Key points
- Weak risk appetite, interest rate volatility, and supply headwinds led to another challenging quarter for securitised credit investors.
- Improved valuations and generally strong fundamentals are balanced with an increasingly uncertain timeline for spread recovery.
- If inflation pressures abate and the Fed turns less hawkish, areas hard hit by interest rate volatility and duration extension concerns should be prime beneficiaries.
Following a dismal first quarter, conditions for securitised credit markets remained challenging over the past quarter as investors continued to face rising Treasury yields and widening credit spreads.1 Yields rose across the Treasury curve as the market reacted to hawkish policy responses from the Federal Reserve in the face of stubborn inflation. With financial conditions tightening, credit spreads broadly widened amid mounting concerns that the Fed's efforts to tame inflation will tip the economy into recession. Lower‑rated securitised tranches suffered larger price declines than higher‑quality tranches in light of macroeconomic worries. And segments with longer spread durations2 struggled as unrelenting inflation led to monetary policy uncertainty, fuelling interest rate volatility, which incited credit spread volatility.
A Difficult Quarter Across the Opportunity Set
As seen in the previous quarter, securitised credit sectors produced negative total returns and underperformed similar‑duration Treasuries, although "safe haven" U.S. government bonds also recorded losses. After gaining traction in late March, credit spreads resumed widening in April and widened further in May before stabilising in June. Securitised markets generally lagged both sell‑offs and relief rallies in the investment‑grade corporate credit market, due in part to their smaller investor base and thinner liquidity. Asset‑backed securities (ABS) were among the best‑performing major fixed income sectors, with total returns of ‑0.91%, trailing duration‑matched Treasuries by just 0.11%.3 Esoteric areas of the ABS market tended to experience greater spread widening than the credit card and automotive‑related debt that dominate the benchmark.
With their longer duration profile, non‑agency commercial mortgage‑backed securities (CMBS) lost 3.19% in absolute terms, equating to excess returns of ‑1.08% versus comparable Treasuries.4 Lower‑rated conduit tranches and single‑asset/ single‑borrower (SASB) securities, which are not part of the benchmark, underperformed amid challenging liquidity and weak risk appetite. With the significant rise in interest rates, the market priced in the likelihood that maturity dates for many CMBS will be fully extended, delaying principal payments to investors.
The diverse non‑agency residential mortgage‑backed securities (RMBS) market broadly generated negative results for the period, hurt by interest rate volatility, constrained liquidity, and lengthening durations as mortgage rates ascended to their highest level since the global financial crisis. Higher‑quality credit‑risk‑transfer securities (CRTs) issued by the government‑sponsored housing enterprises (GSEs) lost ground but fared better than CRTs sitting lower in the capital structure. Nonqualified mortgage (non‑QM) bonds—particularly the lower‑rated variety—struggled amid rampant supply and concerns about duration extension and the health of the U.S. economy. Spreads for prime RMBS assets widened to a lesser degree than other mortgage credit sectors due to minimal credit concerns, but prime mortgage bonds still grappled with interest rate volatility and extension risk given their longer duration profiles.
1 Credit spreads measure the additional yield that investors demand for holding a bond with credit risk over a similar‑maturity, high‑quality government security.
2Duration measures the sensitivity of a bond's price to changes in interest rates. Spread duration measures the sensitivity of a bond's price to changes in its credit spread over U.S. government bonds with a similar maturity.
3As measured by the Bloomberg ABS Index.
4 As measured by the Bloomberg Non‑Agency Investment Grade CMBS Index.
This post was funded by T. Rowe Price
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