Key Investment Themes
- Maintain neutral duration bias and favor curve steepening
- Favor select US and European financials trading cheap to the market
- Build better convexity through mortgages
- Stay long residential mortgage credit
- Reduce CMBS, focus on higher quality deals
Duration— Staying Close to Home
We believe we are moving past the peak in policy rates and that a gradual easing cycle will soon unfold. We expect the yield curve to steepen modestly with a positive slope emerging over the balance of the year.
A Steeper Curve May Favor Banks
The regional banking sector continues to trade wide relative to the rest of the corporate market, and more recently European bank spreads widened on election-related volatility. We believe these trends will reverse. Last year’s banking troubles have not been broadly systemic. As the commercial property market cycle plays out and the yield curve normalizes, banks will work with borrowers to restructure troubled commercial real estate loans. The performance of individual banks will ultimately depend on their size, loan mix and profitability.
Figure 1: Ratio of Financial to Industrial OAS
Data as of June 30, 2024
Option-adjusted spread
Dashed line = Median (monthly data from July 2014 to June 2024)
Source: ICE Data
Adding Convexity Moving Down the Coupon Stack
In the Agency mortgage market, higher coupon securities are trading with wider spreads, lower durations and higher yields than lower rated investment grade corporates. However, as interest rates fall, lower coupons are likely to outperform due to their lower prepayment speeds while offering good liquidity.
Figure 2: Agency MBS Offer a Significant Yield Advantage Over Corporates Without The Rich Valuations
Source: Bloomberg. Data as of June 28, 2024
Don’t Transfer That Credit Risk Just Yet
The Credit Risk Transfer (CRT) market, which was created by the agencies as a way to reduce their credit exposure to borrowers, continues to benefit from limited supply and early payoffs by the Agencies. We believe spreads will continue to grind tighter, particularly on subordinate deals with elevated home price appreciation (HPA).
Additionally, banks are selling credit-linked notes in an effort to reduce risk-weighted assets and qualify for better treatment under new bank capital rules. Many of these notes are tied to prime auto loans that offer attractive spreads. We expect this new market to continue to grow.
Figure 3: CRT B1 to HY BB
Source: ICE Data. Data as of June 28, 2024
CMBS: A Good Diversifier with Resilience
Historically, conduit triple-A spreads have traded tighter than single A-rated corporate credit, reflecting their high credit quality and robust underwriting standards. Recently however we've seen a significant widening, offering a unique opportunity to capture enhanced yields with minimal incremental risk. Given the solid levels of credit support and improved underwriting standards in CMBS, these securities are better positioned to weather market volatility. The senior triple-A tranches in particular are expected to remain resilient, making them a strong diversifier in uncertain times.
Figure 4: Despite the Recent Rally, CMBS Spreads Can Offer Value For Selective Investors
Source: Bloomberg. Data as of June 28, 2024
1. Source: Federal Reserve Chair Jerome Powell remarks to the Committee on Financial Services, U.S. House of Representatives, on July 10, 2024
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Past performance is not indicative of future results.
RISKS OF INVESTING IN ASSET AND MORTGAGE-BACKED SECURITIES
One of the principal risks of mortgage-related and asset-backed securities is that the underlying debt may be prepaid ahead of schedule if interest rates fall, thereby reducing the value of an investment. If interest rates rise, there is less prepayment risk but defaults may increase, potentially causing losses. This is not a complete list of risks associated with the strategy. Consult your professional advisors for further guidance.
COMPARISONS TO AN INDEX
Comparisons to a financial index are provided for illustrative purposes only. Comparisons to an index are subject to limitations because portfolio holdings, volatility and other portfolio characteristics may differ materially from the index. Unlike an index, individual portfolios are actively managed and may also include derivatives. There is no guarantee that any of the securities in an index are contained in any managed portfolio. The performance of an index may assume reinvestment of dividends and income, or follow other index-specific methodologies and criteria, but does not reflect the impact of fees, applicable taxes or trading costs which, unlike an index, may reduce the returns of a managed portfolio. Investors cannot invest in an index. Because of these differences, the performance of an index should not be relied upon as an accurate measure of comparison.
SOURCE INFORMATION
ICE DATA INDICES, LLC (“ICE DATA”), IS USED WITH PERMISSION. ICE® IS A REGISTERED TRADEMARK OF ICE DATA OR ITS AFFILIATES, AND BOFA® IS A REGISTERED TRADEMARK OF BANK OF AMERICA CORPORATION LICENSED BY BANK OF AMERICA CORPORATION AND ITS AFFILIATES ("BOFA") AND MAY NOT BE USED WITHOUT BOFA'S PRIOR WRITTEN APPROVAL. ICE DATA, ITS AFFILIATES AND THEIR RESPECTIVE THIRD PARTY SUPPLIERS DISCLAIM ANY AND ALL WARRANTIES AND REPRESENTATIONS, EXPRESS AND/OR IMPLIED, INCLUDING ANY WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE, INCLUDING THE INDICES, INDEX DATA AND ANY DATA INCLUDED IN, RELATED TO, OR DERIVED THEREFROM. NEITHER ICE DATA, ITS AFFILIATES NOR THEIR RESPECTIVE THIRD PARTY SUPPLIERS SHALL BE SUBJECT TO ANY DAMAGES OR LIABILITY WITH RESPECT TO THE ADEQUACY, ACCURACY, TIMELINESS OR COMPLETENESS OF THE INDICES OR THE INDEX DATA OR ANY COMPONENT THEREOF, AND THE INDICES AND INDEX DATA AND ALL COMPONENTS THEREOF ARE PROVIDED ON AN “AS IS” BASIS AND YOUR USE IS AT YOUR OWN RISK. ICE DATA, ITS AFFILIATES AND THEIR RESPECTIVE THIRD PARTY SUPPLIERS DO NOT SPONSOR, ENDORSE, OR RECOMMEND MACKAY SHIELDS LLC, OR ANY OF ITS PRODUCTS OR SERVICES.
“Bloomberg®”, “Bloomberg Indices®”, Bloomberg Fixed Income Indices, Bloomberg Equity Indices and all other Bloomberg indices referenced herein are service marks of Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited (“BISL”), the administrator of the indices (collectively, “Bloomberg”) and have been licensed for use for certain purposes by MacKay Shields LLC (“MacKay Shields”). Bloomberg is not affiliated with MacKay Shields, and Bloomberg does not approve, endorse, review, or recommend MacKay Shields or any products, funds or services described herein. Bloomberg does not guarantee the timeliness, accurateness, or completeness of any data or information relating to MacKay Shields or any products, funds or services described herein.
The following indices may be referred to in this document:
BLOOMBERG U.S. AGGREGATE BOND INDEX
The Bloomberg U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. Must have at least one year to final maturity regardless of call features. Must have at least $300 million par amount outstanding. Must be rated investment-grade (Baa3/BBB- or higher) by at least two of the following ratings agencies: Moody's, S&P, Fitch. Must be dollar-denominated and non-convertible.
ICE BOFA U.S. CORPORATE INDEX
Tracks the performance of U.S. dollar denominated investment grade corporate debt publicly issued in the U.S. domestic market.
ICE BOFA U.S. HIGH YIELD INDEX
ICE BofA U.S. High Yield Index tracks the performance of US dollar denominated below investment grade corporate debt publicly issued in the US domestic market..
ICE BOFA US MORTGAGE BACKED SECURITIES INDEX
ICE BofA US Mortgage Backed Securities Index tracks the performance of US dollar denominated fixed rate residential mortgage pass-through securities publicly issued by US agencies Fannie Mae, Freddie Mac and Ginnie Mae in the US domestic market. 30-year, 20-year and 15- year fixed rate mortgage pools are included in the Index provided they have at least one year remaining term to final maturity and a minimum amount outstanding of at least $5 billion per generic coupon and $250 million per production year within each generic coupon.
BOFA US FIXED RATE CMBS INDEX
BofA US Fixed Rate CMBS Index tracks the performance of US dollar denominated investment grade fixed rate commercial mortgage backed securities publicly issued in the US domestic market.
ICE BOFA AA-BBB US ASSET BACKED SECURITIES INDEX
Represents the portion of the ICE BofA US Fixed Rate Asset Backed Securities Index composed solely of bonds that are rated AA-BBB.
ICE BOFA HIGH YIELD EMERGING MARKETS CORPORATE PLUS INDEX
ICE BofA High Yield Emerging Markets Corporate Plus Index is a subset of The ICE BofA Emerging Markets Corporate Plus Index including all securities rated BB1 or lower. ICE Bank of America High Yield Master II Index tracks the performance of US dollar denominated below investment grade rated corporate debt publically issued in the US domestic market. To qualify for inclusion in the index, securities must have a below investment grade rating (based on an average of Moody's, S&P, and Fitch) and an investment grade rated country of risk (based on an average of Moody's, S&P, and Fitch foreign currency long term sovereign debt ratings). Each security must have greater than 1 year of remaining maturity, a fixed coupon schedule, and a minimum amount outstanding of $100 million.
ICE BOFA EMERGING MARKETS EXTERNAL SOVEREIGN INDEX
ICE BofA Emerging Markets External Sovereign Index tracks the performance of US dollar and euro denominated emerging markets sovereign debt publicly issued in the major domestic and eurobond markets.
DEFINITIONS
Duration: Duration can measure how long it takes, in years, for an investor to be repaid a bond’s price by the bond’s total cash flows.
Optional Adjusted Spread: The measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is then adjusted to take into account an embedded option.
Spreads: The difference of gap that exists between two prices, rates, or yields.
Yield Curve: A line that plots yields of bonds having equal credit quality but different maturity dates.
NOTE TO UK AND EUROPEAN AUDIENCE
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