basically said, “Yes, we’re going to support U.S. Treasuries and mortgages.” And they bought all these mortgages and Treasuries as part of quantitative tightening. But then they also came out and said, “We’re going to support the corporate credit markets. We’ll actually buy investment-grade corporate credit. We’ll buy ETFs of high-yield corporate credit.”

That gave every corporation in the U.S. a green light to issue as much as they could because they knew either investors will buy it, or the Fed will buy it. Basically, investors said, “I’m going to buy it because I know I have a Fed backstop.” The Fed absolutely did zero for the securitized markets. And if I ever meet Jay Powell, that’s the first question I’m going to ask him: “Why did you not do anything for securitized?”

What you had is all these corporations issuing debt, five, seven, 10 years … That’s just becoming due in the next few years. But over the last couple of years, very few corporations have had to issue in large amounts. I’m not saying zero. But the technical in securitized has been much worse, as Nick said. A lot more supply. Good demand as well, but much less supply in the corporate credit markets.

Castleton: Interesting. And speaking of Powell, it seems that the Fed is nearing the end of its rate hiking cycle. Market is pricing in cuts in the latter half of 2024. John, what do you think? Is that on pace? And how do securitized assets potentially fare in this environment?

Kerschner: It’s a thing that people are really thinking a lot about right now, because we all know the Fed is close to done. But are they done? And what’s the next move? And I actually have this quote here from our Treasury secretary, Janet Yellen, which says, “I think the most likely outcome is that the economy will move forward towards a soft landing.” And she said that in October. That’s October 2007, not October 2023.

Why do I give you that quote? Because it’s very hard to really predict these things. Here’s someone who, at the time, Janet Yellen was head of the Fed bank in San Francisco, and she should be one of the foremost experts on what’s happening to the economy, and she got it completely wrong. It is very difficult to really know what’s going to happen.

And rates have been selling off. And look what happened, all of a sudden, we have this tragedy over in Israel and rates are railing hard today. And getting this exactly right is difficult. But what I will tell you is, if you listen to the Fed, they are saying they’re going to be higher for longer. And why is that? Because the Fed, and particularly Jay Powell, the chair, is very incentivised to wipe out inflation.

Chair Powell is done May of 2026. He will not have another term. He’s basically less than two and a half years away. And the last thing he wants is to leave with inflation still being a problem. He wants to stamp out inflation. And if you think about it right now, because the Fed has a dual mandate, stable prices and low unemployment, he has cover for that, because unemployment is incredibly low at 3.8%. So he can keep rates up quite a bit longer because unemployment looks to be in really good shape. And so if unemployment got up to 4.2% or 4.5%, that’s still pretty historically low.

And then one other factor that a lot of people aren’t talking about is that we have a presidential election next year. And the Fed is supposedly apolitical; I get that. But they do not want to be seen as affecting an election. It’s very difficult to see the Fed coming out and cutting rates in June next year, in July next year, in September next year, right before an election. Maybe they cut once so things slow down in the June, July, but I don’t think there are going to be a lot of cuts next year. Right now, the market has priced in about four cuts. The Fed’s telling us, as of the last meeting, that they’re expecting two cuts. I would say two cuts at the most. Maybe one in the middle of the year and then one after the election. But I can very easily see, based on how strong economic data has been, that they don’t cut at all or maybe they cut once in December of next year.

And what does that mean for investors? One is things that are at the short end of the yield curve – one-year, two-year, three years, which is most of securitized – is going to continue to have a very high rate of interest and carry and yield. And that’s very good for investors because you’re not taking all that interest rate risk and yet you’re still getting all that income and yield.

Castleton: Setting up a good backdrop in terms of where we are today. Thank you both for that. Let’s dive a little bit more specific into these subsectors. Nick, agency mortgage-backed securities, that’s one of the maybe more interest rate-sensitive subsectors. You mentioned a lot of the potential headwinds that have faced that sector, massive rate hikes, QE to QT. Do you at some point start to see those becoming tailwinds? Or what is the sector opportunity in agency mortgages going forward?

Childs: Look, the starting point for agency mortgages has never been as positive, I suppose. It is an interest rates sector, as you mentioned. The higher rates go, the higher the hurdle is for total returns, etc. But one of the great things about mortgages is, and generally fixed income, I think investors should be at least considering adding more interest rate risk to their portfolio and locking these forward total returns in.

Additionally, given where mortgage spreads are today and given what we’re seeing historically, spreads at least seem to have reached the wide level. That drawdown, from a spread perspective, we believe is over. I think what’s great about that is you can wait a bit. Carry is your friend in fixed income.

The tailwind is the change in the demand factor. Supply continues to move lower and lower. Supply in mortgages is purely a function of home sales for the most part, particularly in an environment where the majority of borrowers don’t have an opportunity to refinance. Given home sales are low, supplies continue to go down …. on the demand side, not a lot needs to happen or change really to pick up the demand for mortgages or to tighten spreads.

Examples of that would be banks coming back to the market. I do think banks come back to the market next year. Look, net interest margins continue to be pressured. They’re going to need to add to their securities portfolios. And regulations are actually quite positive for banks adding in mortgages. Overseas, the demand has been terrible, given what’s going on with the dollar and the volatility there. That could easily add to the demand factor.

And look, as rates stabilize and, as we’ve seen, typically after the Fed’s done its final hike, further demand comes to the fixed income market, simply positive fixed income flows in mutual funds and ETFs are all positive for mortgages.

Castleton: And the other thing is, with mortgages, one of the bigger risks in that sector is prepayment risk. And obviously, all of us are sitting here today, having potentially, hopefully, locked in that, hopefully, low mortgage rate in 2020. And now we’re facing almost 8%, so that is another technical there.

Childs: You bring a great point. It’s very counterintuitive. In agency mortgages, there is no credit risk. This is government guaranteed. Your risk is a refi wave – that’s your biggest risk. And we’re obviously incredibly far away from a refinancing wave. And what’s so counterintuitive is the fact that agency mortgages are at their cheapest level in history, given a couple different bouts. But yet the fundamental risk is at all-time lows. It’s an interesting phenomenon.

Castleton: Thank you. And for investors in portfolios, I always talk about adding duration. We talked about that with Seth and John a couple weeks ago, the opportunity to add duration at the end of a Fed hiking cycle. And if you think of just the core index, Agg, being made up of Treasuries, credit, mortgages, it does seem like the technicals, fundamentals, opportunity in mortgages is a great way for investors to get some good capital preservation, ballast in their portfolio, maybe potentially be overweight in that subsector over some of the others.

John, let’s go to you and dive into a different sector. You had mentioned collateralized loan obligations. This is where the scary part comes in, different than what we were thinking about a couple of years ago in 2008. But can you dive into that sector and the opportunities ahead?

Kerschner: Yeah. And it’s funny, I think most people have that scare factor because they don’t understand a certain product. And obviously, what we’re here today is to educate our listeners and viewers into some of these products. But CLOs, collateralized loan obligations, like I said, are just like any other securitization – auto loans, credit card loans, mortgage loans – where you’re taking a pool of loans. These are from corporations. Usually, they go to the leverage loan market because they’re either smaller or newer or they just haven’t been around long enough to tap the normal high-yield market. But sometimes they just want to issue floating rate debt because maybe they think rates are going to go down. The leveraged loan market is floating. And because of that, CLOs are all floating.

So, what does that mean? Most bonds have a fixed coupon. You go out and buy a Treasury right now. Let’s just say you get a 5% type coupon. You will get that for, let’s just say, 10 years, it’s paid every six months, and then at the end, you get your principal. Floating rate debt, obviously, as the name implies, as rates move up and down. And in this case, it’s something called the SOFR rate, but just think of it as a very short-term, risk-free rate that moves one-in-one with the Fed funds rate. As that moves up and down, your coupon will change. Let’s just take last year, for example, where rates were going up a lot. Basically, CLOs on the AAA level went from a couple percent of yield, till today, they’re about 6, 6.5%. And that’s just a function of the Fed raising rates, the SOFR rate going up, and then the CLO rate going up. That’s very, very powerful, particularly in periods like this where rates are going up. Most fixed income has not done that well. Because when rates go up, your bond prices have to go down to equilibrate that. But floating rate debt, just the opposite, as rates go up, you actually get more coupon, and the price basically stays about the same, give or take. Why is it important? Portfolios are all about diversification. You can diversify different asset types, equities versus bonds, different classes within bonds. But having fixed versus floating in your fixed income portfolio is great because, again, we don’t really know if rates are going to go up or down or if the Fed’s going to cut. Or maybe they were going to raise some more. But we do know, because when rates go up, you have something in your portfolio that’s actually doing well.

And the nice thing about CLOs as well, we talked about these layers of risks or tranches, you can go AAA, AA, A, BBB, all the way down. If you want more yield, you can go down the capital stack a little bit. Obviously, it comes with more risk. But if you just want a AAA security, has some volatility, but not a whole lot, you’re still getting about 6.5% right now, which is really, really attractive, particularly given that inflation’s only about 3.5 to 4%. And then finally, these are just very, very default remote, that a AAA CLO has never defaulted. And even at the triple B level, you got to think about something that’s three or four times worse than what happened in the GFC [Global Financial Crisis] for those to take a default.

Castleton: And that’s interesting because, 2008, you said they never had a default. It’s not a CDO-type structure where 2008 or something like that, we actually saw CLOs hold up.

Kerschner: Yes. And just to be clear, leveraged loans slash bank loans, same thing; just two different names for the same thing. Used to be banks that made a lot of these loans. Some people still call them bank loans. But a lot of people think CLOs are cousins to CDOs – one letter different. CDOs that were issued back in the mid-2000s were basically loans of subprime mortgages, and anybody that was around back then knows all the horror stories. Basically, people getting loans that should have never had them, very low credit quality. And whatever you make out of something that was fraught from the get-go and had a high penchant for default as soon as home price appreciation went from basically zero down to negative 30%, which nobody thought was going to happen, the CDOs just did not perform well.

CLOs on the other hand, like you said, made from bank loans or leveraged loans, very long track record with rating agencies, very well calibrated as to what those defaults would look like even in huge dislocations like the GFC. And that’s why CLOs performed so well.

Castleton: For investors, CLOs can be that nice way to upgrade credit quality, maintain some of that floating rate exposure in a higher-for-longer interest rate environment. That just pure diversification from generally fixed income structures, is a nice add to portfolios potentially.

Kerschner: Exactly.

Castleton: Going into … we talked about mortgages, but maybe one of the bigger controversial topics within the securitized market today is commercial mortgage-backed securities. All the headlines around commercial real estate … Nick, talk about the CMBS market today and what we are seeing. Are we as scared about it as the market headlines would suggest?

Childs: I’d say out of all of the securitized credit, as I mentioned, ex agency mortgages, CMBS has underperformed the rest of securitized credit. I’d say some for the right reasons. Clearly, there’s a concern around office space post-COVID and the change in work-life environment. But you can’t throw the baby out with the bathwater. One of the differences is, I think, around commercial real estate or CMBS, commercial-backed securities, is the fact that there is a lot of idiosyncratic risk. Typically, in securitized products, you bundle thousands of loans, let’s say, and then you tranche that, as John was mentioning, to get different risk profiles.

In commercial real estate, it’s much more idiosyncratic. Commercial real estate, I think, is right now, at least media-wise, synonymous with office space. That’s not what all commercial real estate is. Commercial real estate is multifamily units, apartment complexes, etc., industrial properties, data centers. Think Amazon. Hotels, retail, office.

Kerschner: Go back five or six years ago and it was all about malls and how we had way too many malls and they’re all going away. People still, even five or six years later, say, “It’s a mall. I don’t want it in our portfolio, sell it.” And we’re seeing that, maybe not every day, but definitely every week right now, as far as people that are in bigger organizations, they just don’t want the headline risk. And we’re seeing it in office in some respects as well now.

So, the interesting thing about retail or malls is that some of these malls are just going to be bulldozed and turned into multifamily or other developments. Most offices are not going to be. Will there be downsizing? For sure. Will there be some pain? For sure. But a good building, a newer building, in a good location, in a good city, is going to still attract clients and will still … maybe it won’t have as much leverage as it used to, but it will be fine. And another stat is, 40% of office leases don’t roll over till 2030 and later. That’s still six and a half years away. In that six-and-a-half years, yes, 60% will roll, but 40% will not. As Nick said, this is going to take a while to work itself out. And I think it’s a great opportunity.

Castleton:  It seems like a very exciting opportunity that doesn’t come around often. So, let’s dig into the last one before we go into some closing here, which is asset-backed securities. John, you mentioned a lot at the beginning, asset-backed can be this catchall.

Kerschner: The asset-backed market, which is about $600 or $700 billion, give or take, about a third of that is actually auto loans, which I think pretty much everybody is familiar with. A lot of people think whoever gives you that loan keeps that loan. And that’s just not the case. If you get an auto loan, you and 10,000 other people, those loans are basically sold and then packaged by someone in Wall Street and then sold to people like us. Again, not scary whatsoever. We get line-by-line detail. We’re looking at FICO scores, but a lot of other things, size of loan, how long the loan is, how good this person is at paying off their loans, etc, etc. There’s many, many variables that go into these.

But you can become very well calibrated as to a pool of loans, how much will default? And if they do default, how much can we recover by going out and repo-ing that car and then selling that car in the secondary market? And that’s really the secret of success, understanding those risk drivers. And it’s really a statistical exercise.

The thing about asset-backed, yes, it’s consumer. And people are like, “If we go into a recession and unemployment goes up, that hurts the consumer.” Correct. But, again, we’re still at 3.8% unemployment. And if you think about where we got in the GFC, north of 10%, where we got during COVID, north of 16%, and I get during COVID, there was all sorts of stimulus and things like that.

But we’re so far away from these stress scenarios that it gives us confidence as investors that things can get much, much, much worse and these bonds will still be robust and pay us back. And yet the market is pricing them like it was COVID or almost like it was the GFC, very wide spreads. And to Nick’s point, a lot of that is technical. Whereas last year, money managers were getting withdrawals across the board. Not huge, but a little bit here and there. And yet supply was still very strong in asset backs. And that technical drove spreads wider. But we love that because that’s the market being inefficient. And this market is so inefficient.

But from our perspective, it’s just a massive opportunity. And what we do is sit here and we talk about these securities every day and how we are going to allocate capital and the best place to do it and there’s … I’m just trying to think, in my career, I’ve been doing this way too long, over 30 years. And it’s rare. There’s not a time where I’m like, this just is a great opportunity to be invested in securitized.

Castleton: Well, thank you both for walking us through all things securitized. And thank you to our listeners for tuning in today. We hope you came away with a better understanding of this sizable market and the opportunities that it can provide.

For more episodes of Global Perspectives, feel free to download other episodes wherever you get your podcasts or visit janushenderson.com. I’ve been your host for the day, Lara Castleton. Thanks. See you next time.