How structured credit could be resilient against recession

Putnam Fixed Income team, 10/21/22


  • The risk of a larger economic slowdown is high as long as the Fed maintains its recent hawkish stance.
  • We see attractive potential in specific prepayment strategies and residential and commercial mortgage strategies.
  • We prefer to maintain a lower level of risk in this environment but will selectively pursue attractive opportunities as they arise.

The macro landscape looks markedly different today than it did a year ago. After more than two years focused on the pandemic, investor concerns now center around persistent inflation, central bank tightening, and heightened geopolitical tensions. The U.S. Federal Reserve pivoted away from accommodative policy by bringing an end to its asset purchase program, embarking on a hawkish rate-hike path, and signaling its commitment to reining in inflation. Markets have responded with volatility, leaving few places to hide as Treasury rates spiked while risky assets sold off, pushing credit spreads wider.

Looking ahead, the risk of a larger economic slowdown is high as long as the Fed maintains its hawkish stance. Our current base case is that recession is likely inevitable, although the timing and depth depends on how quickly the Fed reacts to visible signs of an emerging recession. This scenario includes a modest rise in unemployment and a tepid housing market. Eventually, the Fed will have to choose between inflation and growth.

Structured credit strategies

Cautious optimism
Despite broader volatility, the fundamentals across many structured credit assets remain on solid footing and, in some cases, continue to improve. Nonetheless, we do not believe risk markets have fully priced in a recession, so we expect volatility to remain elevated in the near term. We prefer to maintain a lower level of risk in this environment but will selectively pursue attractive opportunities as they arise. This set currently includes higher-quality liquid securities that now offer attractive spreads with relatively low risk due to significant spread widening year to date.

The table below provides our current base-case return expectations for the three primary sectors we focus on:

Sector return expectations (over cash)

Sector return expectations (over cash)

For illustrative purposes only. Expected returns and projections represent probabilities and possible outcomes, not promises of future performance. Security prices fluctuate in value unpredictably, and returns cannot be predicted with certainty. The base case scenario provided above is based on numerous assumptions that are subject to risk and may not be realized. Changes in such assumptions could produce materially different results. The return expectations shown are hypothetical in nature, do not reflect actual results, and are not guarantees of future results.

Prepayment

Why we like it
The prepayment market was punished during the pandemic as ultra-low mortgage rates, soaring home prices, and opportunistic mortgage originators fueled a refinancing wave. But 2022 has brought renewed optimism to this market. Mortgage rates have spiked above 6% for the first time since 2008, affordability pressures are dampening housing activity, and mortgage originators are trimming staff and shifting focus to alternative loan products. The degree to which prepayment speeds slow from here is the key question. A scenario of a slowing housing market, falling home prices, and/or capacity or underwriting constraints could further dampen prepayments and fundamentally benefit the sector.

Where we see potential value
Many prepayment-sensitive assets now offer attractive risk-adjusted return potential at current price levels and significant upside potential if prepayment speeds slow further. Our selection efforts span a variety of collateral types that we believe are attractively priced based upon current prepayment speeds.

We now maintain a neutral position to the mortgage basis after significant widening this year. However, opportunities may arise if the Fed signals more aggressive balance sheet trimming or if rate volatility subsides.

Residential mortgage credit

Why we like it
U.S. homeowner balance sheets remain strong. Housing prices have soared to record highs while strong monetary and fiscal policy responses to the pandemic offered immense support to borrowers, improving their credit profiles and helping to keep delinquency rates low. We expect home prices will experience tepid growth for the next few years and likely decline in 2023, due to affordability pressures on demand and a gradual increase in supply.

After rallying to pre-Covid-19 levels in 2021, residential mortgage credit spreads have widened significantly across the capital stack this year, which has created attractive risk-adjusted return opportunities.

Where we see potential value
Given our cautious macro and housing outlook, we favor higher-quality bonds with shorter spread durations as well as bonds with seasoned collateral that can withstand home price declines due to significant built-up home equity.

Commercial mortgage credit

Why we like it
The outlook for commercial real estate is mixed as the U.S. economy continues to reopen to travel, office use, and retail spending while the Fed's efforts to contain inflation will likely push the country into a recession. Broadly, property types that can pass along inflation costs (e.g., hotels and apartments) will hold their value in this environment, while property types with longer leases and exposure to rising capital costs and/or needs for capital investments will face pressure. Office properties represent the largest risk to CMBS at this point in the cycle.

Macro-driven volatility pushed spreads wider across the sector this year, creating strong opportunities for security selection. We expect greater return dispersion across the market in the near term, which increases the importance of rigorous loan-level analysis to uncover relative value.

Where we see potential value
We favor seasoned mezzanine tranches on deals with high-quality collateral, which offer very attractive relative value after adjusting for risk.

This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon as research or investment advice regarding any strategy or security in particular.

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