A tale of two TALFs: considering the potential of securitized debt
Like most risk assets, securitized debt sold off sharply in March 2020 due to the COVID-19 pandemic. The market has since rallied sharply, thanks in large part to fiscal and monetary support.
In recent months, a new Term Asset-Backed Securities Loan Facility, or TALF, piqued investors’ interest—possibly due to memories of high returns associated with the TALF program that supported securitized debt in the 2008 global financial crisis. But unlike the past, the most interesting opportunities today may be just outside the government’s zone of direct support for securitized assets.
The benefits of a government backstop
When the U.S. Federal Reserve (Fed) introduced TALF in 2008, the economy was in substantial disarray, but by establishing this and other programs, the Fed helped ensure the flow of credit to consumers and businesses. Beyond that, investors were able to borrow from the program and use leverage to generate what proved to be outsize returns. As William Dudley, president of the New York Fed, said in June 2009, “The prospect of relatively high expected risk-adjusted returns is precisely what gives investors an incentive to participate in the program.”1 As an example of how the program worked, President Dudley said, “… the spreads on AAA-rated credit card ABS have narrowed from a peak of about 600 basis points over LIBOR to slightly above 200 basis points [by June 2009]."
Fast-forward to 2020. On March 23, the Fed reintroduced TALF, authorizing the program to extend up to $100 billion in loans backed by $10 billion from the CARES Act to support the purchase of a variety of top-rated asset-backed securities, including credit card and auto loans, and some commercial mortgage-backed securities, among other assets. But investors who may have been thinking history would be an exact guide to a total return windfall have so far been disappointed.
As Fed Chairman Jerome Powell testified, “Since the TALF was announced, ABS spreads have contracted significantly. Thus, the facility might be used relatively little and mainly serve as a backstop, assuring lenders that they will have access to funding and giving them the confidence to make loans to households and businesses.”2
As Chairman Powell indicates, spreads have tightened so quickly that relatively little use has been made of TALF. Indeed, the cost of TALF funds now exceeds many coupons on the debt for which it’s eligible, so it doesn’t pay to buy TALF-eligible assets using leverage. Some investors believe there may still be value in certain TALF-eligible assets, but not by purchasing them with TALF loans.
The market, prepandemic
We believe there are other areas of opportunity in securitized debt markets, some of which were offering attractive risk/return characteristics before the current crisis struck.
Coming into the pandemic, investors seeking sources of return uncorrelated with traditional fixed-income sectors may have found a diversified portfolio of residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS), and asset-backed securities to offer attractive characteristics. In our analysis, it made sense to have less exposure to certain commercial sectors, particularly retail, because of the shift to e-commerce. Certain other esoteric securitized debt, such as securities issued by cell towers, provided interesting opportunities, as did agency credit-risk transfer securities issued by government-sponsored enterprises (GSEs, notably Fannie Mae and Freddie Mac). The latter investments enabled the GSEs to transfer some of their risk to investors willing to accept higher default risk from certain mortgage-backed securities.
Covering what today’s TALF doesn’t cover
Much of what TALF covers today misses what was interesting before the advent of the current crisis. Most assets included in the Bloomberg Barclays Securitized Index, a component of the Bloomberg Barclays U.S. Aggregate Bond Index, are fixed-rate securitized debt offering modest yields of less than 1.4%. But TALF-excluded assets, which include single-family RMBS, single-borrower CMBS, and other securities outside the index, offer key points of differentiation. Most segments have provided not only more attractive spreads but also lower correlation to other fixed-income asset types.
What does securitized debt offer investors?
- Securitized debt is backed by the cash flows of either pooled or individual assets, such as homes, commercial properties, and credit card and auto loans.
- Securitized debt can offer attractive yield opportunities relative to other fixed-income types and can enable investors to maintain relatively short duration relative to major benchmarks such as the Bloomberg Barclays U.S. Aggregate Bond Index.
- Much securitized debt also carries floating rates and is tied to the real estate market, making it potentially useful as a long-term inflation hedge.
For these assets as of mid-July 2020, nearly four months since the Fed introduced new backstops for debt markets, spreads haven’t recovered as they have with TALF-eligible securities, indicating spread tightening potential that investors in this space should note.
Real estate market outlook
One of the conditions on which some securitized debt depends is real estate market health. In our view, the shift from urban living to single-family homes will play out over the next few years. Residential supply is constrained, and loan underwriting has been conservative; extended unemployment benefits have also been helping.
Although traditional brick-and-mortar retail, such as shopping malls, present substantial uncertainty, we find interesting opportunities in nonretail sectors such as warehouses, cold storage, and industrial properties. Single-asset single-borrower CMBS, particularly among life science properties, also appear attractive and offer more stable fundamentals. In these cases, we think it’s prudent to stay close to the top end of the capital structure.
In building a portfolio, our general practice is to combine fundamental and quantitative elements and to look throughout capital structures while maintaining an overall investment-grade stance. Considering the devastating effects of COVID-19, we also believe it’s critical to severely stress test assets assuming challenging economic conditions through at least mid-2021.
1 newyorkfed.org, testimony of President William Dudley, June 4, 2009. 2 Testimony of Chairman Powell, June 30, 2020.
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