We believed something would break even before this banking crisis happened. And now bonds are providing a safe haven and protection for investors’ portfolios. Our timeline for recession is pulled forward because of this banking stress. The Fed will be struggling, fighting inflation while also maintaining financial stability. But this should be a good year for the bond market.
Today’s banking stress is unique compared to historical crises. It’s not driven by credit risk, but the mismanagement of duration risk in the U.S., as well as some regulatory oversight and governance issues in Europe. At the same time, hopefully this duration risk can be more easily solved if we give banks a backstop and liquidity. Of course, this will drive bank balance sheet consolidation and, as a result, the banks will tighten their lending standards and we might have a credit crunch if it’s not managed well.
These banking developments have implications for securitized credit. Banks provide a lot of loans to the consumer sector and the mortgage sector. The agency mortgage-backed security (MBS) market is very deep, including foreign buyers, insurance companies and money managers waiting to buy if the spread becomes cheap enough.
In non-agency residential MBS, there is very healthy underwriting. 95% of borrowers have a loan-to-value ratio below 80, and the average mortgage rate that they locked in is a little over 3%. They have years of home price appreciation cushion.
With regards to commercial mortgage-backed securities (CMBS), there might be some stress because regional banks provide 80% of the lending to the commercial real estate market. There's nowhere to hide in CMBS, not even agencies, as spreads widen.
In terms of consumer asset-backed securities (ABS), there is the least risk of forced liquidation because banks only own about 2% of the ABS market, and it’s perceived to be a safe haven due to its short duration. There are some good opportunities in the AAA tranches of subprime auto ABS, which have widened a lot. In terms of collateralized loan obligations (CLOs), you are going to see more distressed CCC rated loans and more downgrades. But, at the same time, AAA rated CLOs also widened close to 200 basis points.
Many emerging market (EM) countries were ahead of the curve this cycle, hiking rates early to fight inflation. And now with this deceleration and the growth outlook moderating, their central banks can focus on lowering interest rates this year. In addition, we have seen the peaking of the U.S. dollar and stronger growth out of China. All of these factors are leading to a Goldilocks situation for EM countries, especially those that can benefit from China's reopening and recovery story, like Thailand and Malaysia. And then there are those that can benefit from near-shoring, like Vietnam and Mexico.
This means there are a lot of opportunities to invest in EM countries, especially local government bonds. They have been performing very well since October of last year, and they should continue to do well if the central banks cut interest rates.
In terms of where the best opportunities are in the global bond markets today, agency MBS offer an attractive opportunity because they will be a good hedge in the case of a recession. They are a cheaper version of Treasuries, meaning they have minimal credit risk and bountiful liquidity. I also like some AAA rated short duration ABS and CLOs and, potentially, CMBS to stay defensive. Seasoned investment grade-rated credit risk transfers (CRT) also look attractive.
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