The first few months of 2022 have brought heightened volatility across financial markets. Investors have grappled with inflation concerns and expectations for monetary tightening by the Federal Reserve. Despite a changing investment landscape, we are optimistic about pockets of the U.S. structured credit market for the remainder of this year.
We review two segments of this market — prepayment strategies and commercial mortgage-backed securities — to glean insights.
Finding potential in prepayment strategies
The Fed used monetary policy to suppress mortgage rates at historical lows throughout the Covid-19 pandemic. As the Fed pivots to a less accommodative policy, 30-year mortgage rates have increased by more than 0.70% year to date and are now back to pre-pandemic levels. This upward trend may continue if the Fed leans more heavily into tightening policy by selling agency mortgage-backed securities to reduce its balance sheet.
Higher mortgage rates decrease borrowers’ financial incentive to refinance and typically dampen prepayment speeds. That, in turn, would benefit the cash flow expectations for agency interest-only (IO) securities.
The “refinance-able” universe is shrinking
In addition, the portion of the mortgage universe that is considered “refinance-able” continues to decline and is now at its lowest point in three years. As of February 25, only 13% of borrowers had a 25-basis point interest-rate incentive to refinance compared with more than 60% in August 2021, according to the Morgan Stanley Truly Refinanceable Index. Refinancing typically slows in a rising interest-rate environment.
The percentage of borrowers with incentives to refinance mortgages has trended lower
Sources: Bloomberg, Morgan Stanley, as of February 25, 2022.
Outlook improves as prepayments slow
Mortgage prepayment speeds — the conditional prepayment rate — have fallen over the past four months. The pace of the deceleration has exceeded financial market expectations. We have become increasingly confident in the upside potential of the prepayment asset class as macroeconomic developments align with our outlook. In our view, these fundamental shifts have yet to be priced into the market, and therefore present an exciting risk-adjusted return opportunity.
Aggregate prepayment rates have slowed
Note: CPR – Conditional prepayment rate.
Sources: Bloomberg, Federal Home Loan Mortgage Corporation (Freddie Mac), as of January 2022.
CMBS market is making a comeback
Over the past year, commercial real estate has continued to recover. We see this on several fronts:
- Cash flow forecasts for the sector continue to improve with rent and occupancy growth.
- Forbearance agreements and other loan modifications have been successful on well-positioned properties.
- Delinquency rates have declined steadily.
While some risk of future shutdowns of commercial spaces remains, we believe overall fundamentals will continue to improve as workers return to offices, consumers head out to local retailers, and hotels welcome travelers back for both business and leisure.
Value emerges from volatility
After staging a strong recovery in the first half of 2021, CMBS spreads have widened in recent months amid broader market volatility. [Spreads are the yield advantage credit-sensitive bonds offer over comparable-maturity U.S. Treasuries.] This has been driven in part by worries about the potential impact of the Omicron variant, as well as concerns surrounding the Fed’s response to historically high inflation. We believe the recent price weakness presents an attractive risk/reward opportunity.
Attractive potential risk/reward opportunity
We believe much of the CMBS debt originally rated A and above, as well as most of the classes originally rated BBB-, may have sufficient credit enhancement to be insulated from principal losses. In addition, CMBS have historically performed well in times of inflation due to having real assets as collateral and the ability to adjust rents. As such, we believe CMBS may provide an attractive relative value and diversification opportunity, particularly when compared with corporate debt.
Adapting to a changing landscape
Putnam’s fixed income team actively analyzes new opportunities and risks in fixed income markets. Overall, we believe the environment for risk assets, especially structured credit, remains generally supportive. We believe prepayment-sensitive areas of the market offer an attractive return potential and offer desirable diversification benefits for investors. In the CMBS market, we believe recent market weakness presents attractive risk-adjusted investment opportunities amid an improving fundamental backdrop.