Securitized Credit Markets Update

The securitized credit markets have remained resilient in the face of increased market volatility affecting other credit sectors thus far in 2018. At the index level, ABS and CMBS delivered 0.17% and 0.05%* of excess return, respectively, during the second quarter, outperforming other high-quality credit sectors, such as US IG Corporates, which were down -1.00% on an excess return basis. Non-Agency RMBS, which lack a comprehensive benchmark, also performed well relative to the broader US investment-grade bond market as represented by the Bloomberg Barclays US Aggregate Index.

Despite the recent run of solid performance, we still find value in the securitized credit asset class. Our constructive outlook is predicated on both strong fundamentals and technicals underpinning the sectors. In terms of fundamentals, the US consumer remains on solid footing, with the unemployment rate at its lowest level since 2000, wages continuing to rise, household leverage moderating, and home prices continuing to appreciate at a healthy pace. Steady US economic growth, albeit at a moderate pace, has also been supportive of commercial real estate prices and low vacancy rates. Providing additional fundamental support, leverage in the commercial real estate market remains manageable, and deal underwriting is generally more stringent relative to pre-crisis standards.

From a technical standpoint, conditions remain favorable for the securitized credit subsectors. ABS and CMBS spreads have been resilient, tightening in some tranches, in the face of a decent sized uptick in new issue supply. Market appetite for new issue Non-Agency RMBS, including Reperforming Loans (RPL) and Non-Qualified Mortgage (NQM) structures, remains strong as investors continue to look to replenish legacy RMBS exposure as the supply of pre-crisis bonds rapidly disappears. A recent wave of new issuance in Non-Agency RMBS resulted in only modest spread widening and, as such, improved valuations for the sub-sector. We expect this positive technical tailwind to persist, lending continued support to residential mortgage credit in the near term.

While securitized credit valuations are somewhat richer than those offered at the beginning of the second quarter, we believe these subsectors continue to offer attractive risk-adjusted carry versus similarly rated corporate credit:

• In CMBS, we continue to find attractive opportunities in the high-quality Single-Asset/Single-Borrower (SA/SB) subsector, which has provided a steady stream of new issues over the last 12 months. Despite healthy market demand for SA/SB issues, we continue to find deals that offer attractive risk premiums. We are also closely monitoring Freddie

Mac K Series-Class B multi-family CMBS activity. Spreads in this area have backed up somewhat in recent weeks. Further widening may provide an attractive entry point relative to conduit CMBS issues in the near term.

• The ABS market has seen an uptick in Whole-Business Securitizations, both new deals and refinancing of existing structures. Given the aforementioned strength of the U.S. consumer, we continue to find value in certain of these deals backed by franchise royalties.

• Non-Agency RMBS – As noted above, recent supply has pushed spreads modestly wider despite continued strength in the fundamentals underlying the sector. The credit metrics we use to monitor the sector (including, delinquencies, forecasted losses, etc) remain solid and we feel current valuations offer opportunities to add to the space.

By T. Rowe Price Associates, Inc.
Chris Brown, CFA, Head of Securitized and Portfolio Manager Total Return Strategy

*Returns based on the Bloomberg Barclays Asset-Backed Securities Index and the Bloomberg Barclays Non-Agency Investment Grade CMBS: Eligible for U.S. Aggregate Index.
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