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(Bloomberg) — As rising energy prices and growing inflation fears make corporate bonds look increasingly risky, big money managers including State Street and Voya Investment Management have been looking at buying mortgage bonds and other securitized debt instead.
Mortgage bonds often perform better than US high-grade corporate debt in “risk off” markets where investors are becoming more fearful, wrote Spencer Rogers, strategist at Goldman Sachs, in a note this week.
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The debt is getting extra support now from Fannie Mae and Freddie Mac, after US President Donald Trump in January directed the companies to buy another $200 billion of the bonds. It’s worth looking at mortgage bonds that might perform better if rates fall again, Rogers wrote. For instance, purchasing specified pools designed to protect against higher prepayment speeds means investors can hang on to those cashflows for longer as rates fall.
Meanwhile, there’s ample reason to be worried about corporate debt. Crude oil futures have surged amid the US and Israeli attacks on Iran, and Iran’s retaliation on energy sites in nearby countries. West Texas Intermediate futures topped the $95-a-barrel range this week, compared with $57.42 at the end of last year. Prices in other markets are rising even more. Higher energy prices can effectively act as a tax on manufacturers and consumers, and can weigh on profits.
Higher oil prices may also make it harder for the Federal Reserve to continue cutting rates. On Wednesday, Fed Chair Jerome Powell said that central banks usually view higher energy prices as transitory, but inflation has been above the Fed’s 2% target for five years, implying that the central bank has less leeway to dismiss higher oil prices now. Bond traders are no longer pricing in any US rate cuts this year.
If rates stay higher for longer than expected, corporate profits could be hit as future borrowing costs rise. That’s at least part of the reason that US high-grade corporate bond spreads have widened by about 0.17 percentage point from their Jan. 22 lows. It may also be part of why the bonds have lost value this year on a total return basis.
Mortgage bonds, meanwhile, have gained a bit, according to Bloomberg index data. The securities look attractive from a relative value standpoint compared with corporate bonds, said Matthew Nest, global head of active fixed income at State Street Investment Management.
The gap between the current production mortgage bond spread and the high-grade corporate bond spread was around 0.33 percentage point as of Thursday’s close, according to Bloomberg index data. The average gap during the last decade was negative, because current coupon mortgage bond spreads have tended to be tighter than the high-grade corporate bond spread. By that standard, MBS are relatively cheap.
It makes sense to avoid credit risk in this part of the cycle, according to Nest. Mortgage bonds are more closely correlated with interest-rate fluctuations, and a measure of that volatility has been declining in recent days. The firm has been overweight mortgage bonds and other securitized debt relative to benchmarks for much of the past year.
“Late cycle, securitized debt tends to seem attractive,” State Street’s Nest said.
There are risks to the trade of favoring mortgage bonds and other securitized debt over corporate debt. The moment the war in Iran ends, or the Trump administration pulls back from the conflict, high-grade credit spreads could snap back quickly, narrowing 0.2 percentage point, said Tony Trzcinka, portfolio manager at Impax Asset Management.
“If we’ve learned anything from the past year, it’s that this administration will do everything in its power to provide a floor on markets,” Trzcinka said.
On top of that, many markets in the coming months may end up being driven by oil prices. As long as energy prices create inflationary pressure, and doubt about the future direction of rates, both corporates and mortgage bonds could be hit, said Brian Quigley, senior portfolio manager and head of MBS and agency debt at Vanguard.
“I think you need to be really careful with what correlation you’re assuming between MBS and corporate bonds at the moment,” Quigley said. While over a long period of time the two tend to have a low but positive correlation, the connection between them may be closer than usual in the near term, he said.
But credit faces other pressure too, including artificial intelligence disrupting software companies, and private credit potentially facing growing losses. Those factors had been weighing on corporate bonds even before the US and Israel first attacked Iran.
Given those risks, it might make sense to favor MBS and other securitized debt over corporate bonds, said David Goodson, managing director and head of MBS at Voya Investment Management.
“In a world like we have today, MBS offers an appealing source of diversification,” Goodson said.
Click here for a podcast on how a bank retreat from private credit is pressuring BDCs
WATCH: This week’s guests include Schwab Center for Financial Research’s Kathy Jones, Allspring Global Investment’s George Bory, BNP Paribas’ Head of Credit Strategy Meghan Robson, and CreditSights’ Head of US IG & Macro Strategy Zachary Griffiths.Schwab Center for Financial Research Kathy Jones, Allspring Global Investment George Bory, BNP Paribas Head of Credit Strategy Meghan Robson, and CreditSights Head of US IG & Macro Strategy Zachary Griffiths.
Week In Review
Goldman Sachs Group Inc. says investors should turn to high-yield debt from the energy sector, mortgage bonds and credit derivatives as turmoil in the Middle East disrupts global oil supply and stokes fears of global inflation. But the Iran war-induced credit market selloff is prompting some money managers to buy oversold investment-grade bonds, in a bet that solid fundamentals will help them withstand the conflict and economic uncertainties. Dealers have accumulated US high-grade corporate notes at the fastest pace in at least 10 years, according to Bank of America Corp., due to a near-record week of issuance.
Wall Street lending giants would get relaxed capital requirements under proposals unveiled by the Federal Reserve on Thursday, in a move that could potentially unleash billions of dollars for lending, share buybacks and dividends.
If finalized, the plans — along with moves to ease the enhanced supplementary leverage ratio and overhaul stress tests — would amount to some of the biggest bank-capital rule changes since those enacted after the 2008 global financial crisis.
Goldman Sachs and JPMorgan are among investment banks offering hedge fund clients ways to bet against the private credit market, by assembling baskets of listed companies with exposure to the space. Meanwhile, Pimco is staying away from loans being put up for sale amid the private credit tumult as they’re “pretty bad,” according to its president Christian Stracke.
The industry may need years to work through the “intense yet warranted reset” that caused a wave of redemptions from some of the market’s biggest funds, according to Sixth Street Partners. Redemption pressures may cause certain retail-oriented structures to be “frozen,” Park Square Capital’s Robin Doumar said.
Morgan Stanley expects that default rates in direct lending will climb to 8% as advances in AI continually disrupt the software industry.
Still, top executives from Deutsche Bank AG, UBS Group AG and Societe Generale SA touted the quality of their exposures to private credit amid the concerns over underwriting standards and AI’s impact. TCW Group’s Katie Koch sees buying opportunities and says the firm is looking to deploy capital across fresh loans and rescue financing. Sumitomo Life Insurance Co. is considering allocating about ¥300 billion ($1.9 billion) in private credit in the fiscal year starting April. Oak Hill Advisors is courting retail investors who have grown more skeptical of private credit with the launch of a fund that will deploy capital across public and private debt.
Banks led by JPMorgan attracted enough demand for the nearly $15 billion of debt it is selling to back the leveraged buyout of video game maker Electronic Arts Inc., the largest of its kind. In a reversal of fortunes, another group of banks led by JPMorgan halted a $5.3 billion debt deal for software firm Qualtrics International Inc. after failing to win over investors amid deepening anxiety around AI disruption.
JPMorgan is also leading a $2 billion debt sale to finance the purchase of Janus Henderson Group Plc by Nelson Peltz’s Trian Fund Management and General Catalyst, which are locked in a bidding war to buy the asset manager with Victory Capital.
Nexstar Media Group Inc. amended the financing tied to its acquisition of fellow TV-station owner Tegna Inc. as demand for risky debt comes under strain amid a flood of loan and bond sales tied to buyouts.
China Evergrande liquidators’ lawsuit to claw back funds from the builder’s auditors will finally reach its first public court hearing in May, about two years after being filed.
Market Financial Solutions Ltd. faces an investigation by the UK financial regulator, marking the first publicly disclosed action by authorities into the mortgage lender that collapsed owing billions to Wall Street lenders.
Meta Platforms Inc., Alphabet Inc. and Microsoft Corp. joining an index of high-grade firms’ credit default swaps is another sign of investors increasingly hedging hyperscalers’ debt amid surging bond sales.
Spandex maker The Lycra Company filed for Chapter 11 bankruptcy to implement a restructuring that will see most of its debt written off after creditors took control.
Billionaire Wes Edens reached a deal with creditors to restructure New Fortress Energy Inc., in a transaction that will cut the company’s debt by 90%.
On the Move
David Rogal, previously a managing director and fixed income portfolio manager at BlackRock, joined hedge fund Millennium Management as a senior portfolio manager in the fixed income group.
Justin Polselli, a leveraged finance banker at Jefferies Financial Group Inc., is leaving the lender to join Moelis & Co. as part of its debt capital markets team.
Derby Lane Partners LP, a real estate credit investment firm formed last year, tapped former Citigroup Inc. banker Nishant Nadella to lead its public investments including commercial mortgage-backed securities.
Deutsche Bank AG named Panos Stergiou global head of large corporate coverage, a newly created group across the corporate bank and the fixed income desk. Meanwhile Jan-Philipp Gillmann is leaving after working on corporate client coverage over the past six years.
