Exploring the world of securitised credit

Please note: This article is more technical in nature than our typical articles, and may require some background knowledge and experience in investing to understand the themes that we explore below.

All data referenced in this article are sourced from Bloomberg unless otherwise stated, and is accurate at the time of publishing.

Key points

• With the Fed having kicked off the rate-cutting cycle in September and a presidential election around the corner, which event will prove decisive for bond markets?
• History shows that political outcomes are hard to predict and bond markets focused rather on economic cycle over the long term. Regardless of the election outcome in the US and October’s budget in the UK, both economies face addressing record debt levels, a hot topic for the bond market.
• Is it still worth buying bonds after the recent retreat in yields? Over the last nine cutting cycles, the US 10-year yield trended roughly 10% lower on average compared to the level seen at the outset of each cutting cycle.
• This article takes a glimpse into the securitised debt market. Outside of US Treasuries, agency MBS are the second largest segment, with short of $10 trillion outstanding. Given the variety and complexity of the securitised debt market selection available, active solutions might be the most efficient way of capturing value in the bond segment which offers interesting dynamics for investors.

After the US Federal Reserve (Fed) kicked off the long-anticipated rate-cutting cycle in September, bond investors seem to be focusing on politics. In the US, November’s presidential elections are taking centre stage, while in the UK, bond investors are awaiting October’s forthcoming autumn budget with baited breath. 

But will these political events be a decisive factor for bond investors? Anticipating the US presidential election shows that trying to assess the impact of political outcomes on markets is tough, if not impossible. 

In the US, market commentary is focused on the possible extension of tax cuts, higher across-the board tariffs and immigration policy, in case of a Republican victory. In terms of a Democrat win, higher taxes and spending could potentially be more neutral to the deficit, growth and inflation consequently. 

But uncertainty over the outcome of the election, the actual implementation of legislation and the effect on the economy remains. In deciding when to start cutting rates, the Fed, for its part, had to focus on the economy rather than political outcomes in the past, and it's unlikely that this focus will change this time (see chart).

Fed policy rate path less impacted by election outcomes

Analysis of US rates in the 260 days before and 250 days after a presidential election highlights the influence the economy, not politics, had on policy moves 

Government debt overhang

Regardless of any outcome or announcement, the UK and US economies face record high debt levels. In the case of the former, the national debt hit 100% for the first time since 1961 recently and is running ahead the government watchdog’s, the Office of Budget Responsibility, expectation.  

Meanwhile, in the US the Congressional Budget Office expects the budget deficit and debt/gross domestic product ratio to rise to $2.8 trillion and 122% by 2034¹. For now, the rate market seems less concerned and seems to focus on the great cutting cycle ahead. In the US investors are pricing in well over two percentage-points worth of cuts over the course of the next 18 months; in the UK roughly 1.5%.

What’s in the price? 

Is it worth investing in bonds given the magnitude of cuts already priced in the market? History suggests that there is likely still some room for lower rates. Over the last nine cutting cycles, the US 10-year yield trended roughly 10% lower on average compared to the level seen at the outset of each cutting cycle (see chart). 

Moreover real bond yields, adjusted for inflation, are at close to the upper range to what they have been over the last 15 years, as shown in The balance is shifting; as such, at least from a buy-and-hold perspective, there is still plenty of juice left.  

US 10-year yield movements around cutting cycles 

The performance of the US 10-year yield before and after the start of a rate-cutting cycle 

A glimpse into the second largest bond market

Diversification of bond portfolios remains key, especially when volatility is heightened, as highlighted in Bond market road map: the path(s) ahead. One area that traditionally offers effective diversification, benefits, combined with preferential yields, is the securitised credit market. 

This segment of the market encompasses a wide range of bonds with different levels of risk and yields. It is divided into, auto loan/lease asset-backed securities (ABS), credit card ABS, student loan ABS and equipment lease ABS, commercial mortgage-backed securities (CMBS) and residential mortgage-backed securities (RMBS), with the latter representing the largest segment. 

Bond redemptions and coupons are usually secured by cash flows created by the respective underlying assets. This can enhance the credit profile compared to unsecured corporate debt, for example. Outside of US Treasuries, agency MBS are the second largest segment, with short of $10 trillion outstanding, and as such is one of the most liquid areas in the global bond market. 

Rate and economic dynamics opened opportunities 

Given the variety and complexity of the securitised debt market, selection and active solutions seem to be the most efficient way when capturing value in the bond segment. Current market dynamics, specifically within RMBS, seem favourable for several reasons:

Valuations

Spreads have underperformed over recent years, as the Fed, one of the largest buyers in the market, reduced its engagement in MBS bonds as part of its balance sheet reduction exercise (quantitative tightening). Commercial banks, on the other hand, have had to reduce exposure for regulatory reasons. This supply overhang has created relatively attractive spreads against corporate bonds, for example. 

Flows

A moderate cutting cycle, as expected, would change the demand picture again. This is because a significant part of large money-market holdings, which have been built up during the post-pandemic era, is likely to be attracted by this higher-quality segment. In addition, banks may park some liquidity again in the highly liquid MBS market, which is more balance-sheet friendly for financial institutions. 

Asset quality

The largest part of the securitised market is comprised of MBS. While part of the commercial real estate market has come under scrutiny in the wake of higher short-term rates, quality of residential mortgage bonds has increased substantially in recent years. 

First, because a regulatory overhaul over the past 15 years, as a response to the credit crisis in 2008, led to very high standards in the market. Second, leverage has declined substantially, as home equity values have increased notably. Third, the majority of homeowners were able to fix mortgages for a very long period during the low interest environment seen during the prior cycle.

Diversification

Institutional and private investors alike engage in the asset class due to the credit enhancement aspect, as well as the possibility to select from very low to medium duration profiles. Furthermore, agency MBS (with explicit and implicit government guarantee), for example, have a negative correlation to the S&P 500 and low correlations to high yield bonds.

The combination of income, low interest rate and credit risk, can therefore act as a beneficial complement in bond and diversified portfolios.

Yields and spreads

Yields in US securitised and corporate credit are similar today, while historic spread volatility is much lower by comparison