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Allocating to MBS and leveraged credit

| January 17, 2020

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.

Performance in major US fixed income assets last year looks like an instructive guide to 2020, and it puts MBS and leveraged credit in good light. A big part of returns came from a sharp drop in rates and a rise in asset prices, something unlikely to repeat this year. But assets with yield and carry did well, and that looks like something that could repeat. There’s a straightforward case for adding exposure in MBS and credit, the higher yielding parts of credit especially.

 Returns dominated by duration and spread tightening

Returns in 2019 across major US asset classes ranged from 4.53% in ABS to 14.54% in investment grade corporates (Exhibit 1). The range largely came down to differences in duration and spread tightening. The investment grade corporate index, for instance, brought duration of nearly eight years into a rallying market and spreads tightened from the start to finish of 2019 by 50 bp.  High yield debt brought a duration of only three years, but spreads tightened by 144 bp—almost enough to catch the investment grade market. Leveraged loans with zero effective duration tightened by around 60 bp. MBS and ABS brought duration of three years and less with, at least for MBS, no nominal tightening from open to close. Across all sectors, of course, the greater the coupon, the stronger the compounded effect of income.

Exhibit 1: Return and risk across fixed income in 2019

Note: Annual unhedged total returns and annualized daily volatility of returns based on the Bloomberg Barclays indices and, for leveraged loans, the S&P/LSTA Total Return Index. Source: Bloomberg, Amherst Pierpont Securities.

Sectors with comparable returns but lower risk

More interesting is the day-to-day risk that investors had to take to earn those returns. Not surprisingly, volatility roughly corresponded with sector duration. That’s where high yield, leveraged loans, MBS and ABS become more intriguing. Those sectors all offered returns with much less risk than competing assets. High yield roughly matched the returns of investment grade with roughly 60% of the daily volatility. MBS roughly matched Treasuries with 45% of the risk. Leveraged loans matched or exceeded returns in CMBS with roughly 40% of the risk. ABS trailed other returns, but with lower volatility than any other sector.

Correlation sets high yield and leveraged loans apart

The other thing worth noting is the correlation of daily returns across asset classes, where leveraged lending clearly sets itself apart from other assets (Exhibit 2). The correlation of Treasury returns with all assets outside of high yield and leveraged loans ranges around 0.90. Duration dominates returns in these assets. High yield and leveraged loan returns, however, are negatively correlated with returns on Treasuries and every other related asset. The diversifying potential in high yield and leveraged loans is clear.

Exhibit 2: Correlation across fixed income in 2019

Note: Correlation of daily returns 12/31/2018-12/31/2019 based on the Bloomberg Barclays indices and, for leveraged loans, the S&P/LSTA Total Return Index. Source: Bloomberg, Amherst Pierpont Securities.

Prospects ahead

The likelihood of another sharp rally in 2020 looks low, with most of the US Treasury curve below 2.0%. That should reduce absolute returns substantially. But it should give advantage to sectors with potential to tighten and spin off compounding income.

Among the sectors most closely tied to rates, MBS looks like a strong candidate. It has a history of generating returns comparable to competing assets but with less risk, and not just in 2019. The current 41 bp OAS in the Bloomberg/Barclays MBS index is wide to its 34 bp average over the last five years. Runoff from the Fed’s portfolio poses a challenge along with an expected $300 billion in net new supply and uncertain demand from banks. But MBS is still likely to outperform Treasury debt with less volatility.

Leveraged lending in the form of high yield or leveraged loans also looks like a core holding both for delivering return with lower risk and for potential to tighten. High yield debt spreads are tight to their 5-year average but still wider than 2018. High yield tightened steadily in 2018 before the Fed convinced the market it would raise rates. With the Fed likely on hold for 2020, it would be a good environment again for high yield and leveraged lending. There are risks in slow economic growth in 2020 and in some sectors of lending where spreads widened late last year, but high yield and leverage loans should add valuable income to most portfolios and especially valuable diversification.

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