Who Are The Best Investment Managers for Alternative Fixed Income?

The Asset-Backed Securities (ABS) market contains many different types of securities backed by different assets. So to understand the outlook for asset-backed securities, investors need to look at examples of how these asset pools will perform in 2023. The latest research from ABS investment managers inside RFPnetworks suggests that the outlook for Asset-Backed Securities in 2023 will be mixed. Some ABS segments may do well. Whereas some ABS segments may face headwinds.

Examples of Asset-Backed Securities with a positive outlook

In general ABS investment managers seem comfortable taking short duration consumer related ABS exposure. Despite immediate recessionary pressures, labour markets remain tight, wage inflation is the norm, and the consumer finances are in much better shape than the pre-GFC period. This is leading to strong demand for pools of assets that are exposed to both student loans and car loans.

Examples of Asset-Backed Securities where the outlook is mixed

Commercial Mortgage Backed Securities (CMBS) are at the longer end of the ABS duration timeline. Investing in these specific asset-backed securities requires expertise and selectivity. The circle of covid, working and shopping from home has 'irreversibly' impacted the demand for office and retail real estate. This makes the risks and returns on these pools of long duration assets less predictable. There are exceptions which can accessed via Single-Asset Single-Borrower deals (SASB), which is why highly active managers are getting all the calls from investors today.

What is clear is that investors will continue to be interested in asset-backed Securities in 2023. But not just for yield and the strong covenants that bind deal originators. The outlook is also being driven by many other factors that solve issues within Fixed Income portfolios that bonds are unable to solve.

It has not gone unnoticed by the some of smartest sales people we talk to, that both the buyers of businesses (Private Equity firms) and Buildings (Real Estate Investors) are now buying loans and CMBS respectively. The thinking goes like this:

Own the company and it's assets. Or own the senior secured financing of that company for a more certain double digit return, with low leverage, that is in line with fund targets.

For CMBS the story is similar, but potentially even more compelling. With interest rates still rising and property valuations falling in many major cities, yields on the mortgages behind these buildings are higher today. A phenomena that may remain for as long as rent and property valuations face continued downward pressures.

CLO Equity is often is often perceived as a bull market product. When the world is awash with liquidity, the ability of corporates to refinance their loans is easier and the subsequent cashflows can cascade down the waterfall to the CLO equity holders. But if your base case is a recession - tighter credit markets - why would you invest in CLO equity?

There are many reasons to consider CLO Equity ahead of a recession. In fact, those that did before the global financial crisis and the COVID pandemic earned approximately 400 basis points excess return above the long term average across CLO Equity vintages going back to 2002.

The trick is to find active CLO managers that can re-invest cashflows into higher yielding loans as prices fall, with strong covenants and limited default risk. Sounds simple, but it is not. It's about finding right active CLO manager, especially ahead of a recession. Investment Manager selectors that do the research, will work out who these managers are. And that is what they are doing inside RFPnetworks.

One of the attractions of Real Estate and Infrastructure Debt is the illiquidity premium that can be earned. But how does that basis point boost perform in a down turn?

Whilst private debt has gained popularity with institutional investors as an alternative to bonds in a rising rate environment, many are new to the asset class. With traditional bond markets struggling year to date, investors are now researching the ability of illiquid assets to outperform in a recession. And critically, which specific market segments will maximise the premium differential as and when public markets rebound.

How do Senior AAA European ABS impact the liquidity, safety, and yield of a cash portfolio over a 6-12 month horizon?

Read the latest analysis from ABS investment managers inside RFPnetworks.

At the end of May, US Retail investors came back to the US leveraged loan market following three previous weeks of net outflows. And whilst this is not necessarily a buy signal to other investors, it marked the climb to a spike last week in Loan research activity in our feeds, by European Institutional Investors. But their interest was not US leveraged loans. It was European leveraged loans.

Read the latest market views on both U.S. and European loans inside RFPnetworks.

At the end of May, US Retail investors came back to the US leveraged loan market following three previous weeks of net outflows. And whilst this is not necessarily a buy signal to other investors, it marked the climb to a spike last week in Loan research activity in our feeds, by European Institutional Investors. But their interest was not US leveraged loans. It was European leveraged loans.

The long-term risk-adjusted relative performance of European Loans versus U.S. loans, U.S. and European high yield bonds, has got institutions interested.

This is interesting, because often in Europe, the first logical step into the asset class is via U.S. loans. Especially given the size of the U.S. market, the larger number of investment managers in this space, and the wider variety of products to choose from. It could be a sign that European investors are looking to diversify their U.S. loan exposure. Or take their first step into the asset class, closer to home.

It could also be driven by a view on future U.S. Loan, U.S. High Yield and European High Yield default rate risk and recovery rates. The numbers seem to stack in favour of European Loans.

And what may be making life easier for some European institutional investors, is that ESG factors are now integrated into European lenders and borrowers.

What is abundantly clear, is that last week our fixed income feed saw more traffic than any of the 9 asset class feeds in our research platform. This is usually a strong signal that portfolios are about to change.

Given the widening in corporate credit-risk spreads since February, consumer-focused ABS is gaining the interest of professional investors.

Given a backdrop of strong labour markets, nominal wages, and solid household balance sheets, there is clearly support for consumer-related segments of the ABS market, such as auto loans.

The unknown risks are how inflation and rising rates will impact future absolute levels of delinquency.

Whilst Loan Issuance for 1Q22 in both the US & Europe was strong, levels were less than 1Q21. But those stats don't tell the whole story.

In Mar 2022 in Europe, there was zero syndicated loan issuance.

The question now is where will loan investors turn?

Read the latest analysis from senior secured loan and CLO investment managers inside RFPnetworks.

Following a fall of 5% in 1Q22, Agency Mortgage Backed Securities posted a quarterly performance that was worse than the taper tantrum of 2013, and more that twice as bad the next worst quarters in 1987 and 1994.

Interestingly, Agency MBS spreads have trended higher higher as the risk of mortgage prepayment has actually trended lower.

Professional Investors are therefore asking whether agency MBS can earn them yields that are relatively attractive for the asset class on a historical basis, but also compared to alternatives within the high quality fixed income space.

Alternative Credit is taking centre stage in professional investors fixed income portfolios.

Given the headwinds faced by traditional bond portfolios in a rising rate and inflationary environment. Plus the breakdown in equity-bond correlations that supported their role as a diversifier in the classic 60-40 portfolio, the future of fixed income portfolios is changing.

But what types of alternative credit are getting the most interest from professional investors? The opportunities are wide and varied, as are the risks.

Classic loans and CLO's have already received a lot of attention. With their floating rate nature, these instruments can protect fixed income investors as both interest rates and inflation rises. However, the question today is whether the credit fundamentals behind the issuers are strong enough to survive the expected steep path of rate rises ahead? Clearly, manager selection is key in this space. As are the sectors to which the portfolio is exposed.

Turning to MBS, all eyes are on the FED's Quantitative Tightening (QT). With both the FOMC meetings in March and May confirming the unprecedented move to sell MBS. The Fed currently has $2.7tn MBS on its balance sheet. Some active managers believe this dynamic can create profitable relative value opportunities, specifically in the agency MBS space. Other investors are still focussed on opportunities in the Dutch or Danish Mortgage market.

But whilst shortening duration and moving up in credit quality ratings seems to be the common focus, meaningful attention is turning to the debt financing of climate transition-oriented and energy security industries. Examples are biofuels, batteries and hydrogen. As well as digital infrastructure projects that facilitate a countries upgrade to fibre-optic broadband.

These were just a few of the alternative credit opportunities gaining traction in our fixed income feed.

Since 2000, there have only been 14 negative quarterly returns for the CLO and Loans asset class. The impact of the Russia-Ukraine crisis on the loan markets, has resulted in 1Q22 being one of those quarters.

However, the negative quarter was one of the smallest compared to what happened during the Global Financial Crisis of 2007/8, the European Sovereign Debt Crisis of 2011, or the China Trade War of 2018.

The question now on investors minds, is what can they expect from loans and CLOs for the remainder of 2022.

With markets expecting increasing central bank hawkishness, should Fixed Income investors turn to Bank Loans?

Read the latest views from the investment manager loan and CLO community inside RFPnetworks.