Higher for longer: the case for securitised assets in a higher rate environment
Portfolio Managers Seth Meyer, John Kerschner, and John Lloyd discuss how securitised sectors might play a key role for bond investors amid a challenging interest rate environment.
8 minute read
- Rising interest rates, high inflation, and low real yields have pressured returns on many fixed income sectors in 2022.
- With the US Federal Reserve’s (Fed) recent mention that interest rates will likely need to remain higher for longer to stifle inflation, bond investors may need to expand their investment tool kit to navigate a tougher rate environment.
- An allocation to securitised sectors could be a solution for some investors, as they offer potential for higher yields, lower interest rate sensitivity, and greater risk factor diversification.
According to the US Federal Reserve (Fed), it’s now official: interest rates will need to move up from here – and remain higher for longer – to stifle unacceptably high inflation. Following a summer of, at times, wild speculation around the Fed’s thoughts and intentions regarding the path of rate hikes, Fed Chair Jerome Powell delivered a crystal-clear statement from Jackson Hole in late August. In it, he dispelled any ambiguity and left little room for conjecture. What he communicated – in no uncertain terms – is that the Fed it is committed to its 2% inflation target, that it will need to move to a restrictive policy stance by raising rates further, and that it must keep at it until the job is done.
Most notable from Powell’s speech was the phrase, “restrictive stance for some time,” because futures markets have been pricing in rate cuts as soon as next year. The Fed poured cold water on this idea, indicating that inflation has become too persistent and broad-based for them not take drastic and sustained action. An imminent return to the post-Global Financial Crisis (GFC) zero-rate regime seems increasingly unlikely.
Of course, a Fed pivot is always a possibility. But this seems an unlikely scenario at present, and a risky one to bet on. We think investors would do well to take the Fed at its word and position their portfolios for a higher-for-longer rate environment. What does that look like for fixed income portfolios? In our opinion, investors should aim to bolster both the offensive and defensive characteristics of their bond allocations. A portfolio’s offense can be reinforced by taking advantage of higher yields and relative valuations, while strengthening defense might entail efficiently managing duration and diversifying one’s risk factor exposure. An allocation to securitised assets may help on both counts.
The case for securitised assets
Securitised sectors are underrepresented in the Agg
While the Bloomberg US Aggregate Bond Index (Agg) serves, for many, as a proxy for exposure to the investable fixed income universe, composition of the index differs materially from the universe itself. As shown in Exhibit 1, investment grade (IG) corporate bonds make up less than 16% of the US investable universe but command an almost 24% weighting in the Agg. Conversely, securitised sectors1 have a smaller than proportional weight of 2.3% in the Agg, relative to their market weight of 8.5%. In our view, investors may need to actively manage the weight discrepancies between the Agg and the investable universe to ensure they are gaining adequate exposure to necessary sectors.
Exhibit 1: Securitised sectors are underrepresented in the Agg
Source: Bloomberg, SIFMA, as of 31 December 2021.
Note: Investment grade securitised category includes ABS, CMBS, CLOs, and CMOs, and excludes agency MBS.
Securitised sectors may offer diversified risk exposure
In a more challenging environment, we encourage investors to think less in terms of asset class diversification and more in terms of risk factor diversification. How much exposure does a bond portfolio have to changes in interest rates? To the corporate credit cycle? To the consumer’s creditworthiness?
To the extent that many securitised markets are backed by loans made to consumers – not corporations – they should offer some diversity from the risks that drive equities and corporate bonds, and this should be reflected in their correlations. Indeed, as shown in Exhibit 2, for the decade ended 31 July 2022, high yield and IG corporate bonds have been positively correlated to equities, while CMBS and ABS have exhibited negative correlations. All else equal, adding negatively correlated assets to a portfolio should provide diversification, and may lead to better risk-adjusted returns in the long run.
Exhibit 2: CMBS and ABS have been negatively correlated to US equities over the long run
Source: Bloomberg, as of 31 July 2022.
Note: Weekly correlations for the 10-year period ended 31 July 2022. Indices used to represent asset classes: ABS (Bloomberg US Agg ABS Index), CMBS (Bloomberg US CMBS Investment Grade Index), IG corporates (Bloomberg US Corporate Investment Grade Index), High yield (Bloomberg US Corporate High Yield Index).
Securitised sectors can be used to manage duration
Over the past decade, the Agg’s duration has steadily crept above six years, as issuers have moved to take advantage of low interest rates by issuing longer-dated debt. Effectively, investors holding the Agg have been taking ever increasing interest rate risk as the duration of the index has ticked up. This duration extension proved to be a tailwind for returns while rates were falling, but would be a headwind for bonds if rates continue to move higher. In our view, investors should consider managing interest rate risk by ‘rebalancing’ their portfolio duration by incorporating lower duration assets into their core bond holdings. Due to the nature of their underlying assets, securitised sectors exhibit inherently lower duration than the Agg, and can help with duration management, as shown in Exhibit 3.
Exhibit 3: The Agg’s duration has crept above six years
The addition of securitised assets provides opportunity to dampen overall portfolio duration
Source: Bloomberg, as of 30 August 2022.
Securitised assets can be used to improve overall credit quality
While a forthcoming recession in the US is not necessarily a foregone conclusion, a slowdown in growth seems undeniable. As investors prepare for a slowdown – and the uptick in corporate defaults that tends to follow – we think there is value in bolstering the credit quality of portfolios through the addition of securitised assets. The average credit quality of both the ABS and CMBS indices is AAA/AA+, higher than the Agg’s average rating of AA+/AA. Additionally, most securitised bonds amortize as time goes on, as each monthly payment includes both an interest and a principal component. This monthly pay down of principal tends to de-risk most ABS and CMBS bonds as time passes.
Securitised assets may provide opportunities for better yields and relative valuations
While the yields on the Agg, CMBS, and ABS indices are all relatively comparable at 4.0%, 4.5%, and 4.1%, respectively2, on an historical basis, the yield spread of CMBS over the Agg is at its widest point since 2012, excluding COVID. The yield spread on ABS stands out to an even greater extent – it has historically traded at a discount to the Agg but is now trading at a premium for the first time since the GFC, excluding COVID, as shown in Exhibit 4.
Exhibit 4: Yield spread of CMBS and ABS over the Agg at historical wides
Source: Bloomberg, Janus Henderson Investors, as of 30 August 2022.
With the threat of rising interest rates, a key metric to follow is the breakeven (yield/duration), which shows the amount of yield a bond delivers per year of duration. The higher the breakeven, the more interest rates would have to rise for price decreases to exceed the yield on the bond. ABS and CMBS are delivering not only higher breakevens than the Agg, but they are at their highest levels in the last 10 years, as shown in Exhibit 5. We believe this presents an opportunity to add CMBS and ABS to portfolios at favorable valuations.
Exhibit 5: Breakeven for CMBS and ABS significantly higher than Agg
Due to lower duration, ABS and CMBS historically offer better protection against rising rates than Agg
Source: Bloomberg, Janus Henderson Investors, as of 30 August 2022.
Positioning for the future
While the tailwinds from falling interest rates after the GFC were a boon to fixed income returns, a potential reversal of that trend is likely to put pressure on fixed income returns. We believe investors may need to be more intentional in constructing portfolios, paying particular attention to actively managing duration and finding pockets of value and yield where they’re available. And as the more challenging landscape begins to take shape, the addition of securitised assets with their strong credit quality, low duration, and competitive yields may provide investors with the opportunity for improved risk-adjusted returns.
1Securitised sectors include asset-backed securities (ABS), commercial mortgage-backed securities (CMBS), collateralized loan obligations (CLO), collateralized mortgage obligations (CMO), and excludes agency mortgage-backed securities (MBS).
2Bloomberg, as of 8 September 2022.
Bloomberg US Aggregate Bond Index is a broad-based measure of the investment grade, US dollar-denominated, fixed rate taxable bond market.
Correlation measures the degree to which two variables move in relation to each other. A value of 1.0 implies movement in parallel, -1.0 implies movement in opposite directions, and 0.0 implies no relationship.
Duration can also measure the sensitivity of a bond’s or fixed income portfolio’s price to changes in interest rates.
S&P 500® Index reflects US large-cap equity performance and represents broad US equity market performance.
The Fed, or Federal Reserve is the central banking system on the United States.
Collateralised Loan Obligations (CLOs) are debt securities issued in different tranches, with varying degrees of risk, and backed by an underlying portfolio consisting primarily of below investment grade corporate loans. The return of principal is not guaranteed, and prices may decline if payments are not made timely or credit strength weakens. CLOs are subject to liquidity risk, interest rate risk, credit risk, call risk and the risk of default of the underlying assets.
Diversification neither assures a profit nor eliminates the risk of experiencing investment losses.
Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.
High-yield or “junk” bonds involve a greater risk of default and price volatility and can experience sudden and sharp price swings.
Mortgage-backed securities (MBS) may be more sensitive to interest rate changes. They are subject to extension risk, where borrowers extend the duration of their mortgages as interest rates rise, and prepayment risk, where borrowers pay off their mortgages earlier as interest rates fall. These risks may reduce returns.
Securitised products, such as mortgage- and asset-backed securities, are more sensitive to interest rate changes, have extension and prepayment risk, and are subject to more credit, valuation and liquidity risk than other fixed-income securities.
Please read the following important information regarding funds related to this article.
- An issuer of a bond (or money market instrument) may become unable or unwilling to pay interest or repay capital to the Fund. If this happens or the market perceives this may happen, the value of the bond will fall.
- When interest rates rise (or fall), the prices of different securities will be affected differently. In particular, bond values generally fall when interest rates rise. This risk is generally greater the longer the maturity of a bond investment.
- The Fund invests in high yield (non-investment grade) bonds and while these generally offer higher rates of interest than investment grade bonds, they are more speculative and more sensitive to adverse changes in market conditions.
- Callable debt securities, such as some asset-backed or mortgage-backed securities (ABS/MBS), give issuers the right to repay capital before the maturity date or to extend the maturity. Issuers may exercise these rights when favourable to them and as a result the value of the fund may be impacted.
- If a Fund has a high exposure to a particular country or geographical region it carries a higher level of risk than a Fund which is more broadly diversified.
- The Fund may use derivatives towards the aim of achieving its investment objective. This can result in 'leverage', which can magnify an investment outcome and gains or losses to the Fund may be greater than the cost of the derivative. Derivatives also introduce other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
- When the Fund, or a hedged share/unit class, seeks to mitigate exchange rate movements of a currency relative to the base currency, the hedging strategy itself may create a positive or negative impact to the value of the Fund due to differences in short-term interest rates between the currencies.
- Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.
- The Fund may incur a higher level of transaction costs as a result of investing in less actively traded or less developed markets compared to a fund that invests in more active/developed markets. These transaction costs are in addition to the Fund's Ongoing Charges.
- Some or all of the ongoing charges may be taken from capital, which may erode capital or reduce potential for capital growth.
- The Fund could lose money if a counterparty with which the Fund trades becomes unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.
- In addition to income, this share class may distribute realised and unrealised capital gains and original capital invested. Fees, charges and expenses are also deducted from capital. Both factors may result in capital erosion and reduced potential for capital growth. Investors should also note that distributions of this nature may be treated (and taxable) as income depending on local tax legislation.
- The Fund invests in Asset-Backed Securities (ABS) and other forms of securitised investments, which may be subject to greater credit/default, liquidity, interest rate and prepayment and extension risks, compared to other investments such as government or corporate issued bonds and this may negatively impact the realised return on investment in the securities.