Trends in the mortgage market
COVID-19 created significant headwinds for the commercial mortgage-backed securities (CMBS) market because commercial real estate is in the “eye of the storm.” Uncertainty about the duration of social distancing measures makes for a challenging backdrop, particularly for hotel and retail properties. We believe most properties that were functioning well prior to the crisis and have reasonable levels of equity will survive, buoyed by government support, operator reserves, and/or debt-service modifications.
We continue to have conviction in our CMBX positions, which we believe offer value at the single A and BBB levels for indexes representing 2012–2014 issuance. CMBX is an index that references a basket of CMBS issued in a particular year. Within CMBS cash bonds, spreads on debt we view as AA/A rated have tightened, but we feel compelling opportunities still exist within the mezzanine tranches. In addition, we think the relatively large sell-off in newer vintages has presented additional value in that part of the market.
In our view, prepayment-sensitive areas of the market are the direct beneficiary when there are increased frictions in the housing finance industry. There are ongoing risks from high unemployment, weaker projected home-price appreciation, lower home turnover, and reduced homeowner mobility. Even as the use of mortgage forbearance grows, cash flows to investors from agency mortgages are guaranteed by government-sponsored enterprises. We continue to have confidence in the fund’s holdings of interest-only collateralized mortgage obligations and inverse interest-only (IO) securities backed by more seasoned collateral. Within residential mortgage credit, we believe existing home prices may decline 2% year over year during the current recession.
Corporate debt: Investment grade and high yieldInvestment-grade corporate bonds and high-yield credit advanced 9% and 9.7%, respectively, during the quarter as investors reembraced risk. Spreads on corporate credit holdings tightened dramatically during the quarter after widening in March. We have a fairly positive intermediate-term view on corporate credit because of still attractive valuations and the market’s supply-and-demand backdrop. We believe earnings during the next two quarters will be lower than prior years, but many companies have bolstered liquidity and flexibility in response to the uncertainty. We continue to have conviction in the “crossover corridor” of investment-grade and high-yield credits. In our view, current spread levels on these securities are attractive compared with the underlying risks.
For the high-yield market, we have a similarly constructive outlook. Over the past several months, the high-yield market has seen some accelerated defaults as companies that were stumbling before the COVID-19 situation were pushed into default. We also saw a large number of investment-grade companies get downgraded to high yield. Between the high-yield defaults and the downgrades of investment grade, the by product has been a high-yield cohort that is higher quality than before. In our opinion, the biggest risk is the still-to-be-determined impact of the pandemic on growth, corporate earnings growth, and cash flows. Although high-yield spreads tightened after widening in March, valuations remain relatively attractive. In our view, spreads continue to offer a broad range of attractive relative-value investment opportunities. Moreover, we think the market’s yield remains compelling due to lower global yields. From a fundamental perspective, we are closely watching sectors vulnerable to the disruption caused by the coronavirus. We are monitoring the impact on energy, gaming, lodging & leisure, retail, and other cohorts.