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Looking for the next new thing

| March 1, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

In Las Vegas last week, more than 7,500 people came looking for the next new thing in securitization. They looked in the agency and non-agency mortgage markets, in residential and commercial loans, in ABS and CLOs. They thought about maybe giving up a little liquidity and maybe adding a little leverage. Risk seemed to have a bunch of new suitors.

Some of those suitors crowded a presentation hall late in the afternoon in the Aria Hotel not long after Structured Finance Industry Group kicked off its conference. The real crowds would come in Monday, but the hall was packed and people stood along the sides of the room. The draw was the second session of the day on CLOs and leveraged loans. Another three more sessions would hit the topic from different angles before the conference ended. Insurance portfolios and asset managers with new money to put into CLOs seemed easy to find.

Investors kicked the tires on loans and on reperforming and non-QM loan securitizations. Insurance companies and asset managers had started building loan portfolios in the last few years, and the flow of reperforming and prime and non-QM securitizations had jumped in 2018. Shops that originated loans came looking for capital and buyers. Portfolios that needed loans came looking for sellers.

The originators and sellers of loans seemed to have plenty to offer. One asset manager who decided to build a non-QM loan portfolio in January and expected to accumulate $100 million over six months had the position full by the time SFIG started. Plenty more sat behind that. A seller of transitional commercial real estate loans had a pipeline full.

Some investors shopped around for new ideas in agency MBS, but the options seemed limited. Nearly 83% of the 30-year MBS market is in just three coupons, and with the new uniform MBS likely on the way in June, investors will be able to choose from either conventional or Ginnie Mae. The conversation then turns to interest-only or inverse IO classes or agency CMBS IO. Or the idea floats around to buy specified pools and finance them or take a leveraged position in TBA and earn whatever is left of the dollar roll after hedging.

Somewhere in the background stood the pressure to stay ahead of the passive funds and ETFs. Pure beta is getting easier to find and less expensive. It’s working its way into insurance portfolios and other places where internal investment teams or third-party asset managers used to go. There’s the pressure on fees and the consequent need for either scale or consolidation.

“There’s lots of money and no ideas,” one investor said. But that didn’t seem true. There were plenty of ideas in the desert, and lots of money wondering where to invest. It needed to be alpha. It needed to be a new exposure or out-of-index or something some ETF couldn’t replicate. Risk had a bunch of new suitors in Las Vegas.

* * *

The view in rates

Rates have drifted a little higher lately but remain in their range so far for the year. The 2.75% rate on 10-year Treasury notes looks a little rich to fundamental fair value; the 2.56% rate on 2-year notes looks fair against a Fed unlikely to move this year. Breakeven 10-year inflation continues to climb back to the Fed’s 2.0% target, sitting at 1.95% in recent days. The slope of the yield curve between 2- and 10-year notes remains around 19 bp. More importantly, implied volatility remains within shouting distance of historic lows. Very little looks likely to shock the market this year. Carry and other risks this year, much more than interest rate risk, should dominate fixed income portfolio returns.

The view in spreads

With the yield curve flat, rates steady, and those conditions likely to persist, carry matters more to fixed income returns. MBS could widen a little this year if new bank liquidity rules reduce bank demand for MBS. Healthy MBS net supply could also weigh on spreads. But low volatility argues for MBS. MBS should still outperform corporate credit. Portfolios buying corporate debt should focus on names that show organic growth or use free cash flow or asset sales to pay down debt.

The view in credit fundamentals

Household balance sheets look strong, and corporate balance sheets look vulnerable. The ratio of household debt service to disposable income is at a record low, corporate leverage at a relative high. Of course, this all can continue for a long time if growth persists. The Fed has signaled that it stands ready to buffer any material softening in growth. Still, corporations may need to trim equity buybacks and reduce debt.

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