The Big Idea

Relative value in risk assets

| May 19, 2023

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.

On the assumption the US gets past its debt ceiling showdown, a range of risk assets should get a new look. Most trade wider than 80% to 90% or more of sessions in the last five years. There is volatility to consider, the risk of recession and the usual idiosyncrasies of each market. But with the Fed widely expected to pause in June, relative value investing should get a new lease on life.

Current spreads and other considerations point to better relative value in risk assets. In particular:

  • Better relative value in MBS than in Treasury debt
  • Better relative value in investment grade corporates, loans, CLOs
  • Fair value in the corporate-to-MBS basis
  • A mixed picture in agency CMBS, non-agency CMBS and ABS

Better relative value in MBS than in Treasury debt

Both 30- and 15-year MBS trade at some of the widest nominal spreads to the Treasury curve since the Global Financial Crisis, due in part to high expected rate volatility. But even after stripping out volatility compensation, option-adjusted spreads look attractive in the current new, new era in MBS without Fed or bank buying. Even though the risks of much wider or much tighter spreads now look evenly balanced, current spreads should set MBS up for more consistently better returns against Treasury debt than seen in markets with strong Fed and bank bids—in other words, most of the time since 2008. And under the heroic assumption that the market gets past the debt ceiling showdown without crossing the X-date—something that should be clear by June 15 at the latest—implied volatility should fall. That argues for holding an MBS position well above the usual index weight. A few details:

  • Nominal valuations. Par 30-year MBS now trades at a nominal spread of 174 bp above the interpolated Treasury curve, wider than 99% of all sessions in the last five years (Exhibit 1). And par 15-year MBS trades at a nominal spread of 112 bp, wider than all sessions in the last five years. The wider 30-year spreads reflect much a much longer tail of prepayment risk, especially with the MOVE index showing implied interest rate volatility at high levels.

Exhibit 1: Par 30- and 15-year MBS nominal spreads at wide levels

Source: Bloomberg, Santander US Capital Markets

  • Option-adjusted valuations. Stripping out the compensation needed to cover prepayment risk, option-adjusted spreads still look attractive. Par 30-year MBS trades at a 60 bp OAS, wider than 91% of all sessions in the last five years, with 15-year at a 63 bp OAS, wider than 93% of sessions (Exhibit 2). Assuming the Fed runs down its portfolio to 15% of outstandings and banks continue to let MBS run off, these spreads look like fair value—but spreads that should allow MBS to outperform a matched-duration Treasury position.

Exhibit 2: Par 30- and 15-year MBS also trade wide on OAS

Source: Bloomberg, Santander US Capital Markets

  • Lower volatility. Investors concerned about debt ceiling volatility should wait until June 15. The market will have two critical pieces of information by then. First, the FOMC on June 14 should show either a Fed on pause or a Fed that hikes one more time and then pauses. Also by that point, either the debt ceiling will get resolved or the Treasury will have enough cash from June 15 tax receipts to make it into late July. The Fed and the tax milestone create grounds for lower volatility.

Better relative value in investment grade corporate debt, loans, CLOs

Relative value also argues for investment grade corporate debt over Treasury debt and for leveraged loan exposure as well, but not for high yield. All of the sectors trade wide, but only spreads on high yield look insufficient to cover recession risk. Most investment grade issuers have healthy balance sheets and used the low rates of 2020 and 2021 to extend debt maturities. Both high yield and leveraged loans look vulnerable if the US slips into recession. But leveraged loan yields and spreads could withstand levels of default last seen during the GFC with much lower recoveries and still deliver returns competitive with much safer assets. Leveraged loans—senior secured in most issuer’s capital structures—look like better diversifying credit exposures than unsecured high yield bonds. CLOs create leeway to customize leveraged loan exposure. Some details:

  • Investment grade and high yield corporate cash spreads. Both investment grade and high yield debt trade wide, but investment grade in particular. The Bloomberg investment grade cash index, adjusted back to LIBOR since 2021 for consistency, trades at a spread to Treasury debt of 148 bp, wider than 90% of sessions in the last five years (Exhibit 3). The high yield cash index trades at a spread of 481 bp, wider than 78% of sessions. Credit may underperform MBS in a recession, but it looks attractive to Treasury debt.

Exhibit 3: Wider IG and HY spreads reflect Fed cycle, bank, credit concerns

Note: Spreads adjusted for a 26 bp shift on Nov 5, 2021, to reflect transition from LIBOR to SOFR.
Source: Bloomberg, Santander US Capital Markets

  • Leveraged loans. Absolute yields on leveraged loans now approach some of the highest levels ever, helped in large part by high yields on their floating index. The average blended ‘BB’ and ‘B’ leveraged loan yield stands at 9.83%–5.37% of that from a high index rate, and 4.46% from the loan margin (Exhibit 4). Note that the margin comes close to the high yield market’s 481 bp spread, but loans are senior secured. Loans are vulnerable to rate stress if the Fed remains tight and the economy slows. But loans would have to see defaults near 10%–levels last seen in the GFC—with average recoveries of 52% to loose all the margin premium. This looks unlikely for now. Investors could add long investment grade corporate positions and floating-rate loans and reduce duration-matched Treasury debt.

Exhibit 4: A high index and wide margins lift absolute leveraged loan yields

Source: Bloomberg, Santander US Capital Markets

  • Not surprisingly, CLO spreads roughly track leveraged loans. The Palmer Square indices show CLO debt by rating class roughly at the same percentile as leverage loan margins (Exhibit 5). Portfolios benchmarked to an investment grade index can use ‘AAA’ through ‘BBB’ CLO debt to get leveraged loan exposure.

Exhibit 5: Spreads on CLO debt tracked leveraged loan margins

Source: Bloomberg, Santander US Capital Markets

Fair value in the corporate-to-MBS basis

Even though investment grade corporate debt and MBS look like better value than Treasury debt, they look like roughly fair value to each other. The OAS of all investment grade corporate debt in the Bloomberg Aggregate US Bond Market Index stands at 146 bp, and the OAS of all MBS in the index stands at 61 bp (Exhibit 6). The 85 bp difference between the sectors is only slightly wide of the median over the last five years, enough possibly to argue for slight overallocation to corporate debt. But corporate debt tends to underperform MBS in recession, which argues for sticking with a market-weighted allocation between sectors.

Exhibit 6: The spread between IG corporate debt and MBS looks roughly fair

Source: Bloomberg, Santander US Capital Markets

A mixed picture in agency CMBS, non-agency CMBS and ABS

In other structured credit, agency CMBS for understandable reasons looks slightly rich to competing assets, non-agency CMBS for understandable reasons looks wide and ABS looks like fair value. Agency CMBS looks rich because of a steady bid from FHLBanks and low supply. Non-agency CMBS looks wide because of the high level of uncertainty about the future of many office properties. ABS trades at a percentile of its spread distribution similar to other major asset classes (Exhibit 7). A major advantage in ABS: a wide range of diversifying exposures. A disadvantage: limited size.

Exhibit 7: Agency CMBS looks tight, non-agency CMBS wide and ABS fair

Source: Bloomberg, Santander US Capital Markets

* * *

The view in rates

Market pricing in the last few sessions has reflected generally improving changes of resolving the debt ceiling showdown. President Biden sounded optimistic about a deal before he left for the Group of Seven summit in Japan, and House Speaker McCarthy said he expected a vote in the coming week. But Friday McCarthy put negotiations on hold. Biden returns to Washington Sunday, and negotiations will likely resume. Nevertheless, the yield gap between May and June bills is narrower at the end of the week than at the beginning, implying less risk of default.

After the debt ceiling plays out, the market turns to the Fed. The Fed clearly sees policy as tight, as Fed Chair Powell noted in his press conference after the May FOMC. The latest Senior Loan Officers Opinion Survey suggests tighter bank credit is helping as well. And the uncertainty around the debt ceiling showdown will also likely tighten financial conditions. OIS forward rates continue to price only a small chance of another hike in June steady fed funds through September and between one and two 25 bp cuts into December. The market is clearly assigning weight to the possibility that tighter bank credit will magnify the impact of cumulative Fed hikes and drive cuts later this year.

The front end of the yield curve continues to show concern about a showdown over the US debt ceiling. Treasury Secretary Yellen’s notice that the federal government could run out of money by June 1 has made that day a bright line for Treasury bills maturing on or after that date. As of market close Friday, the bill maturing on May 30 trades at a mid-market yield of 3.88%% while the bill maturing on June 1 trades at 5.42%

Some key levels:

  • Fed RRP balances closed Friday near $2.28 trillion. Rich levels on May Treasury bills make RRP more attractive.
  • Settings on 3-month LIBOR have closed Friday at 538 bp, up 6 bp from a week ago. Setting on 3-month term SOFR closed Friday at 516 bp, up 9 bp from a week ago. LIBOR and SOFR have stayed in a tight range in recent weeks. LIBOR officially sunsets at the end of June.
  • Further out the curve, the 2-year note traded Friday at 4.27%. With the Fed likely to hold fed funds at current levels longer than the market expects, fair value on the 2-year note is higher than current yields. The 10-year note closed at 3.67%, Fair value on the 10-year note is lower than current yields.
  • The Treasury yield curve traded Friday afternoon with 2s10s at -59, flatter by 6 bp. Expect 2s10s to flatten further. The 5s30s traded Friday morning at 20 bp, 13 bp flatter on the week.
  • Breakeven 10-year inflation finished the week at 225 bp, up 6 bp in the last week. The 10-year real rate finished the week at 143 bp, higher by 16 bp in the last week.

The view in spreads

Volatility has moved up slowly but surely since the collapse of SVB and the broadening of concerns about the ability of regional banks to hold onto deposits at a reasonable cost. Rising volatility has widened spreads on risk assets not only because of the uncertain economic and market impact of tighter credit but also because of resulting wider bid-ask spreads in markets. A debt ceiling showdown that goes right down to the wire should push up volatility, too.

The Bloomberg investment grade cash corporate bond index OAS, without adjusting for the LIBOR-to-SOFR spread, closed Friday at 169 bp. The MBS has generally seen good auctions of the pass-throughs formerly held by Silicon Valley Bank and Signature Bank. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 176 bp, wider by 4 bp from a week ago. Par 30-year MBS TOAS closed Thursday at 63 bp, wider by 2 bp.

The view in credit

Failure to resolve the US debt ceiling with the US running a budget deficit would trigger a sharp fiscal tightening, likely slowing growth, pushing up unemployment and affecting all credits. That is an important event to watch.

Otherwise, most investment grade corporate and most consumer balance sheets look relatively well protected against the likely impact of Fed tightening. Fixed-rate funding largely blunts the impact of higher rates on both those corporate and consumer balance sheets, and healthy stocks of cash and liquid assets allow these balance sheets to absorb a moderate squeeze on income. But other parts of the market are funded with floating debt. Leveraged and middle market balance sheets are vulnerable, especially with the sharp tightening of bank credit in the wake of SVB. Commercial office real estate looks weak along with its mortgage debt. As for the consumer, subprime auto borrowers, among others, are starting to show some cracks with delinquencies rising quickly. Some commercial real estate funded with floating-rate mortgages have started to show some stress, too.

Steven Abrahams
steven.abrahams@santander.us
1 (646) 776-7864

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