Mortgage & Structured Finance Outlook: Where We See the Value

1. How have consumers weathered high inflation so far? What is your view on consumer asset-backed securities (ABS) going forward?

In our view, the consumer has held up pretty well. Consumer fundamentals appear to have largely reverted back to pre-COVID-19 levels after strong performance from 2020 to early 2022. However, a divergence in loan performance between higher- and lower-quality borrowers has recently become apparent in our auto loan delinquency surveillance.[i] The performance deterioration among subprime and near-prime borrowers suggests a combination of inflation pressures and waning pandemic savings has begun to negatively impact consumer balance sheets. Though wage growth remains strong among these lower-quality borrowers, it is starting to fade.

Looking ahead, we think that rising costs of food, rent, energy and childcare will continue to be a major concern for these borrowers. In addition, further stress on consumers could come if the government starts requiring federal student loan borrowers to resume their loan payments. Lenders have tightened underwriting standards in light of the economic pressure on consumers. We believe this tightening of the credit box could hinder consumers’ ability to lever up, helping them maintain stable balance sheets.

Our analysis indicates the investment grade portion of the capital stack would be well supported if we experience a steep rise in the unemployment rate. We favor investment grade classes from top-tier issuers because we believe they offer the most downside protection due to their strong servicing, high levels of credit support and amortizing delevering structures. 

2. Real estate markets are contending with a surge in mortgage rates and rising recession risks. How has that affected commercial and residential mortgage-backed securities (CMBS & RMBS)? In which parts of the market do you currently see the best value in 2023?

Real estate markets have started to come under pressure as potential borrowers face affordability constraints and existing borrowers confront refinancing challenges. As a result of these worsening conditions, we expect 2023 commercial real estate prices to decrease by roughly 10% in our base case scenario, which would be notably less than the price decline during the global financial crisis.[ii] We also forecast residential real estate prices to fall around 5% in our base case scenario. However, this expected price decline is marginal compared to the 38% national home price appreciation we’ve seen since 2020.[iii] Some reasons for our more optimistic view on residential housing include the structural underbuilding of new homes over the past decade, the increased underwriting quality of borrowers, and the low expected supply of existing homes for sale with owners “locked in” to their existing rates. In addition, we don’t anticipate a wave of distressed residential sales. Borrowers have built up high amounts of equity in their properties and lenders are generally more likely to work with borrowers to modify a loan rather than push a foreclosure. Given this macro backdrop, we favor RMBS deals that have shorter spread duration or a focus on seasoned borrowers with high equity in their homes.

Within commercial real estate, we expect a cycle downturn as interest rates rise, operating expenses reset much higher and lending conditions tighten. Property value declines and deceleration of net operating income growth rates will greatly depend on location and asset type. We expect commercial loan default rates to increase slightly in 2023 from recent lows as strong credit fundamentals weaken. Many near-term maturing loans are likely to see extension modifications. We have become cautious on most property types (except retail, which is still recovering from its prior downturn). Within CMBS, we see the most value in the investment grade portion of the capital stack, particularly in selected single asset single borrower (SASB) deals backed by high-quality assets and sponsors. We believe security selection will be paramount in 2023 as recession risks rise and weaker assets potentially struggle to retain tenants and receive financing from conservative lenders.

3. Agency MBS returns experienced extreme volatility in 2022, particularly in the latter half of the year. Why do you think returns were so volatile? Why are you positive on agency MBS for 2023?

In our view, one likely reason for this increased volatility was unfavorable demand/supply technicals. The Federal Reserve stopped reinvesting paydowns of MBS and banks were limiting purchases of mortgage securities due to slowing deposit growth and higher capital requirements, which left money managers (who were largely benchmark neutral on the sector) as the primary source of demand.[iv] Some of the volatility was also likely due to the market pricing in the possibility of MBS sales from the Fed’s balance sheet, which we viewed as a very low-probability event. Agency MBS volatility was so extreme in the second half of 2022 that it was actually higher than similar-duration investment grade corporate bonds.[v] From a historical standpoint, it is very unusual for government-guaranteed securities like agency MBS to have persistently higher volatility than bonds with default risk (corporates).

Heading into 2023, there are several aspects of agency MBS that make it an attractive asset class to us. First, the carry proposition of MBS is high given its current deeply discounted dollar price and natural pull to par. In addition, MBS convexity is now positive with many borrowers out of the money from a refinancing perspective. While the negative demand/supply technicals may spill over into early 2023, we think the attractive valuation of agency MBS will help support forward return potential in the sector over the next year.

[i] Source: Intex/Loomis Sayles

[ii] Green Street Commercial Property Price Index; commercial real estate prices declined 36% during the global financial crisis.

[iii] S&P CoreLogic Case-Shiller U.S. National Home Price NSA Index, February 2017 to November 2022.

[iv] Source: JPMorgan

[v] Source: JPMorgan/Loomis Sayles

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Base case scenarios are illustrative for presentation purposes only. Market scenarios have inherent limitations and should not be viewed as predictions of future events. They rely on opinions, assumptions and mathematical models which can turn out to be incomplete or inaccurate. Past market performance is no guarantee of future results.

Past market experience is no guarantee of future results.

The information is not intended to represent any actual portfolio. 

Market conditions are extremely fluid and change frequently.