US MBS and CLOs have to find a way through leaner times but ABS blossoms
The eclectic nature of US securitization left some sectors of the market flourishing and others floundering in 2023. Ayse Kelce, Kunyi Yang and Tom Lemmon look at which corners of the market have reason for cheer and whether there’s an expectation of a turnaround in sluggish or struggling sectors
When the US regional banking crisis hit in March, large swathes of the ABS market were able to capitalise on the surge in demand for short-dated, high-quality paper. However, in mortgage-backed securities and CLOs, long standing problems began to bite.
Going into 2024, the idiosyncrasies of each sub-segment of the securitization market are pronounced. While ABS is feeling buoyant, commercial real estate is at a critical juncture, homeowners are dealing with the highest interest rates in two decades, and arbitrage continues to prove harder to find in the CLO market.
Perhaps it’s unsurprising, therefore, that there is little consensus on the big macro concerns of the day.
In GlobalCapital’s survey of US securitization market participants, 46% of respondents expect the overall level of volatility to stay the same, while 27% expect a slight increase and 22% expect a slight decrease.
Similarly, there is little conviction about when the US Federal Reserve may begin cutting interest rates, with 24% of respondents predicting cuts in the second quarter, 34% in the third quarter, and 26% forecasting no rate cuts at all in 2024.
Whatever happens in the broader fixed income markets, the mood among structured finance professionals depends on which type of collateral they focus on.
Undoubtedly, the star of the show in US securitization in 2023 was ABS — or those asset-backed securities not backed by mortgages, and excluding CLOs.
The robust new issue volumes in 2023 — the second highest ever bar 2021, when market conditions were exceptionally strong — beat expectations, and the resilience appears to have built confidence.
Unlike in 2022’s GlobalCapital survey, market participants now expect ABS issuance growth to continue, with 78% of respondents predicting slightly higher volumes in 2024.
“Volume will continue to grow as long as consumer credit keeps growing,” says John Kerschner, head of US securitized products at Janus Henderson. “I would assume that, as far as deal numbers and volumes go, we’ll probably be up about 10% next year.”
How do you expect public issuance volume of ABS (excluding MBS and CLOs) to change in 2024 compared to 2023?
That doesn’t mean 2023 was easy. Persistent inflation and continued rising rates, not to mention the US regional banking crisis in March, meant that investors focused on preserving liquidity and taking care of their duration exposure.
Yet these considerations often played into the hands of the ABS market, which offers highly rated paper with short duration. This is especially true of benchmark sectors like prime auto loan and credit card ABS, where bonds have ample liquidity.
“I think a lot of people are a little scared of duration, and if you can get that high yield at the short end of the curve, why wouldn’t you?” says Kerschner. “Why buy seven or 10-year corporate credit at 150bp when you get investment grade ABS with two to three years of duration at 300bp?”
Not only did the ABS market prove more resilient than expected, but so did the US consumer. Despite broad concerns about this in late 2022, many believe that the outlook is positive, supported by tighter underwriting standards.
“The consumer still looks relatively strong even with a low savings rate and unemployment ticking up a bit,” says Kerschner. “In the ABS market, a year ago people were not really expecting that to be the case. It’s worked out much better than expected.”
Zachary Aronson, securitized products research analyst at MacKay Shields, tells GlobalCapital that he is “more comfortable” with ABS and RMBS than unsecured corporates or CMBS.
Auto ABS, which accounts for around half the market, will again drive growth in 2024, with banks and credit unions set to become more active issuers in the sector as the asset class becomes an attractive way to find balance sheet relief. But several market participants, including Kerschner, also expect credit card ABS issuance to tick up in 2024, and forecast higher volumes across sectors like consumer loan and equipment ABS.
There could also be reason for optimism on spreads, given the likelihood that the Fed is coming to the end of its tightening cycle.
“It would be stability that can drive spreads tighter in ABS, not necessarily rate cuts,” says Aronson. “Spreads are historically wide, so there is some room for tightening.”
The majority of survey respondents expect slightly tighter spreads for ABS overall, and for both auto ABS and consumer ABS, though opinion is more divided on where esoteric ABS spreads are headed.
“We’ve come a long way, particularly in auto, at the top of the capital stack,” says Kerschner. “But we’re still a lot wider than corporate credit.”
Do you expect ABS spreads to be wider or tighter at the end of 2024 than at the end of 2023?
Kerschner also believes that banks will increase their investments in ABS as the yield curve steepens.
“I think banks will feel more constructive about putting money to work in securities, particularly because they’re not making as many loans,” he says. “That bank bid, at least at the top of the capital stack, is super important. I do think you’ll see more and more banks allocate money into the market.”
RMBS: esoterics to fore
It is a different story in the US RMBS market, which has suffered its slowest year of issuance since 2016, according to Finsight data — its second consecutive sharp fall in annual volumes.
More than half of the participants in the survey now believe that it is time for a turnaround, with a quarter even responding that overall public issuance in the asset class will grow “significantly” in 2024. Sonny Weng, vice-president at Moody’s, says that growth is going to come from non-traditional sources.
“I think people think [issuance] will be a little higher because of the optimism around more [non-qualified mortgage (non-QM)] and other esoteric asset classes,” says Weng. “This year we have seen the rise of [home equity line of credit], close-end second lien, and other home equity extraction products, and that will likely continue into the next year. Non-QM will also hum along.”
Indeed, with interest rates expected to remain elevated, issuance from more traditional RMBS sectors like prime jumbo should remain muted. If overall volumes are to increase, the burden will be on niche products.
“[In 2024] prime mortgage origination will dry up, and even the rise of the more niche products is not likely to fill that gap,” says Weng.
The difficulty for traditional mortgage products is that it appears unlikely that mortgage rates will drop meaningfully in the next year. In late October 2023, the average 30-year mortgage rate in the US peaked above 7.6% — its highest level since 2001.
“I don’t expect the mortgage rates to go back to even the 5% range,” says Weng. “At best it will go down to the 6%-7% [range].”
On housing prices, there is no consensus. Around half of survey respondents believe that they will be slightly higher in 2024 than 2023, while the other half think they will fall slightly.
There are two competing dynamics at play in the housing market: inventory and affordability. As mortgage rates remain high, people are choosing not to move, suppressing sales inventory, and thus supporting house prices. On the other hand, higher mortgage rates are dampening demand for mortgages, which puts pressure on house prices — especially on the West Coast.
“Our assumption is that affordability is going to trump inventory,” says Weng. “It is not going to be as [large] as in the global financial crisis, but we are predicting a housing correction of around 5% next year.”
Similarly, in the CMBS market there is no clear consensus on where primary issuance will go, with a broadly even split among respondents as to whether it will increase or decrease in 2024.
Mark Fontanilla, founder of fixed income consulting firm Mark Fontanilla & Co, believes that the uncertainty lies in what’s going to happen in the office sector and how many loans can be refinanced.
How do you expect public issuance volume of CMBS to change in 2024 compared to 2023?
“[In 2024] we have a significant maturity wall coming, and I think it is possible that we will see more refinancing of those loans backed by good assets,” says Fontanilla. He predicts higher volumes, based largely on the low bar set in 2023.
Yet at the same time, the office sector is likely to face more liquidations and foreclosures. The chances of refinancing these assets will be slim.
As of mid-November, there had only been $30.8bn of non-agency US CMBS issuance in 2023, through 52 deals. This is down by more than half from the $66bn that was raised in 2022 through 85 deals, according to Finsight data.
Although there is not much expectation of lower interest rates, there is at least optimism of more stability in the rates market in 2024, making execution of new issues smoother, driving primary issuance higher.
Yet stability does not necessarily equate to a lower cost of capital. Most respondents to the survey believe that CMBS spreads will be even wider in 2024 than they were this year, which Fontanilla thinks is partly the result of more downgrades — especially in the office segment — as the asset class’s performance deteriorates.
“When there are more downgrades, it affects liquidity and pricing, and that means wider spreads,” he says. “But there will be opportunistic buyers who are ready to buy at cheap levels.”
Will CMBS spreads be higher or lower at the end of 2024 than at the end of 2023?
There will still be bright spots in the market. Survey respondents are more bullish on issuance prospects for industrial, multifamily, and high-end hotels, for example.
“Industrial, especially storage with strong leases, and data centers will see a lot of demand,” says Fontanilla, “But there will be a question around whether there will be enough rent growth next year to support multifamily financing costs.”
Which of these asset classes within CMBS will see higher volumes in 2024 than in 2023?
As of mid-November, the US CLO market looked on course for the worst year of issuance volumes since 2016. One might think that the only way is up in 2024, and two thirds of participants in the survey predict that issuance will pick up in 2024.
Yet that is hardly an overwhelming vote of confidence, and 13% of participants are even braced for lower issuance again in 2024.
Indeed, Serhan Secmen, head of US CLO investments at Napier Park, estimates that the range is likely to be somewhere between $90bn and $110bn for 2024. He is leaning closer to $90bn, but even the upper end of that range would represent a reduction: as of November 27 there had been $113bn of US CLO issuance year-to-date in 2023, according to data from Finsight.
For one thing, Secmen expects loan defaults to rise, having stayed resiliently low in the face of rapid rate increases since 2022.
“We believe the ability [of borrowers] to withstand a high rate environment with hedging is coming to an end, and that could translate into defaults around mid to late 2024,” says Secmen.
An uptick in defaults could be paired with a broader slowdown in the US economy, and this could see the Fed begin to lower rates. For Secmen, how CLOs fare as rates start coming down is the main question the market will have to answer in 2024.
On credit events, Secmen’s concern is in line with GlobalCapital’s survey results, in which 87% of respondents said they expect an increase in the default rate, and one in five expect a “significant” rise. Alongside this, 83% are forecasting an increase in loan downgrades.
The interesting dynamic for CLOs comes in what happens to spreads. In a weaker economy, investors could head for safer and more liquid assets like triple-A rated CLO debt, which could paradoxically mean spreads tighten towards the 150bp mark. Lower-rated tranches are unlikely to fare so well, reversing the demand dynamic of most of 2023.
Secmen believes investors will remain cautious and that demand will therefore be muted across the capital stack.
In Miami in October, at IMN’s ABS East 2023 event, private credit took a bigger share of attention than ever before. Yet some CLO market practitioners were keen to defend their territory.
Josh Eisenberger, head of US CLO management at Sculptor Capital Management, for example, predicted on a panel that when defaults rise, it will be collateral held by private credit firms that will be most likely to feel the pinch.
“I can tell you that a lot of the stuff that the BSL market does not choose to finance because they don’t like the credit profile [...] is what is being financed in the private credit market,” he said at the conference.
However, Secmen of Napier doesn’t necessarily see private credit as a threat for the CLO market. Rather, he suggests private credit investors help to pick up the debris of the leveraged finance world.
“They are usually focused on the lower part of the credit spectrum, where CCCs and B- [rated assets] are their natural targets,” says Secmen. “In that sense, they are like the oysters of the CLO market.
“They are long-term and patient money. [Private credit] is not going to blossom in one year and blow up the next; this is not Bitcoin or NFTs. I think the lifecycle for private credit is slower.”
A key question in 2024 will be what the evolution in the credit cycle means for the growth of private credit CLOs, which have been a hot topic in the market for most of 2023.
Survey respondents broadly believe that private credit CLOs will increase their market share versus BSL deals, with 64% expecting issuance to increase and only 14% predicting a “slight decrease”.
Nevertheless, Secmen believes there is some truth to the argument that private credit has questions to answer over resilience and performance.
“No market segment draws so much attention and doesn’t have any issues eventually,” he says. “It’s not going to be different for private credit.”
As another CLO investor says, the low interest rates of the last decade made it difficult for debt managers to lose money — but also difficult to stand out. 2024 could be the year that sorts the good from the lucky.