The first half of 2022 has been a challenging market environment, for both equities and bonds. A combination of rapidly rising interest rates, spiraling inflation, and slashed earnings forecasts weighed heavily on equity valuations in the second quarter, with the market officially entering a bear market. The S&P 500 declined -16.1% during the quarter and is down -20.0% for the first half of the year, its worst first six months of a calendar year since 1970. Our Structured Credit Value strategy returned -2.21% gross of fees (-2.57% net of fees) during the quarter, while the Barclays Aggregate returned -4.69%.
After raising the fed funds rate by 25bp in March and ending its $5 trillion Quantitative Easing (QE) program, the Federal Reserve was forced to accelerate and escalate its tightening efforts by raising rates 50bp and 75bp at its May and June meetings. After the CPI reached a new high of 8.6% YOY in May, Chairman Powell admitted that the Fed had made policy errors, including deeming inflation to be a transient phenomenon caused by supply chain disruptions and that the high inflation from earlier this year would eventually taper by year-end. The reacceleration of inflationary pressures led by energy, food, and services components forced the Fed to reaffirm its commitment to maintaining a 2% inflation target and to raise rates by 75bps for the first time since 1994 (despite Powell all but ruling out the possibility at the May meeting). Supply chain disruptions stemming from the military conflict in Ukraine and its related sanctions on Russian energy supplies, along with disruptions of Ukrainian grain exports, continue to create inflationary pressures. China’s Covid related lockdowns have also added to supply chain disruptions. Thus, in reaffirming their commitment to combatting high inflation, Fed members have pushed the median Fed dot to 3.375% by the end of 2022, well above their long term fed funds rate of 2.5%.
Any investors looking to find a refuge in the bond market were left deeply disappointed in Q2. Leading up to the Fed’s June meeting, both the 2-year and 10-year Treasury yields briefly surpassed the 3.5% mark as market participants and short sellers aggressively sold Treasuries following the higher than expected CPI print, the anticipation of hawkish Fed actions, and potential QT effects. However, Treasury yields declined by around 60bp from mid-June to the end of quarter as a recessionary narrative began to take center stage and pushed aggressive Fed tightening into the background. While Jerome Powell remains confident of engineering a soft landing, he acknowledged that it will be very difficult to avoid a recession while dealing with inflationary pressures.
During the quarter, 2-year and 10-year Treasury yields went up by 62bp and 67bp respectively. The Bloomberg Aggregate Index suffered a -4.69% loss in Q2 bringing its total YTD return to a staggering -10.35%. Bloomberg IG Corporate index has had a rough year, largely attributable to the rate move, although the Corporate Index OAS to Treasuries has widened about 65bp in 2022. High Yield spreads widened by 250bp in Q2 as a combination of financial tightening and elevated uncertainty regarding inflation and growth prospects weighed heavily on investors’ minds. Interest rate volatility has been extremely elevated and approaching levels seen during the GFC in 2008/2009, while liquidity has been poor in the fixed income markets, as the Fed’s backstop bid has vanished due to QT.
RMBS performance was dominated by the macro risk-off sentiment that was prevalent across all risk assets in Q2, while housing fundamentals remained solid. Homeowners added to $11 trillion of tappable equity as home prices rose by 30% over the last 2 years and 9.5% since the start of 2022, based on S&P Case Schiller data. This additional home equity helped to accelerate deleveraging across RMBS deals and contributed to significant ratings upgrades. While seasoned RMBS deals were helped by HPA growth, new issue deals faced challenges from rapidly rising mortgage rates. From November 2021 to June 2022, mortgage rates experienced an unprecedented doubling from around 3% to 6%. A combination of historical home price increases and higher mortgage rates has caused housing affordability to decline to the lowest level in 13 years. The dramatic rise in mortgage rates has also eliminated refinancing incentives for the majority of borrowers, which has lowered prepayments across the sector.
Due to meaningful spread widening, supply of Prime Jumbo deals slowed down in the first half with $16 billion issued, compared to $52 billion for calendar year 2021. Banks are choosing to retain originated loans on their balance sheet rather than sell in the new issue market where execution on Prime Jumbo BBB-rated subordinate tranches has widened from 290bp to 450bp year to date. Also notable, 100% of new issue deals have been backed by non-conforming collateral, as conforming collateral has much better execution in the Agency market at current wide Prime Jumbo spreads.
The CRT market had another unprecedented quarter as GSEs issued $17.5 billion of supply during the first half compared to $5 billion in 2021. All CRT tranches suffered meaningful spread widening as negative technicals continued to overwhelm solid credit fundamentals. The record amount of new issue supply coincided with significant outflows from bond mutual funds. Hence, liquidity was challenging with secondary volumes totaling $23 billion YTD, a 12% decrease from 2021. New issue deals are trading wider to more seasoned vintages as investors have a clear preference for deals with greater embedded HPA. Concerns about home price deceleration and slow prepayment speeds are at the forefront for new issue CRT collateral.
The Non-QM sector also saw significant supply in the first half at $23 billion, despite increasing rates. Spreads on AAA bonds widened from 175bp to 200bp in spite of the fact that investors are running deals more conservatively to maturity rather than to call and at slower prepayment speeds. Similarly, BBB tranches widened from 300bp to 350bp under the more conservative assumptions. This makes sense as the vast majority of Non-QM collateral is not refinanceable with just 6% of loans having WAC greater than 6.5%. On a positive note, the majority of new issue deals contain coupon step-up provisions after 4 years which incentivize issuers to call deals. These step-ups provide additional yield enhancements to Non-QM tranches.
Issuance of RPL/NPL deals have slowed down in 2022, to $10 billion, due to lack of collateral from pre-crisis origination. Prepayments on RPL backed deals have shown limited volatility as they benefit from credit curing and turnover. Investors have paid up for RPL seniors and subordinate tranches due to better collateral convexity with senior AAA tranches clearing at ~180bp and subordinate BBBs at 300bp. Legacy RMBS securities have also benefited from superior convexity characteristics but have suffered from poor technicals as most money managers and hedge funds active in Legacy have been plagued by redemptions. As a result, spreads on long duration subprime mezzanine tranches widened from 175bp to 350bp in the first half, with shorter duration fixed-rate and hybrids seeing about 125bp-150bp of spread widening.
The CMBS market traded in line with general macro risk-off conditions, with investors first concerned about run-away inflation and the Fed’s hawkish response to it, followed by concern about the impact of higher mortgage rates and cap rates on the refinancing prospects of CRE loans. CMBS became further bifurcated along sector exposures and sponsorship quality with deals backed by multifamily and industrial properties and strong sponsors trading at a premium to deals backed by high office/regional mall exposures and weaker sponsors. So far cap rates have not kept pace with interest rates moves which means that cap spreads have tightened relative to treasuries. CRE delinquencies continued to tick down with 30+ day delinquency rates falling to 3.1% in May.
The Special servicing rate also fell in Q2 to 5.1%. Lodging and retail sectors again saw the biggest improvement in delinquency rates with 30+ day delinquencies falling to 5.8% and 6.6%.
CMBS SASB outperformed their fixed rate companions as floating rate coupons and low effective duration attracted investors during the rapid interest rate rise. Similar to conduits, SASBs saw bifurcation along collateral and sponsor types. High quality AAAs widening from 150bp to 180bp while single-Bs saw spreads widen to low 600s. Credit performance for SASB deals continued to be superior to Conduits with only a 1.2% 30+ day delinquency rate. CRE CLOs saw AAA spreads widen to 250bp and BBBs to 500bp in Q2. The Small Balance commercial sector saw similar spread widening as senior AAA spreads widened from 160 to 230bp while subordinate BBBs moved from 280bp to 435bp.
Similar to other securitized sectors, ABS spreads have widened with tightened financial conditions. Spreads on ABS senior and subordinate tranches have reached levels last seen in June 2020. Against this backdrop of wider spread levels is very solid credit performance. At 3.5% and 2.5% respectively, delinquency rates on subprime auto and marketplace lending are below 2019 levels, primarily due to increases in wages and disposable income, which is up 11% relative to pre-Covid levels. Roughly $3 trillion of excess savings built up from Covid stimulus packages have greatly contributed to lower ABS consumer delinquencies. ABS deals also benefit from structural advantages relative to RMBS/CMBS deals given the significant amount of excess spread built in. In addition to credit enhancement, which is currently around 2x expected losses for investment grade tranches, ABS securities deploy excess spread as the first line of defense against rising defaults and losses. So while delinquencies and defaults are expected to rise and normalize relative to current low levels, we do not believe that ABS securities are in danger of substantial write-downs as their structural protections should allow them to stand up to a recessionary environment.
CLOs and leveraged loans outperformed their fixed rate counterparts in the first half of 2022. Institutional and retail demand for floating rate assets offset some of the spread widening stemming from the macro-economic situation. Leveraged loan defaults remain at historical lows. However, given that spreads on CLO tranches are only slightly wider relative to non-recessionary averages, CLOs remain vulnerable to further spread widening.
Primary CLO volume has trailed the record issuance numbers of 2021 with $74 billion of new issuance in 2022 relative to $84 billion at the same point in 2021. During the quarter, there were some positive credit developments as the percentage of CCC loans in broadly syndicated deals dropped down to 3.8% vs. 5.7% a year ago due to ratings upgrades, allowing Over-Collateralization ratios to remain healthy. On the negative side, with S&P Leverage Loan index average price dropping from 98.64 to 92.16, MVOC for all CLO tranches declined in the first half of 2022 with MVOC for BB rated tranches falling 7 points below par bringing MVOC ratios back down to June 2020 levels.
CMS Linked notes continued to suffer from rate and spread moves in Q2, with the 2-year, 10-year and 30-year swap rates up by 72bp, 69bp, and 70bp respectively. Unlike the extreme curve flattening seen in Q1, the curve has not flattened as much in Q2, but the swap curve remains inverted between 2 and 10- years (-18bp) and 2 and 30-years (-33bp), causing the coupon for most CMS Linked notes to be zero in Q2. In addition to low coupon rates and higher discount factors, credit spreads on banks that issued these CMS linked notes have widened. Corporate Structured Notes offer excellent optionality to a steeper curve and, as deep discounts, are still generating approximately 3.5% from price accretion to par. In terms of actual credit risk, bulge bracket banks should be in a decent shape to absorb capital hits during a recession since they are much better capitalized due to reforms post-GFC. High multiple CMS spread floaters were down 10-12% in Q2, while lower multiple CMS spread floaters suffered 12-15% declines.
Portfolio Attribution and Activity:
For the quarter, Structured Credit Value posted a gross return of -2.21% versus the Barclays Aggregate Index return of -4.69%. The second quarter completes one of the worst performing first halves in the history of US bond markets. Structured Credit Value’s significantly lower duration and higher yield, relative to the Barclays Aggregate, accounted for most of the outperformance.
Q1 2022 Portfolio Attribution
Attribution represents Net-of-fees mutual fund performance
The strategy had an allocation to short duration, high carry securities trading around par that posted positive returns by offsetting small price declines due to spread widening with high coupons. Corporate Structure Notes continued to be the main drag on the performance. CMS spread floaters suffered additional declines in Q2 due to higher rates and corporate spread widening.
Among the notable transactions in Q2, we increased our allocation to shorter duration, higher carry RMBS securities, which behave like high yielding cash equivalents. These were purchased at spreads above 300bp despite their high credit quality. We also added Prime 2.0 investment grade subordinate tranches at spreads above 350bp. We added exposure to new-issue Non-QM BBBs at spreads above 300bp when run to maturity. In CMBS, we continued to add investment grade tranches at the top of the credit stack at spreads ranging from 250bp for AS to 350-400bp for AA/A bonds that have duration inside of 2 years. Finally, we added to our ABS exposure, in subprime auto BB rated subordinate tranche at a spread above 700bp and a short AA rated senior tranche backed by precious metals loans at 5.25% yield.
We believe that the more transient drivers of inflation, for example supply chain disruptions and pent-up demand from Covid lockdowns, will begin to abate later this year. However, we believe that CPI statistics will likely remain elevated throughout 2022, as housing inflation, in the form of rent inflation and owners’ equivalent rent, converge with HPA increases and higher asking rents and become reflected in the inflation measure. Thus, we believe the Fed will have plenty of justification to continue with its hawkish path. Given the continued upward pressure on rates and their potential impact on economic growth, we believe credit spreads will remain volatile throughout 2022, potentially widening from current levels at times.
Due to expected spread and interest rate volatility, we plan to maintain our current 2-year duration on the overall portfolio and maintain ample liquidity in the form of cash instruments and Treasuries. We continue to focus on carry at the top of the credit stack in RMBS, CMBS, ABS, and CLOs, but are prepared to tactically add risk during periods of significant dislocation when compensated by wider spreads.
Orange Investment Advisors, LLC is an investment advisor registered with the SEC. Registration does not imply a certain level of skill or training. All information in this communication has been obtained from sources believed to be reliable but cannot be guaranteed. There can be no assurance that the investment objective for these long only strategies can be achieved and past performance is no guarantee of future results. The Bloomberg Barclays US Aggregate is an index of unmanaged securities, and the indices are not securities that can be purchased or sold.