The Big Idea

Wide spreads in MBS and structured credit

| September 8, 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.

Current spreads in MBS and structured credit argue for better relative value in those corners of the debt markets than in Treasury debt or in industrial corporates or similarly tight credits. MBS and structured credit broadly trade on the wide side of their 5-year range with most corporate debt somewhere between fair and tight. Even after considering the fundamental and technical factors shaping spreads, relative value still points to sectors trading on the wide side. And,within MBS and corporate debt, there is also room to improve portfolio prospects.

Spreads and spread percentile ranks

This picture of relative value in MBS and structured credit is based on where current spreads rank against spreads in the same asset over the last five years. Absolute spread clearly helps screen for relative value across sectors, but the percentile rank of a spread over time provides important context. The Treasury OAS on the Bloomberg conventional 30-year MBS index, for example, currently is 56 bp. But the 5-year percentile rank is 74, meaning the OAS is wider than 74% of sessions in the last five years. Sectors trading at the same rank, absent major changes in fundamental or technical risks, arguably should be fair value against one another. Sectors trading at different ranks show which are trading relatively wide, which are relatively tight, and which arguably are relatively better or worse value.

The current picture of percentile rank shows MBS and structured credit trading wider than corporate credit (Exhibit 1). The current Bloomberg conventional 15-year MBS index OAS has a 5-year percentile rank of 98, meaning it is wider than 98% of sessions in the last five years. Measures of par coupon MBS spreads—whether nominal or OAS—rank 93 or higher. Benchmarks for private CMBS, agency CMBS, card ABS and auto ABS rank 72 or higher. The discount margin on most CLOs rank at 60 or higher. Most investment grade or high yield corporate credit, meanwhile, rank 60 or lower. The ranks lead to useful discussions of why sectors trade at these levels and where they might represent genuinely better or worse value.

Exhibit 1: MBS and structured credit trade at high 5-year percentile spread ranks

Note: Ranks based on spreads over the last five years. Index OAS based on Bloomberg indices. The Industrial Index includes basic industry, capital goods, communications, consumer cyclical, consumer non-cyclical, energy, technology and transportation. The Utility Index includes electric, natural gas and other. The Financial Index includes banks, brokerages/asset managers/exchanges, finance companies, insurance, REITs and others. CLO DMs based on Palmer Square indices.
Source: Bloomberg, Santander US Capital Markets.

Agency MBS

The high rank of agency MBS, whether measured in nominal spreads or OAS, looks like good relative value certainly against Treasury debt and likely against some of the richer parts of the corporate market such as investment grade industrials. MBS spreads reflect the impact of runoff from the Fed portfolio, low bank demand, the sale of big MBS portfolios by the FDIC from the collapsed SVB and Signature Bank and rising outstanding supply. MBS spreads look likely to remain relatively wide, but the carry should help the sector outperform matched-duration Treasury debt. The richer parts of the corporate market meanwhile have priced in a lot of the good news about a possible soft landing and look more vulnerable to widening than MBS.

The rank of the 30-year MBS index OAS at 74 and the 15-year MBS index OAS at 98 raises the case for better relative value in 15-year MBS (Exhibit 2). Sale of big blocks of 15-year MBS from the SVB and Signature Bank portfolios likely has contributed to the gap. Less attention to the sector may be contributing as well, with 15-year pass-throughs now only around 9% of the MBS index—down from around 27% in the early 2000s. Asset managers should consider rotating some 30-year MBS exposure into 15-year.

Exhibit 2: OAS and 5-year percentile rank in MBS argues for 15-year paper

Source: Bloomberg, Santander US Capital Markets.

Corporate debt

Most corporate debt looks somewhere between fair value and overvalued. Bloomberg’s investment grade index OAS of 120 bp ranks at 51, squarely at fair value (Exhibit 3). The emerging market index OAS of 313 bp ranks at 44, also roughly fair value. And the high yield index OAS of 371 bp ranks at 38, leaning toward overvalued. But these levels mask some differences within the investment grade and high yield markets.

Exhibit 3: OAS and 5-year percentile rank in corporate debt looks fair-to-rich

Source: Bloomberg, Santander US Capital Markets.

Within the investment grade market, industrials look the most overvalued with a rank of 32, utilities broadly look fair with a rank of 56 and financials look the most undervalued at a rank of 70 (Exhibit 4). Industrials arguably reflect residual flight-to-strength from financials after the volatility triggered by SVB in the spring and ongoing bank regulatory uncertainty. But our investment grade strategists see regional banks as particularly undervalued. Investors should consider rotating out of industrials into financials or into MBS.

Exhibit 4: OAS and 5-year percentile rank argues for investment grade financials

Note: The Industrial Index includes basic industry, capital goods, communications, consumer cyclical, consumer non-cyclical, energy, technology and transportation. The Utility Index includes electric, natural gas and other. The Financial Index includes banks, brokerages/asset managers/exchanges, finance companies, insurance, REITs and others.
Source: Bloomberg, Santander US Capital Markets.

Within the high yield market, all sectors look fair-to-overvalued. High yield utilities rank at 22, high yield industrials at 35 and high yield financials at 60 (Exhibit 5). Aggressive levels on utilities and industrials probably explain the relatively low rank of high yield overall compared to investment grade or emerging markets.

Exhibit 5: OAS and 5-year percentile rank show high yield at fair-to-overvalued

Note: The Industrial Index includes basic industry, capital goods, communications, consumer cyclical, consumer non-cyclical, energy, technology and transportation. The Utility Index includes electric, natural gas and other. The Financial Index includes banks, brokerages/asset managers/exchanges, finance companies, insurance, REITs and others.
Source: Bloomberg, Santander US Capital Markets.

Collateralized loan obligations

While most investment grade and high yield debt shows up as fair-to-overvalued, CLOs debt shows up as largely fair value. Across rating category, CLO debt ranks between 55 and 67 (Exhibit 6). CLO debt does have the complication of relying on underlying leveraged loans, which are predominately floating rate. Funding costs for these borrowers have gone up significantly since the Fed started tightening. The median ‘B-‘ borrower through March had a median EBITDA-to-interest-expense ratio of  -0.8, according to S&P, meaning more than half of ‘B-‘ issuers were burning cash. Many of these issues have cash on the balance sheet, which gives them some runway. But persistent high funding costs could further weaken some of these companies. The investment grade classes of CLOs should offer more than adequate protection against this risk and could make a good substitute for short investment grade corporate debt—possibly paired with Treasury debt to match the corporate debt duration.

Exhibit 6: DMs and 5-year percentile rank show CLOs as roughly fair

Source: Palmer Square indices, Bloomberg, Santander US Capital Markets

Cards, autos and CMBS

Card ABS, auto ABS and agency and non-agency CMBS show up as broadly undervalued. Cards show a 5-year percentile rank of 79, autos a rank of 72, non-agency CMBS a rank of 87 and agency CMBS a rank of 80 (Exhibit 7). All of these corners of structured credit trade at the wide end of their 5-year range. Non-agency CMBS clearly is showing the impact of concerns about office properties. But card and auto ABS have the benefit of a generally strong consumer and could stand in as good substitutes for overvalued parts of the corporate market with similar rating and duration.

Exhibit 7: OAS and 5-year percentile rank shows most ABS, CMBS undervalued

Source: Bloomberg, Santander US Capital Markets

Wider spreads in MBS and structured credit, tighter spreads in industrial corps

Sectors with wide spreads and high 5-year percentile ranks clearly can go wider and the ranks can go higher, and sectors with tight spreads and low ranks can go tighter and lower. Nothing requires spreads to revert to the median. But even after accounting for the fundamentals and technical that have shaped current spreads, MBS and structured credit look like better relative value than material parts of the corporate market. Asset allocators should take advantage.

* * *

The view in rates

OIS forward rates broadly see a limited chance of more hikes from the fed and roughly steady rates through March. The same forwards then anticipate 80 bp of cuts from March to December 2024. The market is probably missing one more hike in November. Other than the missing hike, the market at this point is pricing a fair path. The Fed may hold rates high into July next year and then cut 100 bp by December, but that amounts to a small difference in the long run. The risk to the market is that sticky inflation keeps the Fed at higher rates for even longer, which would eventually create credit problems for balance sheets funded at floating rates that already are burning cash.

Other key market levels:

  • Fed RRP balances closed Friday at $1.52 trillion, down $294 billion from mid-August.
  • Setting on 3-month term SOFR traded Friday at 541 bp, up 3 bp since mid-August
  • Further out the curve, the 2-year note closed Friday at 4.99%, up 5 bp from mid-August. With the Fed likely to hike again and hold fed funds closer to 5.50% into next year, fair value on the 2-year note is above 5.00%. The 10-year note closed at 4.26%, up 1 bp since mid-August. Much of the rise in 10-year yields came after late July hints of a shift in Japan’s yield curve control and the Treasury announcement of heavy supply ahead. With inflation likely to drift down and growth likely to slow through this year and next—shaping the Fed path—fundamental fair value on the 10-year note for now is closer to 3.50%.
  • The Treasury yield curve closed Friday afternoon with 2s10s at -72, flatter by 3 bp since mid-August. Expect 2s10s to reflatten beyond -100 bp again as the Fed keeps short rates high and concerns about growth and recession grip long rates. The 5s30s closed Friday at -6 bp, flatter by 5 bp since mid-August.
  • Breakeven 10-year inflation traded Friday at 234 bp, up by 3 bp since mid-August. The 10-year real rate finished the week at 193 bp, down by 2 bp since mid-August.

The view in spreads

The Bloomberg investment grade cash corporate bond index OAS closed Friday at 146 bp, tighter by 2 bp since mid-August. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 166 bp, tighter by 16 bp since mid-August. Par 30-year MBS TOAS closed Friday at 58 bp, tighter by 19 bp since mid-August. Both nominal and option-adjusted spreads on MBS have been particularly volatile in the last month but trending wider.

The view in credit

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 funded with floating debt look vulnerable. Leveraged and middle market balance sheets are vulnerable, especially with the tightening of bank credit in the wake of SVB. At this point, mainly ‘B’ and ‘B-‘ loans show clear signs of cash burn. Commercial office real estate looks weak along with its mortgage debt. Credit backing public securities is showing more stress than comparable credit on bank balance sheets. As for the consumer, subprime auto borrowers, among others, are starting to show some cracks with delinquencies rising quickly. The resumption of payments on government student loans in September should add to consumer credit pressure.

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

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