On the latest episode of the Behind the Markets podcast, we had a fascinating conversation with Don Kohn, former Federal Reserve vice chair, and Dave Goodson, Head of Securitized Fixed Income and Senior Portfolio Manager at Voya Investment Management. We discussed:
- A Policy Debate: In the first half of the episode, Professor Jeremy Siegel and Don Kohn debated the inflationary impulse in the economy and the appropriate path for the Federal Funds Rate. Kohn is more hawkish than the interest rate curve priced into the market, and Professor Siegel is more dovish. Given Kohn’s prior role at the Federal Reserve (Fed), this was an important conversation about how the Fed might approach policy over the coming meetings and into 2023. We are starting to see Fed speakers push back on market pricing that implies rate cuts in 2023 quickly after this hiking cycle, and Kohn’s commentary reflects that thinking.
- Quantitative Tightening (QT): Goodson talks about the opportunities in the securitized credit space and how quantitative tightening could impact the mortgage-backed securities market. Fed transparency and guidance has helped market participants assess quantitative tightening and price in concessions to compensate for perceived risk to securitized debt. But the pace of balance sheet runoff will double in two months, and it is hard to know how an already jittery market will react.
- Attractive Valuations/Opportunities: Currently, the spreads across most of the securitized debt markets Goodson invests in are at levels that reflect outlier scenarios that have occurred less than 1% of the time. Essentially, a lot of bad news has been priced into spreads already. This over-discounting reflects good value for the securitized debt market, in Goodson’s opinion, even though there are many uncertain elements.
- Goodson highlighted two corners of the non-agency residential mortgage-backed market where this over-discounting was pronounced
- Credit Risk Transfer securities – a new type of security in which Fannie Mae and Freddie Mac compensate institutional investors to bear some of the credit risk of their portfolio
- The non-qualifying mortgage-backed market, which pools mortgages from lenders that do not meet specific criteria demanded for mortgages pooled by the government-sponsored enterprises (GSEs)
- For commercial mortgage-backed markets, Goodson sees opportunity in the multi-family space but remains leery of the office space given the trends in work-from-home mindsets
- Diversifying Fixed Income Portfolios: In Goodson’s view, the securitized bond market is under-appreciated by investors, leading to sub-optimal allocations. If you consider the entire range of securitized debt (agency MBS, commercial MBS, non-agency MBS¸ asset-backed (ABS) and collateralized loan obligations (CLOs)), it totals more than $12 trillion (more than $9T in agency MBS and $3T outside of it). The securitized market dwarfs the high-yield market, emerging market bonds and bank loans and starts to compete in total size with the investment-grade corporate bond market.
- With the Fed moving aggressively to tighten policy, Goodson notes some signs of stress from less experienced borrowers and lower income consumers, as reflected in firming default levels for unsecured loans, despite very low levels of unemployment and high wage levels.
