What the inverted yield curve could mean for securitization
Regardless of whether you think the inversion of the Treasury yield curve signals a recession, or is simply an unfortunate but inevitable side effect of the Federal Reserve’s unwinding of its balance sheet, the last several weeks have been challenging.
Consumer lenders that rely on the securitization market for funding are unsure exactly how slower economic growth would affect their cost of capital, since it’s unclear whether credit spreads would widen more than base rates go down, or rates would go down more than spreads widen.
Investors in corporate credit may feel that the fundamental and technical factors are diverging, since there do not appear to be any leveraged loan defaults on the horizon, but they are still cautious about taking on too much risk.
And, while everyone seems to think the housing market is still on pretty solid ground, this hasn’t made things easier for money managers who have to spend a lot of time reassuring their investors that U.S. homeowners are still a safe bet.
Nor does the market volatility serve CMBS lenders well for holding onto market share against banks and insurance companies, the other big commercial real estate lenders.
ASR spoke with five market pros about what could happen in a risk-off environment.
The question for all issuers about a recession that no one can answer.
CEO David Klein says CommonBond’s business model responds quite well in a recessionary environment. The consumers it targets will only be more interested in looking for ways to save money by refinancing their student debt.
Still, the company needs to plan for how a recession might affect its funding costs, he says. “Pretty much all of the basic economic data — productivity, unemployment, wages, spending, housing — everything more or less indicates that the U.S. consumer is holding up relatively well, so some folks are scratching their heads” at the yield curve inversion and resulting volatility.
“A big question is to what extent is the trade war putting downward pressure on economic growth? If investors don’t feel confident about the [business] environment or economy, they want more spread relative to risk, but if the economy starts to take a turn, the Fed would also likely decrease rates or stop increasing rates. The question will become which of those two forces will be stronger. If credit spreads widen more than base rates go down, that means our effective cost of capital will go up. Alternatively, if market rates go down more than spreads widen, our capital costs go down. That is the outstanding question for all issuers about a recessionary period that no one can answer.”
“The key for lenders is how to plan for either one of these scenarios. That has everything to do with the operating levers at our disposal, a combination of rates we charge to consumers, a hedging program against interest rate volatility, and the ability to acquire customers at low cost.”
“I think our business model responds quite well in a recessionary period, from two sides, consumer and investor. On the consumer side, when consumers feel like they are in a recession, they tend to want to tighten their belts and figure out where they can save more money. We have a product that helps them do that.”
On the investor side, “in a recessionary environment, there’s a flight to quality, and given the high credit quality on our platform, that would likely benefit us as investors flee from riskier assets.”
Bonds with yields north of 4% and a two-year WAL are a safe haven.
"I don’t think it’s the right time to step up on risk levels across our funds given fixed income investors’ expectations not to lose money," said Berkin Kologlu, a managing director and senior portfolio manager at Angel Oak Funds. "We can accomplish a lot of that by minimizing credit risk here, especially with Libor at 2.7%. You’d want to see lot more steepening of the credit curve before move away from AAA into BB risk.”
Kologlu does not think the inverted yield curve is not necessarily a sign of a recession. So while growth can slow down, he doesn't think things are going to turn bad really quickly. “For us, there are lot of different implications; we do invest in floating-rate assets, heavily - they account for about 80% of fund – and in general a flat yield curve makes us look good. We haven’t added much risk because you’re not paid appropriately for higher risk so we remain top of capital structure. RMBS is our favorite sector because of the solid consumer fundamentals as well as more tailwinds real estate.”
Kologlu is opportunistic when it comes to collateralized loan obligations. “Broadly speaking if you’d asked me couple of months ago, I’d have comfortably told you CLO spreads would be wider at the end of 2019. However, we’ve had pretty substantial moves in November and December, so I think that’s a more difficult claim to make now, even if you factor in the risks everyone talks about for CLOs and loans.”
“There’s a discrepancy between the new issue and secondary [CLO] markets today; if you believe the secondary is going to reset the primary market, then we are starting at a pretty wide place already. There’s been a bunch of forced sellers, there’s very poor liquidity in the dealer community, as you’d expect at year end. All of these fundamentals, redemptions, and forced selling are pushing CLO spreads wider, and new issue investors are paying attention. I don’t know if new issue investors want to capture all of that spread widening, but we’re already part way there.” For a top-tier manager, new issue AAAs are pricing at Libor plus 125 basis points, that’s 30 bps wider than the tights of 2018. “The downside is limited there.”
“Even if there is modest additional spread widening the total return on AAA CLO securities, with a 4% carry, you’re pretty well protected.”
The potential downside for BB CLO securities “is lot lower, spreads in early 2016 reached 1,000 for the best names and well wider for weaker deals. There’s definitely 10, 15 or 20 points of downside. I can’t say my 9% carry will bail me out if spread widening continues. I’m definitely not bullish on mezzanine or BB. I think cautious is a better way to describe it, more selective.”
“It definitely feeling like fund and tech are diverging” for CLOs. “I don’t see imminent defaults, but we also have a market that’s almost at a consensus as to how weak some recent loan structures have been. There’s a lot of leverage in the system and there are expectations for a corporate credit-led recession. So technicals can overwhelm fundamentals in an environment like this, if we see spreads widen and people want to position for poor performance from credits at some point down the line.”
The best trade could be to short BBB corporate credit.
Tracy Chen, portfolio manager and head of structured credit at Brandywine, is more pessimistic about corporate credit.
“Leverage in the corporate market has increased a lot over the past several years, even in investment grade,” she said. “I don’t think GE is idiosyncratic. We see cracks here and there. There’s a major trade war, and the supply chain relocation will be very messy. Apple has a lot of cash, but you still see their bonds getting pummeled, CDS widening. It’s not about default, it’s about the shake-up in the supply chain and a very complacent market.”
“I think that the best trade next year could be to short BBB names.”
“Compared with before financial crisis, most of leveraged loan market is structured with less subordination; there are issues without any high yield below” them. There’s been a decoupling of the typical relationship between the amount of leverage in the corporate market and defaults; historically, when leverage has been high, defaults have gone up. This time they haven’t. This tells us we have central bank support. Now as the Fed is withdrawing [that support], something has to give.”
‘It’s as if some great inventory at Nordstrom went on sale.’
For Greg Parsons, CEO of Semper Capital Management, the last six to eight weeks have been “the most challenging, stressful time we’ve had in years. It’s coming on top of stable-to-improving cash flow on the underlying collateral.
“It’s as if some great inventory at Nordstrom went on sale,” he said.
“While the investment team is excited, from an intellectual standpoint, about the opportunity created by the volatility or market weakness, we spend a lot of time talking to clients convince them to stay calm through the storm, so to speak.”
“The Fed has been pretty deliberate with its intent to continue to raise short-term rates, so it’s not surprising the long end hasn’t moved. Folks can debate for hours about why; is it U.S. factors signaling [an economic] challenge, or just our increasingly interconnected world that makes the 10-year, on a relative basis, sensitive to what’s going on elsewhere in the world?”
Either way, “from our vantage point, the underlying cash flow and strength of collateral is stable, at worse and improving at best,” he said.
“The fundamental thesis still applies: Mortgage credit is a narrow bet on the U.S. homeowner. There’s a data set that’s easy to analyze and all of the fundamental economic metrics are supportive of that. Whether Trump gets into a trade war with China does not have a big impact on whether Greg Parsons pays his mortgage. It’s a great credit space to be in, because the structure continues to be opaque, the market is fragmented, and there’s no index. You can’t buy [exposure] on an exchange, so there’s a real value to understanding collateral.”
While curve flattening may be viewed as an indicator of a recession, “there’s nothing in housing data suggesting that is coming. The very flat or inverted curve is not changing our perspective, or pushing us into other areas of structured finance — though we still look at other areas, opportunistically.”
“We spend a lot of our time in a business development role articulating this thesis. People are worried. They see more volatility in the market or are concerned about where the economy is going. It certainly feels like there is an extreme elevated level of stress in markets. We spend most of our time articulating, ‘Here’s why we continue to put money to work in mortgage credit.’ ”
Volatility doesn’t serve the CMBS market for keeping market share
The commercial mortgage bond market historically has two or three competitive advantages, according to Manus Clancy, senior managing director at Trepp. “The first is a willingness to offer longer-term debt than banks; banks like to make loans with terms of five or less, while CMBS lenders will offer 10 years. That puts [the market] very much in competition with insurance companies. The second [advantage] is that insurance companies like more trophy assets, not as much assets in secondary or tertiary markets. But at the end of the day, the big benefit to CMBS is that it is a low-cost lender. It offers the best [lowest] cost financing and execution for a borrower.”
That’s only the case when rates are stable and CMBS issuers can be more aggressive lenders, however.
“When you start to see that kind of volatility, you see issuance tap the brakes a bit. Dealers either quote loans wider” — making CMBS less competitive — “or they stop quoting at all, as we saw in early 2016,” Clancy said. “Once you see volatility ratchet down again, CMBS will become more competitive again.”
The environment “does remind us a lot of late 2015/early 2016, when commodity prices plunged and spreads blew out. People were worried about corporate, energy companies. Issuers were reluctant to quote loans. It doesn’t feel quite as edgy now, at least in CMBS ... but that does lead to more caution.”