Securitized Views-Q1 2021 - Franklin Templeton ...
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January 2021
Franklin Templeton Fixed Income
Securitized Views—Q1 2021
Agency Mortgage-Backed Securities (MBS) in his position under President-elect Joe Biden’s administration,
The housing market has rebounded since April, and the supply of he could continue administrative reforms of higher capital
mortgages is expected to increase in coming months. Prepayment requirements (recap and release) until the end of his term in 2024.
risk in the MBS market remains elevated as US mortgage rates This would be a negative for the agency MBS market, as the
have reached record-low levels 16 times this year, including the cost of securitization through the GSEs would increase to facilitate
month of November. As the economy normalizes, we expect the higher capital requirements.
prepayments to rise, with 80% of the agency MBS universe
The Fed has actively participated in the Agency MBS market this
having an incentive to refinance at current rates. Primary and
year, purchasing $1.3 trillion worth of securities through the end of
secondary market spreads remain elevated, and while
November. The Fed is expected to continue its active role in the
prepayments are their highest levels since 2012, refinance activity
MBS markets, absorbing a large share of the market supply,
should be much higher. If these spreads were to normalize to
which should keep spreads well supported and rangebound. The
historical averages, 90% of the mortgage universe would have an
Fed currently owns 29% of the Agency MBS market. Balance-
incentive to refinance their loans. However, forbearance requests
sheet scrutiny of Agency MBS holdings could begin, as it did in
have started to taper, which could lead to lower involuntary
the first round of quantitative easing (QE1), as the ownership
prepayments in the coming months. To mitigate prepayment risk
approaches 33% of the market. We could see spread widening if
over the intermediate term, we prefer to be positioned down in
the Fed were to alter its Agency MBS purchases. However, we
coupon in 2.0% and 2.5% coupons. Technical support from
believe the Fed would be more measured in its program changes,
Federal Reserve (Fed) MBS purchases will continue to bolster the
with more transparent communication, compared to what was
MBS sector, potentially limiting spread widening and keeping
experienced during the so-called “taper tantrum” of 2013.
spreads rangebound which will benefit lower coupons and
associated mortgage dollar rolls.
Non-Agency Residential Mortgage-Backed
Elevated prepayment risk, combined with yield spreads near their Securities (RMBS)
10-year averages, led us to retain our neutral recommendation on
US housing has been resilient despite facing the biggest downturn
agency MBS. While we remain neutral, we believe there is room
since the global financial crisis (GFC). Limited home supply
to add MBS on market dips and the asset class continues to
coupled with strong demand and historically low mortgage rates
provide good carry and could benefit from corporate credit
should keep home prices supported over the short to medium
crossover buying. Within MBS, we prefer 30-year securities over
term. Year to date through August 2020, home price appreciation
15-year securities and generally favor conventional 30-year and
stood at 3.82%, and our model forecasts 2.7% home price
conventional 15-year securities prepayment characteristics over
appreciation (HPA) through Aug 2021. Supply and demand forces
Ginnie Mae (GNMA) 30-year securities.
continue to be supportive for housing. Despite headwinds in the
In other news that could potentially affect the agency MBS market, we still expect non-agency RMBS to provide strong risk-
market, the constitutionality of the Federal Housing Finance adjusted returns and we are upgrading our 12-month outlook to
Agency (FHFA) director position is currently being challenged in neutral with reasons for optimism.
the Supreme Court. The current head of the FHFA, Mark
While new delinquencies are tapering, roll rates to late-stage
Calabria, could be asked to leave or be forced out, which would
delinquencies remain elevated. This was expected as borrowers
be positive for the agency MBS market, as it is likely that
are likely to take up forbearance plans when facing hardship or
government-sponsored enterprises (GSEs) continue to remain
job losses. Forbearance has given borrowers the time neededto get back on their feet while keeping foreclosed homes from homeowners, stay current or provide the potential for down-
flooding the property market. Currently, about 2.8 million payment savings. Higher individual tax rates could impact housing
borrowers are under some forbearance plan. If we consider all affordability, but additional stimulus may create a meaningful
these property owners eventually default and the properties make offset. Any delay in government-sponsored enterprises’ (GSEs)
their way into the market for sale, the inventory levels would be far reforms could postpone anticipated disruptions in the housing
lower from the levels we saw in the GFC (when home prices market due to privatization of the GSEs. Reducing the racial
dropped 30%). Based on current delinquency pipelines, housing gap, along with a push for affordable housing programs,
prepayment speeds and credit enhancement, we do not expect may increase first-time home borrowers. Additionally, the potential
any losses in fixed severity last cashflow tranches without the repeal of state and local tax cap could be a substantial tailwind for
natural disaster language. However, overall deal losses are higher-priced homes in high-property tax areas.
expected on some transactions.
Driven by low mortgage rates and high home price appreciation,
Commercial Mortgage-Backed Securities (CMBS)
prepayments have been elevated for most non-agency RMBS The fundamental credit backdrop in the Commercial Real Estate
products. This has allowed credit enhancement levels to increase (CRE) sector continues to be challenged. CRE Transaction
and structures to deleverage, thereby alleviating some credit volumes, a leading indicator for property valuations, are, on
concerns. New and existing home inventory combined, at 1.756 average, down by 65% YoY as of September and it is evident that
million units, are near their historically lowest levels. The there continues to be a widening bid/ask in the commercial real-
September existing home sales at 6.54 million units (annualized) estate market. Significant headwinds exist in the short to medium
is the highest level since June 2006. Pending home sales term for CRE. A resurgent second wave followed by stricter
were up 22% in September, indicating the seasonal fall lull for implementation of lockdowns and near non-existent direct support
housing may not occur this year. to CRE sponsors makes matters worse for the sector. CMBS
conduit delinquencies (30+ days) continued to be elevated at
Overall spreads in various RMBS sectors have recovered 85%- 7.9% as of September and, as expected, hotel and retail
100% since March wides, but early fixed-severity deals which do delinquencies continue to be significantly higher than other
not contain natural disaster language have recovered only 66% property types such as office, multifamily and industrial. AAA last
from their wides in mid-May. A second COVID-19 wave-led cashflow (LCF) spreads have continued to tighten and are
downturn could cause a resurgence of volatility and RMBS spread currently at the tighter end of historical levels. We believe
widening and market value fluctuations. The risk of natural downside risks outweigh upside potential at these levels. We
disasters such as hurricanes and earthquakes continue to remain continue to maintain a bearish outlook on CMBS, and we remain
a tail risk for CRTs and may negatively impact valuations if they positioned up in the capital structure in CMBS transactions with
were to occur. We expect 2016 credit risk transfer (CRT) cohorts solid credit fundamentals.
to provide the highest risk-adjusted returns. Fixed Severity CRT
transactions could benefit from risk-on across markets and Low issuance coupled with the street pushing cleaner deals has
migrate closer to par. We have confidence in CRTs, but do not helped maintain tighter spreads in New Issue LCF AAA’s. Looking
anticipate increasing our exposure. forward, we do not foresee issuance picking up meaningfully in
the near-term and we believe the CRE market is still in a flux on
Non-agency RMBS supply is approximately 17% lower than the pricing. Given current valuations, we would not add below-AAA
same period last year. In CRT, supply will be constrained given CMBS exposure and in AAA LCFs, we prefer deals with lower
that Fannie Mae has paused new CRT issuance after the Federal exposure to hotel and retail sectors. The silver lining for CRE
Housing Finance Agency’s (FHFA’s) proposed capital rule for remains the industrial sector which has continued to demand
GSEs in May, but Freddie Mac has issued four CRT transactions higher rental rates and is witnessing low vacancy levels, but we
since July, which were generally well-received by investors. The believe the valuations in this sector are pricing in all the optimism.
combination of the FHFA-proposed GSE capital rule and the lack
of regular CRT issuance, may lead some investors to re-evaluate From a sub-sector perspective, we believe retail and hotel sectors
the sector for liquidity issues. are currently in the recession phase in the commercial real estate
cycle, which is typically characterized by negative and below
The outcome of the US elections should not have a material inflation rent growth, increasing vacancies and increased
impact on housing dynamics, but greater fiscal stimulus is likely, completions. Multifamily and office sectors are in the hyper-supply
which is positive for mortgage and other credit products. Fiscal phase, which generally witnesses increased vacancies, new
stimulus has provided relief and helped borrowers remain current construction, and a slowing, but positive rent growth. Industrial is
on mortgage and rental payments, and any further stimulus strongly placed in the expansion phase which is characterized by
should help keep homeowners, particularly low-income declining vacancies, new construction, and high rent growth.
Securitized Views—Q1 2021 2The impact from a Biden Administration on the sector will likely In recent months, a large increase in payment deferrals has
include greater scrutiny of CRE taxation, as President-elect Biden resulted in a dramatic decline in delinquencies and charge-offs in
has proposed a plan to invest $775B for a “caring economy” over both the prime and subprime auto loan ABS markets. As
10 years, which would be funded by ending tax breaks for real borrowers exit these programs, however, we expect a portion will
estate investors and ensuring high-income earners pay their be unable to resume making payments. This will likely pressure
taxes. Additionally, under a Biden Administration, renewed credit metrics. We expect overall credit performance for credit
contagion of COVID-19 will likely be met with a stricter card ABS to deteriorate in 2021 due to slower receivable
enforcement of lockdowns which would be a further drag to growth and, similar to other consumer debt sectors, elevated
sectors like hotel and retail. unemployment, the end of payment relief programs, and the
likelihood of a smaller stimulus package. Even so, we do not
From a stimulus standpoint, the Non-Agency CMBS sector has
expect charge-offs to reach levels comparable to the last
not received any meaningful support from the Fed. The Paycheck
recession. We remain neutral on prime consumer ABS, as
Protection Program (PPP) and the Main Street Lending Program
spreads offer little incremental yield pickup versus cash
(MSLP) did not provide direct aid to CRE owners/sponsors.
alternatives and expectations for fundamental pressures on
Inclusion of Conduit LCF AAAs for the Term Asset-Backed
trusts will remain. Given the relative flatness of the credit curve,
Securities Loan Facility (TALF) program and liquidity support from
we prefer to be up in the capital structure at the AAA level
Primary Dealer Credit Facility (PDCF) did little to stimulate the
in both prime auto and credit cards, and we are avoiding non-
CMBS market (of note is that New Issue Conduit LCFs are not
benchmark ABS, despite the incremental yield pickup in the lower
eligible for the TALF program unlike in CLOs and ABS). Due to
quality, albeit thinner, tranches. Additionally, we would avoid
the TALF program, however, AAA LCFs have a backstop in
subsectors such as aircraft and container ABS that face an
spreads. At current spread levels, we do not think they look
uncertain outlook as well as floating-rate bonds without explicit
appealing for TALF but may garner interest if spreads widen out
LIBOR fallback language.
by 20-30 bps. We believe approximately 85% of the market has
no direct Fed support and this has resulted in high delinquencies The impact from the outcomes of the US election should have a
in sectors like hotel and retail. Conversely, Agency CMBS minimal impact on the ABS market. A divided government limits
purchases by the Fed helped the sector by tightening the spreads possible legislative action and even if Democrats win both seats in
close to 52-wk tights. Despite which administration is in the White the Georgia runoff election in January, their margin will be slim
House, it will be tough to support the sector, especially due to and contingent on the votes of more moderate Democrats. The
public opposition to relief for CRE owners/operators. We are of sub-sector that could see a possible impact is student loan ABS
the opinion that the extent and size of any additional stimulus may (SLABS), although even that outcome is remote. Senator
not necessarily help the CRE sector directly. Elizabeth Warren has called on President-elect Biden to cancel
student loans through executive action. Blanket student loan
Asset-Backed Securities (ABS) forgiveness is generally considered a progressive agenda item
and was not part of the proposed moderate policy that President-
The ABS market has rebounded significantly post the COVID-19
elect Biden ran on. Additionally, while there is precedent for
selloff with robust primary and secondary market activity and
executive actions on forbearance and temporary payment relief
spreads for most prime subsectors at pre-COVID tights. TALF has
for student loan borrowers on federal student loans under both the
been minimally utilized and we believe requests for TALF
Trump and Obama administrations, executive action on outright
loans to finance ABS (auto, card, equipment, floorplan, premium
debt forgiveness or cancellation for federal student loans will likely
finance and private student loan ABS) will remain low as
test the legality and limits of presidential power. Given the
current spread levels for most sectors result in negative TALF
scenario of a divided government under a Biden administration,
yields. We expect the credit performance of consumer-related
Republican Senate and Democratic House, with a conservative
ABS sectors to largely reflect the performance of the broader
majority Supreme Court, executive actions will most likely be
lending market with performance expected to vary by loan type.
limited and/or challenged. Outside of student loans, we do not see
Specifically, we expect higher delinquency and charge-off rates as
the prime auto or credit card sectors being directly influenced by
COVID-19 related payment relief programs expire, the second
the change in the administration.
round of stimulus is likely to be smaller and, although it’s
expected to continue to improve but at a moderate pace, the Even with another round of stimulus likely to be approved, we
unemployment rate remains at elevated levels. Even so, the believe consumers are likely to maintain financially conservative
faster-than-expected improvement in the employment situation behavior as COVID-19 headlines are relatively grim with surging
should result in a more muted credit outcome for most sectors. cases, potential for further lockdowns and questions remaining
We expect overall credit performance for retail auto loan ABS to regarding vaccine safety, availability and willingness of Americans
deteriorate in 2021 as lender-based deferral programs end, to be vaccinated. Additional stimulus would help mitigate some of
on top of elevated unemployment. the deterioration we are expecting in the fundamental
performance of the trusts.
Securitized Views—Q1 2021 3WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal. Municipal bonds are sensitive to interest rate movements, a
municipal bond portfolio’s yield and value will fluctuate with market conditions. Bond prices generally move in the opposite direction of
interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline.
The price and yield of a MBS will be affected by interest rate movements and mortgage prepayments. During periods of declining
interest rates, principal prepayments tend to increase as borrowers refinance their mortgages at lower rates; therefore MBS investors
may be forced to reinvest returned principal at lower interest rates, reducing income. A MBS may be affected by borrowers that fail to
make interest payments and repay principal when due. Changes in the financial strength of a MBS or in a MBS’s credit rating may
affect its value. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political
developments. Investments in emerging markets involve heightened risks related to the same factors, in addition to those associated
with these markets’ smaller size and lesser liquidity. Investments in fast-growing industries like the technology sector (which historically
has been volatile) could result in increased price fluctuation, especially over the short term, due to the rapid pace of product change and
development and changes in government regulation of companies emphasizing scientific or technological advancement. Changes in
the financial strength of a bond issuer or in a bond’s credit rating may affect its value. High yields reflect the higher credit risks
associated with certain lower-rated securities held in the portfolio. Floating-rate loans and high-yield corporate bonds are rated below
investment grade and are subject to greater risk of default, which could result in loss of principal—a risk that may be heightened in a
slowing economy.
Any companies and/or case studies referenced herein are used solely for illustrative purposes; any investment may or may not be
currently held by any portfolio advised by Franklin Templeton. The information provided is not a recommendation or individual
investment advice for any particular security, strategy, or investment product and is not an indication of the trading intent of any Franklin
Templeton managed portfolio.
Securitized Views—Q1 2021 4IMPORTANT LEGAL INFORMATION This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market. All investments involve risks, including possible loss of principal. Data from third party sources may have been used in the preparation of this material and Franklin Templeton (“FT”) has not independently verified, validated or audited such data. 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