Securitized Views—Q1 2021

    Franklin Templeton Fixed Income

    Agency Mortgage-Backed Securities (MBS):

    The housing market has rebounded since April, and the supply of mortgages is expected to increase in coming months. Prepayment risk in the MBS market remains elevated as US mortgage rates have reached record-low levels 16 times this year, including the month of November. As the economy normalizes, we expect prepayments to rise, with 80% of the agency MBS universe having an incentive to refinance at current rates. Primary and secondary market spreads remain elevated, and while prepayments are their highest levels since 2012, refinance activity should be much higher. If these spreads were to normalize to historical averages, 90% of the mortgage universe would have an incentive to refinance their loans. However, forbearance requests have started to taper, which could lead to lower involuntary prepayments in the coming months. To mitigate prepayment risk over the intermediate term, we prefer to be positioned down in coupon in 2.0% and 2.5% coupons. Technical support from Federal Reserve (Fed) MBS purchases will continue to bolster the MBS sector, potentially limiting spread widening and keeping spreads rangebound which will benefit lower coupons and associated mortgage dollar rolls.

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    Visit Global Fixed Income Macroeconomic & Sector Views: Q1 2021 to learn more about our outlook for each sector.

    Elevated prepayment risk, combined with yield spreads near their 10-year averages, led us to retain our neutral recommendation on agency MBS. While we remain neutral, we believe there is room to add MBS on market dips and the asset class continues to provide good carry and could benefit from corporate credit crossover buying. Within MBS, we prefer 30-year securities over 15-year securities and generally favor conventional 30-year and conventional 15-year securities prepayment characteristics over Ginnie Mae (GNMA) 30-year securities.

    In other news that could potentially affect the agency MBS market, the constitutionality of the Federal Housing Finance Agency (FHFA) director position is currently being challenged in the Supreme Court. The current head of the FHFA, Mark Calabria, could be asked to leave or be forced out, which would be positive for the agency MBS market, as it is likely that government-sponsored enterprises (GSEs) continue to remain under conservatorship. And we could see more securitization in the agency MBS market. The Trump administration appointed Mark Calabria in 2019, and the term of the contract is set to expire in 2024. If Calabria were to remain in his position under President-elect Joe Biden’s administration, he could continue administrative reforms of higher capital requirements (recap and release) until the end of his term in 2024. This would be a negative for the agency MBS market, as the cost of securitization through the GSEs would increase to facilitate the higher capital requirements.

    The Fed has actively participated in the Agency MBS market this year, purchasing $1.3 trillion worth of securities through the end of November. The Fed is expected to continue its active role in the MBS markets, absorbing a large share of the market supply, which should keep spreads well supported and rangebound. The Fed currently owns 29% of the Agency MBS market. Balance-sheet scrutiny of Agency MBS holdings could begin, as it did in the first round of quantitative easing (QE1), as the ownership approaches 33% of the market. We could see spread widening if the Fed were to alter its Agency MBS purchases. However, we believe the Fed would be more measured in its program changes, with more transparent communication, compared to what was experienced during the so-called “taper tantrum” of 2013.

    Non-Agency Residential Mortgage-Backed Securities (RMBS):

    US housing has been resilient despite facing the biggest downturn since the global financial crisis (GFC). Limited home supply coupled with strong demand and historically low mortgage rates should keep home prices supported over the short to medium term. Year to date through August 2020, home price appreciation stood at 3.82%, and our model forecasts 2.7% home price appreciation (HPA) through Aug 2021. Supply and demand forces continue to be supportive for housing. Despite headwinds in the market, we still expect non-agency RMBS to provide strong risk-adjusted returns and we are upgrading our 12-month outlook to neutral with reasons for optimism.

    While new delinquencies are tapering, roll rates to late-stage delinquencies remain elevated. This was expected as borrowers are likely to take up forbearance plans when facing hardship or job losses. Forbearance has given borrowers the time needed to get back on their feet while keeping foreclosed homes from flooding the property market. Currently, about 2.8 million borrowers are under some forbearance plan. If we consider all these property owners eventually default and the properties make their way into the market for sale, the inventory levels would be far lower from the levels we saw in the GFC (when home prices dropped 30%). Based on current delinquency pipelines, prepayment speeds and credit enhancement, we do not expect any losses in fixed severity last cashflow tranches without the natural disaster language. However, overall deal losses are expected on some transactions.

    Driven by low mortgage rates and high home price appreciation, prepayments have been elevated for most non-agency RMBS products. This has allowed credit enhancement levels to increase and structures to deleverage, thereby alleviating some credit concerns. New and existing home inventory combined, at 1.756 million units, are near their historically lowest levels. The September existing home sales at 6.54 million units (annualized) is the highest level since June 2006. Pending home sales were up 22% in September, indicating the seasonal fall lull for housing may not occur this year.

    Overall spreads in various RMBS sectors have recovered 85%-100% since March wides, but early fixed-severity deals which do not contain natural disaster language have recovered only 66% from their wides in mid-May. A second COVID-19 wave-led downturn could cause a resurgence of volatility and RMBS spread widening and market value fluctuations. The risk of natural disasters such as hurricanes and earthquakes continue to remain a tail risk for CRTs and may negatively impact valuations if they were to occur. We expect 2016 credit risk transfer (CRT) cohorts to provide the highest risk-adjusted returns. Fixed Severity CRT transactions could benefit from risk-on across markets and migrate closer to par. We have confidence in CRTs, but do not anticipate increasing our exposure.

    Non-agency RMBS supply is approximately 17% lower than the same period last year. In CRT, supply will be constrained given that Fannie Mae has paused new CRT issuance after the Federal Housing Finance Agency’s (FHFA’s) proposed capital rule for GSEs in May, but Freddie Mac has issued four CRT transactions since July, which were generally well-received by investors. The combination of the FHFA-proposed GSE capital rule and the lack of regular CRT issuance, may lead some investors to re-evaluate the sector for liquidity issues.

    The outcome of the US elections should not have a material impact on housing dynamics, but greater fiscal stimulus is likely, which is positive for mortgage and other credit products. Fiscal stimulus has provided relief and helped borrowers remain current on mortgage and rental payments, and any further stimulus should help keep homeowners, particularly low-income homeowners, stay current or provide the potential for down-payment savings. Higher individual tax rates could impact housing affordability, but additional stimulus may create a meaningful offset. Any delay in government-sponsored enterprises’ (GSEs) reforms could postpone anticipated disruptions in the housing market due to privatization of the GSEs. Reducing the racial housing gap, along with a push for affordable housing programs, may increase first-time home borrowers. Additionally, the potential repeal of state and local tax cap could be a substantial tailwind for higher-priced homes in high-property tax areas.

    Commercial Mortgage-Backed Securities (CMBS):

    The fundamental credit backdrop in the Commercial Real Estate (CRE) sector continues to be challenged. CRE Transaction volumes, a leading indicator for property valuations, are, on average, down by 65% YoY as of September and it is evident that there continues to be a widening bid/ask in the commercial real-estate market. Significant headwinds exist in the short to medium term for CRE. A resurgent second wave followed by stricter implementation of lockdowns and near non-existent direct support to CRE sponsors makes matters worse for the sector. CMBS conduit delinquencies (30+ days) continued to be elevated at 7.9% as of September and, as expected, hotel and retail delinquencies continue to be significantly higher than other property types such as office, multifamily and industrial. AAA last cashflow (LCF) spreads have continued to tighten and are currently at the tighter end of historical levels. We believe downside risks outweigh upside potential at these levels. We continue to maintain a bearish outlook on CMBS, and we remain positioned up in the capital structure in CMBS transactions with solid credit fundamentals.

    Low issuance coupled with the street pushing cleaner deals has helped maintain tighter spreads in New Issue LCF AAA’s. Looking 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 pricing. Given current valuations, we would not add below-AAA CMBS exposure and in AAA LCFs, we prefer deals with lower exposure to hotel and retail sectors. The silver lining for CRE remains the industrial sector which has continued to demand higher rental rates and is witnessing low vacancy levels, but we believe the valuations in this sector are pricing in all the optimism.

    From a sub-sector perspective, we believe retail and hotel sectors are currently in the recession phase in the commercial real estate cycle, which is typically characterized by negative and below inflation rent growth, increasing vacancies and increased completions. Multifamily and office sectors are in the hyper-supply phase, which generally witnesses increased vacancies, new construction, and a slowing, but positive rent growth. Industrial is strongly placed in the expansion phase which is characterized by declining vacancies, new construction, and high rent growth.

    The impact from a Biden Administration on the sector will likely include greater scrutiny of CRE taxation, as President-elect Biden has proposed a plan to invest $775B for a “caring economy” over 10 years, which would be funded by ending tax breaks for real estate investors and ensuring high-income earners pay their taxes. Additionally, under a Biden Administration, renewed contagion of COVID-19 will likely be met with a stricter enforcement of lockdowns which would be a further drag to sectors like hotel and retail.

    From a stimulus standpoint, the Non-Agency CMBS sector has not received any meaningful support from the Fed. The Paycheck Protection Program (PPP) and the Main Street Lending Program (MSLP) did not provide direct aid to CRE owners/sponsors. Inclusion of Conduit LCF AAAs for the Term Asset-Backed Securities Loan Facility (TALF) program and liquidity support from Primary Dealer Credit Facility (PDCF) did little to stimulate the CMBS market (of note is that New Issue Conduit LCFs are not eligible for the TALF program unlike in CLOs and ABS). Due to the TALF program, however, AAA LCFs have a backstop in spreads. At current spread levels, we do not think they look appealing for TALF but may garner interest if spreads widen out by 20-30 bps. We believe approximately 85% of the market has no direct Fed support and this has resulted in high delinquencies in sectors like hotel and retail. Conversely, Agency CMBS purchases by the Fed helped the sector by tightening the spreads close to 52-wk tights. Despite which administration is in the White House, it will be tough to support the sector, especially due to public opposition to relief for CRE owners/operators. We are of the opinion that the extent and size of any additional stimulus may not necessarily help the CRE sector directly.

    Asset-Backed Securities (ABS):

    The ABS market has rebounded significantly post the COVID-19 selloff with robust primary and secondary market activity and spreads for most prime subsectors at pre-COVID tights. TALF has been minimally utilized and we believe requests for TALF loans to finance ABS (auto, card, equipment, floorplan, premium finance and private student loan ABS) will remain low as current spread levels for most sectors result in negative TALF yields. We expect the credit performance of consumer-related ABS sectors to largely reflect the performance of the broader lending market with performance expected to vary by loan type. Specifically, we expect higher delinquency and charge-off rates as COVID-19 related payment relief programs expire, the second round of stimulus is likely to be smaller and, although it's expected to continue to improve but at a moderate pace, the unemployment rate remains at elevated levels. Even so, the faster-than-expected improvement in the employment situation should result in a more muted credit outcome for most sectors. We expect overall credit performance for retail auto loan ABS to deteriorate in 2021 as lender-based deferral programs end, on top of elevated unemployment.

    In recent months, a large increase in payment deferrals has resulted in a dramatic decline in delinquencies and charge-offs in both the prime and subprime auto loan ABS markets. As borrowers exit these programs, however, we expect a portion will be unable to resume making payments. This will likely pressure credit metrics. We expect overall credit performance for credit card ABS to deteriorate in 2021 due to slower receivable growth and, similar to other consumer debt sectors, elevated unemployment, the end of payment relief programs, and the likelihood of a smaller stimulus package. Even so, we do not expect charge-offs to reach levels comparable to the last recession. We remain neutral on prime consumer ABS, as spreads offer little incremental yield pickup versus cash alternatives and expectations for fundamental pressures on trusts will remain. Given the relative flatness of the credit curve, we prefer to be up in the capital structure at the AAA level in both prime auto and credit cards, and we are avoiding non-benchmark ABS, despite the incremental yield pickup in the lower quality, albeit thinner, tranches. Additionally, we would avoid subsectors such as aircraft and container ABS that face an uncertain outlook as well as floating-rate bonds without explicit LIBOR fallback language.

    The impact from the outcomes of the US election should have a minimal impact on the ABS market. A divided government limits possible legislative action and even if Democrats win both seats in the Georgia runoff election in January, their margin will be slim and contingent on the votes of more moderate Democrats. The sub-sector that could see a possible impact is student loan ABS (SLABS), although even that outcome is remote. Senator Elizabeth Warren has called on President-elect Biden to cancel student loans through executive action. Blanket student loan forgiveness is generally considered a progressive agenda item and was not part of the proposed moderate policy that President-elect Biden ran on. Additionally, while there is precedent for executive actions on forbearance and temporary payment relief for student loan borrowers on federal student loans under both the Trump and Obama administrations, executive action on outright debt forgiveness or cancellation for federal student loans will likely test the legality and limits of presidential power. Given the scenario of a divided government under a Biden administration, Republican Senate and Democratic House, with a conservative majority Supreme Court, executive actions will most likely be limited and/or challenged. Outside of student loans, we do not see the prime auto or credit card sectors being directly influenced by the change in the administration.

    Even with another round of stimulus likely to be approved, we believe consumers are likely to maintain financially conservative behavior as COVID-19 headlines are relatively grim with surging cases, potential for further lockdowns and questions remaining regarding vaccine safety, availability and willingness of Americans to be vaccinated. Additional stimulus would help mitigate some of the deterioration we are expecting in the fundamental performance of the trusts.


    WHAT 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.