Opportunistic Securitized Credit: How to Prepare for the Great Consumer Rebound

Matt Toms
Dave Goodson

Securitized spreads reflect current liquidity conditions, not intrinsic value.

For long-term investors, the current environment presents a wealth of opportunities to
purchase fundamentally sound credits at significant discounts—this is especially true
in the securitized market.

  • Even after acknowledging the diminished economic growth prospects as a result of the COVID-19 pandemic, none of the impacts to growth are likely to come close to the magnitude of the move in securitized bond prices. For example:
    • Spreads for AAA rated credit card and prime auto debt blew out to levels that would suggest a prolonged period of 30% unemployment
    • Spreads in the non-agency RMBS market imply a 20% decline in home prices
  • While monetary policy will need some time to take root, it will ultimately flow through to securitized markets and, in the Zero Interest Rate Policy world ahead, less distressed and more rational markets will begin to highly value the yield and income opportunities currently available.
  • In the meantime, we believe significantly wider spreads in select areas of the securitized market represent an extremely attractive starting point for asset allocators seeking to capitalize on a rebound in the U.S. consumer.

How We Got Here

While significant uncertainty remains, one aspect of the COVID-19 market shock has become clear: The recent technical price dislocation is more liquidity-driven than a deterioration in underlying fundamental credit strength. For long-term investors this means the current environment could present a wealth of opportunities to purchase fundamentally sound credits at significant discounts. From our perspective, one of the most attractive ways to capitalize on this market dislocation is to opportunistically invest in areas of the securitized credit market most connected to the U.S. consumer, where security prices reflect current liquidity conditions, not longer-term intrinsic value.

The dislocation in securitized credit has been swift and severe, leaving credit spreads wider and prices lower, at levels last seen in the 2008 crisis, but over an incredibly compressed time frame. While the magnitude of price moves is comparable to the 2008 crisis, the velocity greatly outpaced it (Figure 1). This reflects the forced selling and technical nature of the move, rather than a repricing that has emerged from real fundamental risk, which tends to come from more visible developments over longer time periods. Selling pressure is responsible for the majority of the move, as access to cash collapsed, willing buyers disappeared amid the unprecedented volatility and the brokerdealer community proved incapable of moderating the imbalance.

Figure 1. Charting the velocity of recent spread widening
Figure 1. Charting the velocity of recent spread widening

As of 3.26.20. Source: Bloomberg Barclays. Represents BB rated option-adjusted spreads
for asset-backed index securities.

Consumer Balance Sheets Were Strong Heading into This Market Shock – Stimulus Will Help Them Emerge Strong on the Other Side

Heading into this market shock, the U.S. consumer was strong. Since the 2008 crisis, U.S. consumer leverage steadily declined as individuals were often times hesitant or unable to re-lever balance sheets, even at historically low interest rates.

In addition to supporting the broader economy, recent monetary and fiscal measures will have specific benefits for the securitized markets. For example, recent fiscal measures like long-term mortgage loan modification programs have been specified, extending term and increasing the loan balance. This will reduce stress for borrowers with past-due mortgage payments and provide time for them to catch up as incomes normalize. It should be noted that this is not a loan forgiveness program. Rather it works to minimize longer term loss potential for non-agency mortgage-backed securities stemming from payment disruption. We believe these policies will suppress a growth in delinquencies as society navigates the near-term economic disruption from the pandemic. This should ultimately be supportive of the nonagency MBS market.

In central bank news, the Federal Reserve has announced several measures that support the consumer and securitized markets. This includes an agreement to purchase Treasury and both agency residential and agency commercial mortgagebacked securities “in the amounts needed to support the smooth functioning of markets”. Additionally, a second version of the successful 2008/2009 Term Asset-Backed Securities Loan Facility (TALF) program was announced. This emergency facility plans to use $100 billion to purchase securities backed by consumer loans and small business, including student loans, auto loans and leases, credit card receivables, and some small business loans. What is striking is the swiftness of the Fed’s response. TALF 2.0 was announced within 4 weeks of market dislocations and is expected to be operational in May. This is less than half the time that lapsed from the Lehman Bankruptcy to the launch of TALF 1.0 in March 2009. This should help normalize issuance, liquidity, and therefore spreads, much as it did during the first iteration (Figure 2).

Other measures include the Primary Dealer Credit Facility (PDCF), which is targeted towards buying debt from primary dealers, including investment-grade corporate debt, municipal debt, and mortgage- and asset-backed securities.

Figure 2. As “TALF 2.0” moves towards implementation, we look back at spreads during “TALF 1.0”
Figure 2. As “TALF 2.0” moves towards implementation, we look back at spreads during “TALF 1.0”

January 2007 – November 2010. Source: Bloomberg Barclays. Represents BB rated optionadjusted
spreads for asset-backed index securities.

Where we are Seeing the Most Attractive Opportunities

While the majority of the market move has been technical in nature, we do think it is important to acknowledge economic growth prospects have diminished and overall uncertainty regarding the outcome for all risk markets has increased. As the economy contracts, likely sharply for a period of time, unemployment is likely to increase, home price growth is expected to slow and commercial real estate valuations will temporarily decline for sectors like hotel and retail.

While economic risks are a key input into the underwriting of securitized credit, even after acknowledging the diminished economic growth prospects, none of the impacts to growth are likely to come close to the magnitude of the move we have endured in terms of securitized bond prices. We believe current valuations across the ABS and RMBS markets reflect a substantial and sustained decline in home prices and relatively high and sustained unemployment. For example:

  • Spreads for AAA rated credit card and prime auto debt blew out to levels that would suggest a prolonged period of 30% unemployment
  • Spreads in the non-agency RMBS market imply a 20% decline in home prices

The most attractive opportunities we see are in residential mortgage-backed securities, especially after the Federal Reserve announcement regarding unlimited QE asset purchases and asset-backed securities on the support from the TALF 2.0 program. Embedded structural protections in these securitized credit investments (subordination, overcollateralization, cash flow diversion) further reinforce their credit worthiness.

Opportunistic Securitized Credit – Areas of Focus
Opportunistic Securitized Credit – Areas of Focus

As of 3/26/20. Source: Bloomberg Barclays and Voya Investment Management.

Prepare for the Post COVID-19, Zero Interest Rate World Ahead

While many very dark tail scenarios can be feared, our central case as we emerge into the post COVID-19 world sees fundamentals defined by a swift bounce in economic activity followed by choppy global growth thereafter. This growth outlook is coupled with the odd bedfellows of high debt levels and low risk free interest rates.

In the securitized markets, risk has started transferring to more appropriate holders and deleveraging is occurring where necessary. While monetary policy will need some time to take root, it will ultimately flow through to securitized markets and, in the Zero Interest Rate Policy (ZIRP) world ahead, less distressed and more rational markets will begin to highly value the yield and income opportunities currently available. In the meantime, we believe meaningfully wider spreads in select areas of the securitized market represent an extremely attractive starting point for asset allocators seeking exposure to the strong fundamentals of the U.S. consumer.

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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.

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