Mortgage & Structured Finance Outlook: Supply, Demand and the Consumer

1. In August 2023, you talked about the demand void left in the agency MBS market after some of its largest buyers moved to the sidelines. Do you expect agency MBS demand concerns to linger in 2024?                                                                                                   

We see potential for the technical backdrop to improve in the agency MBS market. Demand could come from a variety of different buyers, including banks, money managers and non-US buyers. While bank reserves remain under pressure, they could start to increase again, particularly if the Fed begins tapering its quantitative tightening (QT) program. Tapering QT would lead to higher reserves, which could increase bank demand for agency MBS, especially Ginnie Mae securities (Ginnie Mae securities are fully backed by the government). We are also watching how banks respond to Basel III Endgame regulatory requirements, a potential wild card that could transform the regulatory capital regime for banks. While many money manager allocations are near their historical maximum overweight to agency MBS, we believe aggregate bond fund inflows could help support demand. Finally, demand for agency MBS has picked up in non-US countries. We think this trend could continue among buyers in countries with more attractive relative value on a currency-hedged basis, such as Canada or the UK.

2. Many market participants have cited commercial real estate and the consumer as factors to watch in 2024. You covered your views on commercial real estate in a recent blog post, so let’s talk about the consumer. How has the consumer been doing? What are your expectations for consumer ABS?

Overall, the consumer appears to be doing well. However, when we dig into age brackets and incomes, we see two different stories. Prime and super-prime consumers tend to have higher incomes or are part of the baby boomer and silent generations, and typically have strong retirement and investment accounts. These consumers have been spending well and delinquencies within these groups have been generally low. On the flip side, near-prime and subprime consumers, who tend to be younger and lower-income, appear to be struggling more. With the effects of pandemic-era stimulus largely behind us, we’ve seen delinquencies in these buckets pick up, particularly among subprime borrowers. These consumers were less prepared for high inflation and have been spending less as they feel the squeeze from higher prices. Lenders are aware of the pressure on subprime borrowers and have cut back on their lending to this group. Currently, most lending activity is occurring within the prime and super-prime buckets because of their predictable payment activity and performance.

Collateral performance reflects the bifurcation among consumers, with largely strong performance among prime borrowers while near-prime and subprime auto and personal loans have been underperforming pre-COVID levels. This underperformance is particularly notable in collateral issued in 2021 and 2022, when loan underwriting was looser, car prices hit peak levels and inflation was soaring. We’ll be watching borrower behavior to see how it responds to inflation pressures, weakening labor markets among younger age groups, and slowing wage growth (especially among lower-income borrowers working in more cyclical sectors). We believe consumer ABS spreads remain attractive compared to corporate bonds, with a preference for auto loan and student loan-backed transactions from high-quality sponsors.

3. Are there any sectors that stand out as particularly attractive to you?

We think aircraft ABS remains attractive, especially selected aircraft engine deals and mezzanine tranches[i] of pre-COVID-19 aircraft deals still trading at distressed levels. Air travel has recovered back to pre-pandemic levels. However, the disruptions to new aircraft production during the pandemic have contributed to long-term aircraft and engine supply constraints. More recently, engine flaws on new-generation aircraft have grounded more planes as they undergo earlier and more frequent maintenance and inspections, adding to the supply woes and increasing the demand for older aircraft and engines. We believe these supply/demand dynamics will support asset values and lease rates in aircraft ABS.

[i] Mezzanine tranches are hybrid securities located between senior debt and equity in the capital stack. These securities combine debt and equity financing, allowing the lender the right to convert the debt to an equity interest in the event of default.

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