First Quarter 2024
Fixed-Income Sector Views
Table of Contents Portfolio Management Outlook..................................................... 2
Municipal Bonds ..............................................................................8
Macroeconomic Update................................................................. 3
Asset-Backed Securities and CLOs..................................................9
Rates ................................................................................................4
Non-Agency Residential Mortgage-Backed Securities (RMBS).... 10
Investment-Grade Corporate Bonds ............................................. 5
Commercial Mortgage-Backed Securities (CMBS) ........................ 11
High-Yield Corporate Bonds ...........................................................6
Agency Mortgage-Backed Securities (MBS) ..................................12
Bank Loans ..................................................................................... 7
Commercial Real Estate (CRE)........................................................13
Portfolio Management Outlook
Investing as the Fed Prepares to Start Rate Cuts Shifting policy drives uncertainty and opportunity. As the Federal Reserve (Fed) moves closer to easing and the macroeconomic backdrop persists in sending conflicting signals, we believe the continued high level of volatility in the fixed-income market should reward active management. From our perspective, several signals of economic information cut through the noise: Inflation is moving in the right direction, as the Fed’s preferred Core personal consumption expenditures (PCE) measure is currently running at less than the targeted 2 percent on a six-month annualized basis; the lagged impact of higher interest rates, along with ongoing quantitative tightening, are showing up at the margins of the economy; bank lending volumes are falling; and commercial real estate stress is building. At the same time, we still have tailwinds from the significant fiscal spending of the last three years as well as continuing massive deficits, recent easing of financial conditions, and the relatively strong financial position of larger companies and wealthier consumers. Taken together, we believe that the risk of a recession in coming quarters remains higher than average, but it should be a comparatively mild one. At the January FOMC meeting and press conference, the Fed and Fed Chair Jerome Powell injected some uncertainty about the timing of rate cuts, but there is little doubt in the market that cuts are coming. In this environment, we believe that the investment landscape will continue to reward diversification and higher-quality fixed income. History shows that when the Fed is paused and easing, longer duration higher-quality fixed income has outperformed riskier assets, as well as money market instruments1. Our thinking on portfolio positioning and relative value can be gleaned from the reports by our different sector teams: Spreads generally tightened across all sectors in the fourth quarter as rates fell and favorable technical conditions (strong demand and reduced supply) supported market prices, but all-in yields remain high relative to history. We continue to reduce our exposure to generic credit beta, and instead favor exposure to higher-quality, high carry, low-duration instruments, particularly in non-Agency RMBS, senior CLO tranches, commercial ABS, and shortduration higher-quality high yield. Structured credit opportunities have generally offered less markto-market volatility than similarly rated corporate credit, with higher investable yields. We prefer to pick up duration using Agency RMBS given their wider spreads and attractive convexity profile, but longer term we expect the yield curve to bull steepen so we have a marginal bias to increasing our duration exposure to the belly of the curve. We continue to maintain a healthy allocation to shortterm investments as dry powder for taking advantage of opportunities as they arise.
By Anne Walsh, Steve Brown, Adam Bloch, and Evan Serdensky
1. https://www.guggenheiminvestments.com/perspectives/portfolio-strategy/learning-from-turning-points-in-monetary-policy
Fixed-Income Sector Views | 1Q 2024
2
Macroeconomic Update
Fed Shifting to Easing Mode as Inflation and Labor Market Cool Shift to Fed easing cycle helps brighten the economic outlook, but risks remain. Economic conditions have been in a sweet spot recently, with solid real gross domestic product (GDP) growth, a labor market cooling toward a more sustainable pace even with layoffs remaining very low, and inflation arguably already back under the Fed’s 2 percent target (see for example core PCE inflation over the last six months). Whether by design or just good luck, the most acute negative impacts from the Fed’s tightening were largely cushioned by expansive fiscal policy in 2023. Meanwhile, inflation managed to cool significantly despite solid—but slowing—aggregate demand because the supply side showed rapid improvement, including both from international supply chains and expansion of the labor force.
few industries and could weaken further, especially now that the length of the workweek has been reduced aggressively. We also worry that the aggregate economic data are hiding stress under the surface in areas like small businesses, small banks, low-income consumers, and commercial real estate. We expect stress in these areas, many of which lie outside public markets, will stay relatively contained, but we are on watch for spillovers. And while not our base case, a risk in the other direction is that progress on inflation stalls or even reverses, whether due to new supply or commodity price shocks (increased shipping costs or higher oil prices from Mideast tensions come to mind) or demand not cooling enough.
As we look to the rest of 2024, the market seems to be extrapolating that this positive confluence of economic forces will continue to strike a perfect balance. That is a real possibility, particularly with the Fed making a more dovish shift and the associated easing in financial conditions taking some pressure off the economy. But in our view the long list of macroeconomic risks is underappreciated.
The economic outlook has gotten more positive now that further Fed hikes are off the table and broad financial conditions are easing as substantial rate cuts are priced in. But with markets priced for such a benign outlook, we continue to expect volatility as risks of something upsetting the favorable growth-inflation mix remain elevated.
Chief among these risks is a further cooling in demand that transitions the economy from a gradual slowdown to an abrupt downshift. Job growth has been narrowly concentrated in just a
By Matt Bush and Maria Giraldo
Job growth has been narrowly concentrated in just a few industries and could weaken further, especially now that the length of the workweek has been reduced aggressively, which as our chart shows, has stalled the year over year growth rate in aggregate hours worked.
Can the Fed Stop Further Job Slowdown Without Reigniting Inflation? Fed Funds Rate (LHS) Market Pricing for Fed
Aggregate Hours Worked, YoY% Change (RHS)
6%
8% 7%
5%
6% 4%
5%
3%
4% 3%
2%
2% 1%
1%
0% June 2021
Dec. 2021
June 2022
Dec. 2022
June 2023
Dec. 2023
June 2024
0% Dec. 2024
Source: Guggenheim Investments, Bloomberg, Haver. Data as of 1.22.2024 for fed funds, 12.31.2023 for payrolls. Aggregate hours worked is average weekly hours x total employed workers.
Fixed-Income Sector Views | 1Q 2024
3
Rates
Positioning for Fed Easing A dovish Fed and elevated real yields signal opportunity in inflation-protected Treasurys. The Fed’s rhetoric and forward guidance will continue to exert a significant influence on capital markets in the upcoming quarters. Our expectation is that the Fed will continue to become more dovish throughout the year and will eventually cut interest rates by more than the 75 basis points that were projected in its December Summary of Economic Projections (SEP), also known as the dot plot. Considering this view, we anticipate that the next large move in the Treasury yield curve will be a bull steepening, where front and intermediate yields decline more than longer yields. The rally in rates, which began in mid-October following a speech by Fed Governor Christopher Waller, continued with the dovish November rate pause. It was further fueled by the shift in the Fed’s monetary policy messaging at the December FOMC meeting, reflected in Fed Chair Powell’s dovish press conference and the revised SEP, which represented a turning point in the Fed’s hiking cycle.
By Kris Dorr and Tad Nygren
Treasury Yield Curve Is Likely to Steepen Once Easing Starts 2s10s (LHS)
5s30s (LHS)
Fed Funds (RHS)
350 bps
7%
300 bps 200 bps
5%
150 bps
4%
100 bps 50 bps
3%
0 bps
2%
-50 bps
1%
-100 bps -150 bps
Jan. 2000
Federal Funds Target Rate
6%
250 bps Yield Curve Slope
We anticipate that the next large move in the Treasury yield curve will be a bull steepening of the curve, where front and intermediate yields decline more than longer yields.
Looking ahead, we believe Treasury Inflation Protected Securities, or TIPS, could thrive in a macroeconomic environment in which real yields are significantly elevated. With the likelihood of policy easing later this year, we foresee a scenario where real yields could decline and breakeven rates remain well supported. Additionally, with the U.S. Treasury confirming another quarter of increased nominal Treasury issuance across the curve at its February refunding announcement, we believe Treasury yields could move higher as record supply is brought to market, but view this as an attractive opportunity to add duration. Finally, as yields decline and the yield curve steepens we expect to see increased call activity in Agency bonds.
May 2002
Aug. 2004
Dec. 2006
April 2009
July 2011
Nov. 2013
Feb. 2016
June 2018
Oct. 2020
Jan. 2023
0%
Source: Guggenheim Investments, Bloomberg. Data as of 12.31.2023.
Fixed-Income Sector Views | 1Q 2024
4
Investment-Grade Corporate Bonds
Keeping an Eye on Technicals…and Fundamentals Yields look attractive, despite tight spreads. Despite tight credit spreads, yields are attractive, technical dynamics are solid, and fundamentals, though deteriorating, are doing so at a manageable pace. These factors present a good opportunity to reshape positioning on the credit curve and within different subsectors as we work through the first quarter and head into what may be a more volatile second quarter. The favorable technical picture for investment-grade corporate bonds that we saw in the fourth quarter of 2023 should continue through the first quarter of 2024. On the supply side, we saw record breaking primary issuance in January of around $195 billion. This supply should be more than offset by the demand side of the equation, which remains strong due to historically attractive all-in yields for investment-grade corporates. As we go further into the year, we expect gross and net supply trends to continue reverting to the mean after reaching post-2020 record highs and to trend lower in 2024 relative to 2023. Additionally, thematic asset shifts from insurers and pension funds continue to fuel the demand for longer duration corporate debt alongside the dearth of 30-year supply. Investor weighting to investment-grade credit was still defensive going into year-end 2023, but more offensive positioning was triggered when the Fed signaled no further rate hikes and potentially aggressive rate
While spreads are in historically low percentile ranges relative to the last 20 years, all-in yields remain attractive enough to support spreads this quarter.
cuts in 2024. This was evidenced by accelerating inflows to both ETFs and mutual funds in the fourth quarter, from $5.8 billion of outflows in October to inflows of $14.4 billion in November and $20.2 billion in December. This sentiment continued into the New Year, with January inflows totaling $28.9 billion. Strong technicals will likely continue to outweigh slowly deteriorating fundamentals, which should help keep spreads rangebound near the tighter end. While spreads are in historically low percentile ranges relative to the last 20 years, all-in yields remain attractive enough to support spreads this quarter. We continue to favor financials over industrials. Financials are currently trading cheap to industrials on a historical basis and the market is well-positioned for an expected seasonally strong wave of issuance by large banks. As fundamentals shift, overbought industrial sectors like consumer cyclicals and energy should underperform. Although we expect 10/30s credit curves to remain flat this quarter, the duration in the industrial portion of the Bloomberg U.S. Corporate Bond Index is nearly 2.5 years longer than that of financials, which leaves industrial credit curves more vulnerable to the 10/30s credit curve steepening.
By Justin Takata
Elevated All-In Yields Support Relatively Low Spreads IG Corporate Bond Yield (RHS)
IG Corporate Bond Spread (LHS) 800 bps
10%
700 bps
9% 8%
600 bps
7%
500 bps
6%
400 bps
5%
300 bps
4%
200 bps
3%
100 bps 0 bps 2004
2% 2006
2008
2010
2012
2014
2016
2018
2020
2022
1% 2024
Source: Guggenheim Investments, Bloomberg. Data as of 12.31.2023. Gray area represents recession. Past performance does not guarantee future returns.
Fixed-Income Sector Views | 1Q 2024
5
High-Yield Corporate Bonds
Default Rates Should Remain Stable, if Slightly Elevated, in 2024 Expect more downgrades, but default rates should remain manageable. The evolving macroeconomic environment in 2023 led to elevated uncertainty, restricted lending, and C-suite anxiety. This climate forced companies that missed revenue or cash flow targets to restructure debt and slash costs, as soaring inflation eroded margins. The par-weighted default rate on the ICE BofA High Yield Index ended 2023 at 2.4 percent, up from a low level of just 1.5 percent in 2022. The fixed-rate nature of high-yield bond coupons and the relatively low amount of maturing bonds meant that there weren’t many interest or payment defaults. According to BofA research, defaults in the index were almost evenly split between bankruptcy and distressed exchange.
A more gradual credit deterioration story is likely to spread out over the next several years. Although we expect the Fed to start easing this year, we do not believe short-term interest rates will return to decade lows. This means that most borrowers will still need to adjust to a higher interest rate environment once their debt comes due or as borrowing needs arise. The slow-moving impact of this factor on the high-yield market can already be seen in the shifting credit profile of the index over the past couple of years. While the highyield index remains mostly comprised of BB-rated bonds (47 percent of the index as of Dec. 31, 2023), that share has gradually fallen from almost 55 percent in mid-2021. In its place, single B-rated bonds have gained 6 percentage points to a 39 percent share.
Many of the same credit themes that drove trends in 2023 are likely to carry into 2024, but some headwinds are fading. The dearth of maturities in 2024 should again help keep payment defaults to a minimum. In the high-yield index, over 50 percent of bonds by amount outstanding were issued in 2020 and 2021 when yields were very low, which has supported interest coverage ratios. Scheduled maturities are spread out over the next five years, with the peak as a share of outstanding happening in 2029. Sentiment is improving as financial conditions have eased substantially with the decline in rates since October, which should help issuers access capital markets at reasonable spreads if needed. High-yield corporate bond spreads tightened from 481 basis points to 339 basis points by year-end.
Over 50 percent of bonds by amount outstanding were issued in 2020 and 2021 when yields were very low, which has supported interest coverage ratios. Scheduled maturities are spread out over the next five years, with the peak as a share of outstanding happening in 2029.
Taking into account the combination of positive factors (recent easing in financial conditions, the index’s concentration in BBratings, the upcoming Fed easing cycle) against negative factors (the market’s continued adjustment to higher interest rates and the ongoing lagged impact of inflation on costs), we believe the default environment in 2024 will resemble 2023. We expect to see more downgrades than upgrades and a higher frequency of restructuring unsustainable leverage profiles. But the par-weighted default rate for the index will likely land again in the 2.5–3 percent range, which should be manageable for the high-yield market.
By Thomas Hauser and Maria Giraldo
The Majority of the High-Yield Market Was Issued in 2020 and 2021 Issuance Year
Scheduled Maturity Year
35% 30%
30% 25%
22% 19%
20% 15%
13%
14%
12%
10%
8%
13%
20%
15%
14%
13%
7%
5% 0%
Pre-2019 2019
2020
2021
2022
2023
2025
2026
2027
2028
2029
2030
After 2030
Source: Guggenheim Investments, ICE Index Services, Bloomberg. Data as of 1.23.2024.
Fixed-Income Sector Views | 1Q 2024
6
Bank Loans
Fed Easing Cycle Could Support Loan Issuer Fundamentals We expect bank loan coupons will continue to look attractive to investors. Our Macroeconomic and Investment Research Group expects a Fed easing cycle to start this year, which could impact the loan market in two ways. First, our view suggests that loan coupons could decline to 8.1 percent by year-end from the current level of 9.5 percent, keeping all else constant. We still view this as attractive, as prior to 2022, the last time coupons were near 8 percent was in 2008 when spreads were significantly wider. Second, an easing cycle helps lower interest expense for issuers, which will benefit interest coverage ratios. Assuming unchanged earnings, the median single B loan borrower could see their interest coverage ratio increase from 3.2x to 4.3x (with some lag) if the Fed lowers rates to 4.0 percent by the end of 2024, and even more if the easing cycle continues into 2025. We expect more distribution around the median interest coverage figure as some loan borrowers will struggle to adapt to interest rates remaining above 10-year average levels. Already, Pitchbook LCD’s figures show that the share of the market with coverage between 1.5x–2.99x has increased to 34 percent. But this high-level sensitivity exercise helps depict how strategies focused on well-positioned borrowers could benefit.
since 2009. We believe the continued lack of market supply could support prices this year, which are averaging 95 percent of par. Net supply in the primary market, often driven by leveraged buyout (LBO) activity, is likely to remain muted given the level of rates and the market’s limited appetite for high leverage. Most of the supply this year will likely be refinancing activity as loan issuers address maturities. Already in January, refinancing represented 75 percent of total volume. We continue to find opportunities in loans given that yields and coupons are still attractive, and expect that loan prices could rally further. The backdrop is likely to result in more bifurcation and dispersion in the loan universe, which supports evaluating relative value opportunities on an issuer-by-issuer basis. An elevated degree of caution is warranted given the lagged effect of higher interest rates, highlighting the importance of re-underwriting key positions in industries that have been hurt by inflation and tight labor market dynamics and avoiding structures with unsustainable leverage.
By Christopher Keywork and Maria Giraldo Attractive coupon return of 9.8 percent in 2023 plus a recovery in average loan prices brought the annual return of the Credit Suisse Leveraged Loan Index to 13 percent, the best annual performance
As the Fed begins its easing cycle, we expect coverage ratios to improve but some loan borrowers will struggle to adapt to interest rates remaining above 10-year average levels. Already, Pitchbook LCD’s figures show that the share of the market with coverage between 1.5x–2.99x has increased to 34 percent.
Leveraged Loan Median Interest Coverage Has Declined Median Interest Coverage (LHS)
Share of Interest Coverage 1.5–2.99x (RHS)
5.5x
40%
5.0x
34%
4.5x
28%
4.0x
22%
3.5x
16%
3.0x
10% 3Q15
3Q16
3Q17
3Q18
3Q19
3Q20
3Q21
3Q22
3Q23
Source: Guggenheim Investments, Pitchbook LCD. Data as of 9.30.2023.
Fixed-Income Sector Views | 1Q 2024
7
Municipal Bonds
Ongoing Rally in Munis Attractive performance but supply is slim. After a fairly dismal performance for much of 2023, municipal bonds took off during the fourth quarter. High all-in yields, a decline in net par outstanding due to large principal and interest reinvestment, and change in rate expectations all combined to drive buyers back to the market.
to keep retail buyers engaged and prevent a major valuation reset. On the credit front, revenue trends have decelerated and more states are reporting intra-year deficits. Some of the slowdown can be attributed to tax cuts enacted in the last two years. For example, 25 states have cut personal income tax rates since 2021—including 14 states that will see lower rates in 2024—and 19 are holding some version of a sales tax holiday this fiscal year.
The strength in the market left municipals entering the first quarter with municipal/Treasury yield ratios at three-month and 12-month tights, while all-in yields have dropped by nearly 100 basis points since October. Secondary trading volumes are lower year-over-year, and demand exceeds supply. In this environment, market participants are reluctant to transact at current levels in the secondary market, and are instead waiting for a rebound in new issuance to reset valuations.
Many states are required to balance their budgets, and their elevated rainy day funds will help them operate comfortably through a couple years of flat to slight declines in tax collections. However, we are keeping an eye on how reduced state appropriations affect smaller municipal entities such as local governments, which tend to have less budgetary flexibility. For now, defaults remain manageable. Although the total defaulted par amount rose by 29 percent to $2 billion in 2023, more than half of those came from the historically risky nursing home and hospital sectors. We are cautiously watching market technical conditions develop as we evaluate attractive entry points for higher-quality credits.
Some 86 percent of the record-setting fourth quarter return came from price appreciation, with the balance from coupon. Given the starting valuations in 2024, we expect coupon to drive the bulk of municipal market performance over the next few months. Muni/ Treasury ratios should move incrementally wider on the back of new issuance, but we believe all-in yields are sufficiently attractive
High all-in yields, a decline in net par outstanding due to large principal and interest reinvestment, and change in rate expectations have driven buyers back to the market, and left municipal/Treasury ratios at threeand 12-month tights.
By Allen Li and Michael Park
Higher Yields Have Increased Demand for Municipal Bonds 30yr AAA / Treasury Ratio (LHS)
30yr AAA Yield (RHS)
300%
5.0% 4.5%
250%
4.0% 3.5%
200%
3.0% 2.5%
150%
2.0% 1.5%
100%
1.0% 0.5%
50% Oct. 2018
0.0% Oct. 2019
Oct. 2020
Oct. 2021
Oct. 2022
Oct. 2023
Source: Guggenheim Investments, Municipal Market Monitor. Data as of 2.12.2024. Past performance does not guarantee future returns.
Fixed-Income Sector Views | 1Q 2024
8
Asset-Backed Securities and CLOs
Focusing on Quality Experienced managers and high-quality collateral are key. A notable development in the CLO market in 2023 was the more than doubling of new issuance for private credit CLOs, compared to a decrease of 24 percent for broadly syndicated loan (BSL) CLOs. We expect that private credit CLOs will continue to grow market share in 2024 as the underlying asset class has shown resilient performance and credit enhancement levels are 5–6 percent higher than for BSL CLOs. Private credit CLOs are pricing in the 7.5–9.25 percent yield range for AAA to single-A rated tranches. In this challenging debt service environment, underlying credit performance dispersion will likely increase. We continue to prefer staying senior in the capital structure in the private credit or middle market CLO sector and investing in a select group of experienced managers. In the ABS market, we favor senior exposures to issuers backed by high-quality commercial collateral. High conviction investment themes include data centers backed by investment-grade tenants, diversified triple net lease real estate, and royalties of recognizable high-quality brands. Certain segments of the consumer ABS market
A notable development in the CLO market in 2023 was the more than doubling of new issuance for private credit CLOs, compared to a decrease of 24 percent for broadly syndicated loan (BSL) CLOs.
have experienced stress, including downgrades in subprime auto and unsecured loans. Full-year issuance for all ABS increased by 5 percent year over year, fueled by increases in auto and equipment ABS. Commercial ABS issuance in 2023 fell by 28 percent vs. 2022, with declines across all major categories except data center and fiber networks, where robust capital investment fueled demand for financing despite high debt costs. With commercial ABS maturities not expected to pick up until 2026, low supply expectations are supportive of valuations. Commercial ABS credit spreads are historically attractive—ranking above the 90th percentile both on an absolute basis and relative to similarly rated corporate bonds. As of Jan. 30, the ICE/BofA Commercial ABS index currently yields 6.5 percent, and senior commercial ABS with defensive underlying collateral have recently traded between 5.7–6.1 percent. Given both recessionary and idiosyncratic risks, commercial ABS offer a unique opportunity to capture complexity premiums in subsectors that require scrutiny across sponsors and structures.
By Michael Liu, Scott Kanouse, Pooja Shendure, and Dominic Bea
New Private Credit CLO Issuance Doubled in 2023 While BSL Declined BSL CLO New Issue
% Private Credit (RHS)
Private Credit CLO New Issue
$200bn
30%
$180bn
24%
$160bn $140bn
25% 20%
$120bn 15%
$100bn $80bn $60bn
12%
12%
12%
13%
12%
10%
10%
$40bn
5%
$20bn $0bn
0% 2017
2018
2019
2020
2021
2022
2023
Source: Guggenheim Investments, JP Morgan. Data as of 12.31.2023.
Fixed-Income Sector Views | 1Q 2024
9
Non-Agency Residential Mortgage-Backed Securities
Finding Value Amid High Rates Elevated mortgage rates should suppress supply and support performance. As the average 30-year mortgage rate reached 7.79 percent in October 2023, its highest level in 20 years, home purchase activity contracted to its lowest level on record, and mortgage refinancing activity declined dramatically. Consequently, mortgage loan originations decreased significantly, and non-Agency RMBS new-issue volume closed 2023 at $66 billion, almost 50 percent lower than 2022. New-issue transactions for 2024 are expected to be only marginally higher than the totals seen in 2023, which should be constructive for non-Agency RMBS valuations.
subdued housing activity and tepid home price gains will likely prevent meaningful expansion in purchase loan volume. Against this backdrop, RMBS credit spreads will have limited potential to widen, and the market will likely take near-term cues from changes in valuations in the larger Agency MBS market. We continue to favor non-qualified mortgage, or non-QM, RMBS 2.0 senior and mezzanine tranches with loss-remote, stableweighted average life profile. We also prefer RMBS 1.0 and re-performing loan deals backed by loans with significant home equity. While carrying a low likelihood of principal loss, current RMBS valuations reflect spreads wider than the long-run averages and routinely trade at discounted dollar prices, which may provide investors additional protection from both collateral losses and prepayments. These subsectors offer 5.5–6.0 percent yields.
Looking ahead, we expect non-Agency RMBS issuance to remain low across a range of economic scenarios. The rates on most outstanding mortgages remain lower than the prevailing market rate: only 3 percent of outstanding 30-year conventional mortgages have a meaningful refinancing incentive (greater than 50 basis points) at a 6.60 percent mortgage rate, and only 10 percent have such an incentive at a 5.50 percent mortgage rate. Furthermore,
The rates on most outstanding mortgages remain lower than the prevailing market rate: only 3 percent of outstanding 30-year conventional mortgages have a meaningful refinancing incentive (greater than 50 basis points) at a 6.60 percent mortgage rate, and only 10 percent have such an incentive at a 5.50 percent mortgage rate.
By Karthik Narayanan and Roy Park
Just 3 Percent of Borrowers Have Incentive to Refinance Percentage of Borrowers with 50+ Basis Points Refi Incentive Percentage of Borrowers with 50+bp Refi Incentive 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
2022
2023
Source: Guggenheim Investments, eMBS, Goldman Sachs. Data as of 12.31.2023.
Fixed-Income Sector Views | 1Q 2024
10
Commercial Mortgage-Backed Securities
Selectivity Remains Key in CMBS CMBS rallies but remains rich relative to other sectors. Though near-term market technicals are positive, CMBS fundamentals remain challenged. Lower interest rates portend improved returns for owners of well-positioned buildings, but lower rates do little to improve the outlook for fundamentally challenged or overlevered assets. For example, owners of affordable housing will see margin compression as regulated rent growth fails to offset increasing maintenance and insurance costs. Lower-quality malls continue to struggle given changed shopping patterns, and office demand remains structurally and permanently below available supply, causing some office properties to become essentially obsolete.
Perhaps of greater concern, the prices achieved on distressed sales have been declining. The loss severity rate, defined as the percentage of loan balance lost upon the liquidation of an underperforming CMBS property, has been increasing in recent months around property types that are operationally intensive, such as retail, and/or are at risk of obsolescence, such as office properties. We are in the early innings of this commercial real estate cycle, and we recommend maintaining a highly selective approach to CMBS investing, focusing on securities that can withstand a meaningful increase in stress without losing principal and deliver returns that compensate for the incremental risk and complexity inherent to this sector at this time.
As of December 2023, 6.5 percent of loans backing conduit CMBS were in some stage of special servicing or workout, up 0.3 percent from the prior quarter as more properties are now under duress.
The loss severity rate, defined as the percentage of loan balance lost upon the liquidation of an underperforming CMBS property, has been increasing in recent months around property types that are operationally intensive, such as retail, and/or are at risk of obsolescence, such as office properties.
By Tom Nash and Hongli Yang
Office and Retail Properties in CMBS Continue to Struggle Six-Month Average Loss Severity for Office and Retail Properties in CMBS Office
Retail
65% 60% 55% 50% 45% 40% 35% 30% 25% 20%
Jan. 2023
Feb. 2023
March 2023
April 2023
May 2023
June 2023
July 2023
Aug. 2023
Sept. 2023
Oct. 2023
Nov. 2023
Dec. 2023
Source: Guggenheim Investments, Morgan Stanley. Data as of 12.31.2023.
Fixed-Income Sector Views | 1Q 2024
11
Agency Mortgage-Backed Securities
What a Difference a Quarter Makes Positioning for rates to decline over a medium- to long-term horizon. Agency MBS salvaged 2023 with an impressive fourth quarter performance. The sharp decline in interest rates and the December Fed pivot provided welcome relief to underwater bank portfolios, and reduced fears of further fixed-income fund outflows. While mortgages trailed other subsectors of the Bloomberg U.S. Aggregate Bond Index for the entirety of 2023, investors who allocated to the sector at the end of the third quarter when valuations were historically attractive were able to capture significant outperformance as the Bloomberg U.S. MBS Index total and excess returns went from negative territory to 5.05 percent and 0.70 percent, respectively. MBS valuations have since normalized relative to recent wides but as of Jan. 30, still yield 5–5.5 percent, roughly 1.4 percent above Treasurys.
5–5.5 percent coupon MBS allow for price appreciation due to their lower sensitivity to increases in prepayment rates relative to MBS currently priced above $100. Since these MBS are priced to relatively low prepayment speeds, they also carry less extension risk if mortgage rates retrace their recent highs. Among $95–$100 priced MBS, we also see an opportunity to monetize the price appreciation in MBS-specified pools—MBS backed exclusively by loans with favorable prepayment attributes—that occurred over the past quarter. Selling specified pools in favor of buying generic, new production MBS pools both potentially boosts yield and increases exposure to falling interest rate volatility. Meanwhile, in contrast to single-family mortgage MBS, spread volatility in Agency CMBS has been muted, which has limited relative value opportunities. Supply has shifted into shorter tenors and the dearth of long duration origination has flattened the spread curve in the sector. As a result, we favor adding long duration via single-family collateralized mortgage obligation (CMO) structures that offer both wider spreads and higher yields relative to multifamily offerings.
Rather than focusing on the timing and extent of future Fed rate cuts, we recommend positioning for the eventual realization of lower short-term interest rates over the medium to long term. We favor 5–5.5 percent coupon MBS at $95–$100 prices, which offer wider nominal spreads, higher yields, and more favorable exposure to falling interest-rate volatility relative to the lower coupon MBS that dominate the index. If rates move lower,
Agency RMBS Cumulative Excess Returns Turned Positive in Q4 2023 US Agg
Agency CMBS
Agency RMBS
1.5% 1.0% Cumulative Excess YTD Return
While mortgages trailed other subsectors of the Bloomberg U.S. Aggregate Bond Index for the entirety of 2023, investors who allocated to the sector at the end of the third quarter when valuations were historically attractive were able to capture significant outperformance.
By Louis Pacilio
0.5% 0.0% -0.5% -1.0% -1.5% -2.0% Jan. 4
Feb. 15
March 29
May 10
June 21
Aug. 2
Sept. 13
Oct. 25
Dec. 6
Source: Guggenheim Investments, Bloomberg. Data as of 12.31.2023. Past performance does not guarantee future returns.
Fixed-Income Sector Views | 1Q 2024
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Commercial Real Estate
When Maturity Means Default What the looming maturity wall means for office mortgage loans. Nearly $1.2 trillion of commercial mortgage loans will mature in 2024–2025. Office loans make up over 17 percent of those maturities, according to the Mortgage Bankers Association. With few lenders making new office loans, we anticipate that the existing mortgage lenders will be forced to either extend maturity or declare the loans in default. Some borrowers whose loans are underwater may simply hand over the keys at maturity. This maturity wall will create stress for smaller commercial banks in particular. Of the commercial real estate exposure held by banks, Green Street estimates that 75 percent of the loans are held by local and regional banks with less than $250 billion in deposits. This stress is coming at a time when these same banks have struggled to retain deposits and have experienced increased funding costs, so they have less room to absorb losses from maturing loans. We have already seen this happening. From July to September 2023, only about 10 percent of maturing office CMBS loans paid off at maturity on original terms, according to Moody’s. Although the percentage improved at the end of the year with Treasury rates moderating in the fourth quarter, there is limited capital available to refinance maturing loans, especially in the office sector. Several factors are contributing to this stressed situation. The carry cost of mortgage debt has increased materially, with current
Nearly $1.2 trillion of commercial mortgage loans will mature in 2024– 2025. Office loans make up over 17 percent of those maturities, according to the Mortgage Bankers Association. With few lenders making new office loans, we anticipate that the existing mortgage lenders will be forced to either extend maturity or declare the loans in default.
mortgage rates two to three times higher than they were when the loans were originated. At the same time, the post-pandemic decline in demand for office space is putting downward pressure on rents and property values. Operating costs, particularly insurance costs, have increased significantly. Lenders that are willing to make a mortgage loan secured by an office property today are underwriting to very conservative standards. To achieve a mortgage refinancing, borrowers may be required to contribute fresh equity, which some are unwilling to do when current property values demonstrate that the loan may be underwater. During the Global Financial Crisis, lenders were able to limit losses from maturing loans by simply extending maturities to bridge the loans into a more favorable refinance climate. With the reset in property values that we are seeing in the office sector, buying time in the current market may not be enough to avoid losses on maturing office loans. In an environment like this, commercial real estate investors and lenders must be extremely vigilant in assessing their existing portfolios and run draconian stress tests before committing new capital. This highly illiquid environment, however, may create opportunistic buying opportunities for savvy investors willing to take a long-term view.
By Jennifer A. Marler and Farris Hughes
Nearly $1.2 Trillion of Mortgage Loans Will Mature in 2024–2025 Office
Apartment
Industrial
Retail
Lodging
Other
$728bn $127bn
$660bn $102bn
$101bn $55bn $71bn $185bn
$189bn 2023
$60bn $64bn $62bn
$541bn $66bn $44bn $55bn $42bn
$383bn $45bn $46bn
$255bn
$243bn
$34bn
$21bn
$323bn $40bn $18bn $35bn $22bn
$178bn
$144bn
$117bn
$91bn
$59bn
$64bn
2024
2025
2026
2027
Source: Guggenheim Investments, Mortgage Bankers Association. Data as of 12.31.2023.
Fixed-Income Sector Views | 1Q 2024
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Longer term bonds are more sensitive to interest rate changes and subject to greater volatility than those with shorter maturities. During periods of declining rates, the interest rates on floating rate securities generally reset downward and their value is unlikely to rise to the same extent as comparable fixed rate securities. Investors in asset-backed securities, including mortgage-backed securities, collateralized loan obligations (CLOs), and other structured finance investments generally receive payments that are part interest and part return of principal. These payments may vary based on the rate at which the underlying borrowers pay off their loans. Some asset-backed securities, including mortgage-backed securities, may have structures that make their reaction to interest rates and other factors difficult to predict, causing their prices to be volatile. These instruments are particularly subject to interest rate, credit and liquidity and valuation risks. 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