Credit Strategies for the End of the Cycle

Dave Goodson

Dave Goodson

Head of Securitized

Colin Dugas

Colin Dugas, CFA

Portfolio Manager, Securitized

The Power of Securitized Credit in Diversifying Fixed Income Portfolios

  • Understanding the differences between the current market environment and the dynamics leading up to the 2008 crisis can help investors more effectively prepare their portfolios for the next phase of the cycle.
  • While housing was a significant catalyst of the last crisis, a closer look at today’s economic data reveals that residential mortgage debt and the consumer are actually in the earlier innings of their cycle when compared to corporate debt.
  • By providing exposure to residential mortgages and the consumer, we believe securitized credit can help investors improve their credit risk profile.

The Next Cycle is Always Different: Yesterday’s Risk will not Write Tomorrow’s Headlines

In the current market environment, many investors are focused on balancing the need for growth with downside protection. In this context, we believe the current yield potential, floating-rate instruments and structural protections of securitized credit are particularly valuable. Yet despite these potential benefits, few investors consider standalone allocations to securitized credit strategies, instead dismissing it as a tactical “trade” believed to have largely played out after home prices and household debt surpassed pre-2008 levels. 

Investors tend to characterize the entire securitized space—with its broad array of risk types—as a significant catalyst of the 2008 crisis, a perception stemming primarily from the lasting stigma around subprime mortgage credit. However, anchoring portfolios to the risks of the previous cycle may not help investors successfully navigate the path ahead. History rhymes, as the saying goes, but does not repeat. In that vein, no two cycles are alike whereby current macroeconomic and regulatory conditions provide a significantly different backdrop for this market cycle versus last. In fact, a closer look at today’s data reveals that mortgage debt is actually in the earlier innings of its cycle when compared to the current corporate debt cycle (Figure 1).

Figure 1. Mortgage Debt Cycle Still Early versus Corporate Credit

Figure 1. Mortgage Debt Cycle Still Early versus Corporate Credit

Source: Federal Reserve Bank of St. Louis, Federal Reserve Bank of New York, BLS and Voya Investment Management. Corporate Debt as represented by Federal Reserve Bank of St. Louis Non-Financial Corporate Credit Instruments through 01/31/18. Mortgage Debt as represented by Federal Reserve Bank of New York Survey of Household Debt & Credit through 03/31/18.

Comparison of the corporate and mortgage debt cycles illustrates the current disconnect between U.S. corporations and the American consumer. While both sectors have recovered in the decade since the 2008 financial crisis, the disparity in leverage between the two sectors will likely have meaningful implications going forward. As the pace of corporate issuance resumed its higher trajectory following the crisis, the debt-to-GDP ratio of corporate debt has risen above its long-term average. Meanwhile, a very different picture is forming in the U.S. mortgage sector. While mortgage debt issuance has resumed growing in the post-crisis era, its debt-to-GDP ratio is instead falling.

Lessons Learned

Often the most important and lasting lessons are those learned the hard way. By just about every measure, today’s post-crisis U.S. residential mortgage market is a prime example of lessons not only learned the hard way, but also of those with lasting influence.

Following the 2008 crisis, significant changes have affected Government Sponsored Enterprises, banks, broker-dealers, rating agencies, mortgage servicers and—perhaps most dramatically—mortgage lending standards. With conservative lending dynamics still in play, mortgage loans exhibit vastly superior credit characteristics, including less leverage, compared to those underwritten before the financial crisis. Also of importance, securitizing “non-qualifying” risks like residential mortgages requires investors to keep skin in the game—so called risk retention.1 While the regulatory backdrop will continue to evolve (see removal of CLOs from risk retention requirements earlier this year2), the post crisis regulatory backdrop in securitized is decidedly in favor of investors. Figure 2 outlines the long list of regulatory and market enhancements implemented in recent years.

In addition to regulatory and market enhancements, a closer look at the broader macroeconomic backdrop reveals dynamics supporting the U.S. residential lending environment (Figure 3). While home values and household debt are above their pre-crisis levels, the U.S. population has grown by 26 million and the U.S. labor force is 8 million stronger than in 2007. Meanwhile, the current number of households and nonfarm payrolls are higher by 9% and 7% respectively and, perhaps most significant of all, at $19 trillion (and growing) U.S. gross domestic product is 34% higher than it was in 2007. Each of these measures points to additional firepower that has accrued in the U.S., with potential benefit to the housing market and reinforcing a potential virtuous cycle for consumers.

Figure 2. The Evolution of Securitized Credit: Increasing Legislative and Regulatory Clarity

Figure 2. The Evolution of Securitized Credit: Increasing Legislative and Regulatory Clarity

Source: Voya Investment Management

Figure 3. Economic data suggests the U.S. housing market is only just exiting the recovery phase

Figure 3. Economic data suggests the U.S. housing market is only just

As of 12/31/17. Source: Bloomberg, Case Shiller, Voya Investment Management, and The Federal Reserve. 

*Case-Shiller is an index that tracks nationwide, single-family housing values in the U.S.; the beginning value is measured from its pre-crisis peak, which we set as 07/2006.

Investment implications: Complement corporate exposure with securitized credit

Given the identified differences between the current stage of mortgage and corporate credit cycles, many investors may find that current portfolio allocations leave them overexposed to corporate credit risk. We believe securitized credit, with its U.S. focused, consumer and real estate centric risk drivers, is an effective way to diversify a portfolio otherwise dominated by corporate credit debt.

And for those investors who remain dubious on the prospects for investing in pre-crisis issued forms of securitized credit, the market has evolved meaningfully in recent years. In addition to these ‘legacy’ non-agency residential mortgage-backed securities, relatively new RMBS sub-segments include transactions collateralized by prime jumbo loans, re-performing loans, nonqualifying mortgages and GSE issued credit risk transfer (“CRT”) securities. CRTs, now 5 years in the making, continue to grow and provide securitized investors with access to residential mortgage credit. As the legacy portion of the non-agency RMBS market shrinks, new forms of mortgage risk like CRT enables investors to maintain exposure to residential mortgage credit (Figure 4).

Figure 4. The growing market for Credit Risk Transfer

Figure 4. The growing market for Credit Risk Transfer

Source: SIFMA, Bloomberg. Data as of 03/31/2018

And as Figure 5 indicates, securitized credit also represents much more than residential mortgage credit risk. In addition, securitized investors can invest in more direct forms of exposure to the U.S. consumer. While current assessments of particular lending markets such as student loans and auto debt (perhaps unsurprisingly) look in later cycle stages, other forms of borrowing like credit cards and HELOCs look decidedly earlier cycle.

While data in Figures 1 and 5 suggests that the corporate cycle is more advanced than the mortgage cycle, diversification remains a key tenant for long term investing. Therefore, maintaining exposure to multiple forms of risk remains a critical component of constructing a broadly diversified portfolio. However, potentially adding corporate credit risk in pursuit of much needed income in the current environment requires an even greater focus on protecting against the potential for downside losses. In this context, securitized credit is an effective addition to a yield hungry fixed income portfolio.

Figure 5. Securitized credit sub-sectors are at different points in their cycles

Figure 5. Securitized credit sub-sectors are at different points in their cycles

As of 6/28/2018. Source: Bloomberg Barclays, S&P and Voya Investment Management. Representative cycles are normalized relative to nominal GDP. Each representative cycle incorporates all available data starting from the year 2000. Covered time frames and sample rates may vary depending upon availability of specific cycle data.

Conclusion: Securitized Credit has evolved into a “through-cycle” allocation

For investors balancing the need for growth with downside protection, we believe securitized credit represents a compelling solution in the current market environment. More importantly, we believe the asset class has evolved to represent a standalone strategic allocation through a full market cycle.

Primary fundamental drivers of performance in the securitized market include residential mortgage credit, the consumer and the commercial real estate market. In addition, securitized investments offer strong structural protections, relatively attractive yield and a lower duration profile. The weighted average life of securitized credit investments also varies across sub-sectors, providing potential access to lower volatility investments in a world where downside outcomes across risk markets may be skewing more significantly. In this sense, securitized credit can provide both diversification from other asset classes, as well as a diversification within a potential allocation.

Securitized credit managers with the appropriate expertise across each of the sub-sectors can tactically adjust allocations based on the most attractive opportunities and perceived relative value at any given time, which creates the potential for consistent outperformance as market conditions change during and through market cycles.

1 https://www.sec.gov/rules/final/2014/34-73407.pdf

2 https://www.lsta.org/news-and-resources/news/clo-risk-retention-the-window-to-appeal-has-closed

 

Investment Risks
All investments in bonds are subject to market risks. Bonds have fixed principal and return if held to maturity, but may fluctuate in the interim. Generally, when interest rates rise, bond prices fall. Bonds with longer maturities tend to be more sensitive to changes in interest rates.
All investing involves risks of fluctuating prices and the uncertainties of rates of return and yield inherent in investing. High Yield Securities, or “junk bonds”, are rated lower than investment-grade bonds because there is a greater possibility that the issuer may be unable to make interest and principal payments on those securities. As Interest Rates rise, bond prices may fall, reducing the value of the share price. Debt Securities with longer durations tend to be more sensitive to interest rate changes. High-yield bonds may be subject to more Liquidity Risk than, for example, investment-grade bonds. This may mean that investors seeking to sell their bonds will not receive a price that reflects the true value of the bonds (based on the bond’s interest rate and creditworthiness of the company).

Disclosures
This commentary has been prepared by Voya Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest rate levels, (4) increasing levels of loan defaults, (5) changes in laws and regulations, and (6) changes in the policies of governments and/or regulatory authorities. Past performance is no guarantee of future results.