Investors flock to floating-rate assets during periods of rising interest rates for two primary reasons: they stand to benefit from increasing coupon payments as policy rates rise, and the assets’ minimal duration risk provides insulation during periods of volatility in long-duration assets. Judging by the $53 billion of inflows since the start of 2021, investors are often steered towards leveraged loans when it comes to floating-rate assets. Yet, for those seeking other approaches, high-quality securitized products provide the benefit of floating-rate assets as well as the opportunity to select high-quality, loss-remote assets amid moderating global growth.
The persistent uncertainty from splintered global growth, central banks’ varied phases of fighting inflation, and the unpredictability of war reinforces the importance of sector rotation and security selection. High-quality securitized products provide ample scope for these key elements of relative-value investing as they span economic sectors—ranging from industrial warehouse facilities to rental car fleets—and offer varying degrees of credit risk throughout the capital structure. The securities also appear poised to provide additional income as the Fed ramps up its tightening cycle.
Many of the securities within the space feature coupons based on the secured overnight financing rate (SOFR), which will rise alongside increases in the Fed funds rate.1 For example, the overnight and three-month term SOFR rates started the year at 5 bps and 9 bps, respectively. They subsequently climbed to 78 bps and 1.2% after the Fed’s 75 bps of cumulative rate hikes thus far in 2022. Looking forward, the market is pricing in a Fed funds rate of about 2.8% by the end of the year and 3.3% by May 2023.
In addition to likely increases in the base rate, high-quality securitized credit spreads trade notably wider than similarly rated, fixed-rate assets (Figure 1). For example, AAA-rated collateralized loan obligations (CLOs) recently traded wide of the benchmark U.S. IG corporate index, which averages an A rating. Thus, AAA CLOs offer a base rate that could more than triple by the end of 2023 as well as sizable pickups in credit spreads vs. other credit sectors, but with less credit risk.
Figure 1
The Universe of Securitized Assets vs. Comparably Rated Fixed-Rate Assets
Bloomberg Barclays, JPMorgan, Bloomberg, PGIM Fixed Income. Past performance is not a guarantee or a reliable indicator of future results. Please see the Reference section for important disclosures. Performance over one-year is annualized.
Investors seeking high-quality, floating-rate assets may look to other reference points, such as floating-rate notes issued by money center banks. In mid-April, Bank of America and J.P. Morgan issued $500 million in three-year and four-year A rated floating-rate notes that priced at overnight SOFR plus 110 bps and 132 bps, respectively. Another look at Figure 1 indicates a range of AA, and AAA rated securitized assets that are trading well wide of the levels on recently issued bank floaters.
A Rough Stretch for Duration
Many fixed income investors remain highly attuned to duration risk at this point in the cycle, and an allocation to floating-rate, high-quality securitized assets also provide a streamlined approach—without the need for undue hedging costs—to manage it with no duration or a very short duration of about 0.3 of a year, for example.
The recent volatility in market-determined rates indicates the variation in performance by duration. One of the longer-duration assets—U.S. Treasury Strips 25+ years (with a nearly identical duration)—posted a year-to-date total return of -28.6% as of mid-May.2 Meanwhile, a U.S. ABS Floating Rate Index with AAA average ratings and a duration of 0.1 year posted a total return of -0.3% through the same timeframe.3
Credit Concerns Coming to the Fore
Concerns about credit risk are increasingly mounting as the Fed tightens policy into moderating U.S. economic growth, which we see easing from 5.7% in 2021 to 2.9% in 2022 and 2.4% in 2023. Therefore, we continue emphasize high-quality securitized products given that they are generally loss remote. For example, Figure 2 provides a stylized example of how credit downturns would have affected the various CLO tranches. While this example does not capture the structural nuances of deals and the positive impact from debt covenants for CLO tranche investors, it highlights the robustness of senior tranches as they do not need to rely on excess spread. In this exercise, AAA tranches are unscathed, even in scenarios where loans only recover 35% upon default, whereas they’ve historically averaged 65%.
Figure 2
The Historical Loss Remoteness of Senior CLOs
Moody’s Investors Service and PGIM Fixed Income. This simplified analysis does not fully incorporate CLO features that, in stress, divert cashflow to the senior most tranches at the expense of the mezzanine tranches. It also ignores credit migration and active management of the collateral.
High-quality securitized products are also downgrade remote, particularly in comparison to longer-dated high-quality corporate bonds, which often encounter the challenges of meeting the interests of equity holders, such as launching debt-financed stock buybacks or dividends. Indeed, Figure 3 shows that AAA-rated corporates experienced a 10-year downgrade rate of nearly 33% relative to the 1.87% rate for AAA CLOs and 4.19% for Super Senior AAA CMBS.
Leveraged loans and collateralized loan obligations (CLOs) remain a focal point for investors amid concerns about duration exposure and rising central bank policy rates. Given this interest, this paper revisits the compelling case for global senior CLOs, which includes: strong structural protections, historically low defaults and credit migration risk as well as higher-than-average spreads when compared to sectors with similar credit quality.
Figure 3
10-year Rating Migration Comparison Amongst U.S. CLOs, CMBS, and Corporates4
See footnote #4 for sources and methodology.
Conclusion
This year’s fixed income performance reflects an apprehension that investors’ bond income may fall short of inflation, while duration and credit risk could lead to capital losses. Yet, as disconcerting as conditions may be, an allocation to floating-rate, high-quality securitized assets could provide an approach that addresses some of investors’ foremost concerns.
1 The SOFR rate is a broad measure of the cost of borrowing cash overnight, which is collateralized by Treasury securities.
2 Based on the respective component of the Bloomberg Barclays U.S. Strips Index.
3 Based on the Bloomberg Barclays ABS Floating Rate Index.
4 U.S. CLO Rating transition matrix. 10-Years Long Average Rating Migration Rates: January 1, 1993-December 31, 2020. Moody's "Structured Finance - Global: Structured Finance Rating Transitions: 1993 – 2020. U.S. CMBS Rating transition matrix.10-Years Long Average Rating Migration Rates: January 1, 1993-December 31, 2020. Moody's "Ratings Symbols and Definitions," February 2019, Impairment includes all events that meet definition of default. U.S. Corp rating migration. 10-Years Long Average Rating Migration Rates: January 1, 1993-December 31, 2020. Moody's Default and Rating Analytics, Historical Rating Transitions, withdrawals excluded. Source of ratings: Fitch as of December 2020.
Note: The Global CLO Rating Transition and Corporate Rating Migration tables were not derived from the same source. The underlying methodologies are not be identical due to the use of original versus cohort ratings although we believe the information is comparable. Aaa SSNR is defined as conduit securities with 30% CE and original AAA. Sources: PGIM Fixed Income, Intex, and Bloomberg.
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