SECOND HALF 2010
Fixed Income Securities Markets
In our view, the rally in fixed income over the past twelve months is attributable to demand-side stimulants and downward revisions in investors' loss estimates. Basic fundamentals still appear weak, whether we look at housing, private sector payroll growth or the potential for higher interest rates. Clearly, market technicals have changed. Whereas buyers of deep credit had the upper hand in early 2009, we now observe more capital at the ready and fewer forced sellers. Prices in high yield bonds, levered loans and mortgage credit are up 50% or more from their lows depending upon the sub-sector. The liquidity phase of the distressed market has passed and a sharper focus on security selection and risk control is warranted.
How should we position our portfolio at this point in the cycle? We recommend investments in residential and commercial mortgage backed securities although careful security selection and tactical flexibility will be the best way to exploit opportunities in the current environment. Over the past two years, public policy and Fed intervention have propped up the financial sector and thereby lifted the capital markets. Federal actions have included re-capitalizing Fannie Mae and Freddie Mac, lowering interest rates, buying Agency mortgages outright and providing leverage to CMBS and non-Agency RMBS investors via PPIP. We like markets that are large, complex and subject to distortions. Looking ahead, we expect to find imbalances — the unintended consequences of public policy — which may be exploited through cross-sector or security specific trades. Some themes may include:
Prepayment Strategies: Uncertainty over borrower behavior and the effects of public policy can lead to mis-pricing in prepayment sensitive securities. Declining real estate values and tighter underwriting standards have made refinancing more difficult than at any other time in the last two decades. Prepayment expectations and asset performance will vary based on location, loan type and borrower attributes. Capacity constraints in the mortgage banking industry are likely to persist in selected market segments, offering potential for excess return on securities whose performance may ultimately differ from current market expectations.
Credit Strategies: We recommend tactical flexibility to actively manage exposure to deep credit. Static or macro beta allocations to credit should be avoided. Non-Agency RMBS and CMBS are complex and collateralized by large pools of loans. For investors, barriers to entry include accurate loan-level information as well as a solid quantitative framework to forecast borrower behavior and credit performance. The opaque nature of non-Agency markets is fertile ground for investors with deep resources and patience.
Relative Value Trading Strategies: Prepayment uncertainty coupled with supply-demand imbalances due to buyer segmentation and lack of dealer risk appetite may create significant trading opportunities in the liquid sectors of the Agency MBS market. More recently, government actions have been a principal cause for performance tiering in different sectors of the liquid mortgage and Treasury markets.
In summary, the mortgage securities market including Agency MBS and non-Agency RMBS appears to offer value provided security selection is informed by skill and caution. We believe distortions due to public policy may persist in these markets for some time. We also see advantages in strategies that are not highly correlated with pure credit or more traditional core fixed income strategies.
Commercial Real Estate Market
We see commercial real estate tracking the trends in the broader economy related to payroll growth, liquidity, interest rates and the potential "double dip" recession. Throughout the year, demand for grade A, cash-flowing properties has steadily increased as capital chases yield in light of historically low treasury rates. These investments should weather short-term market corrections as long as rates remain low and property-specific rent income is supported by high quality tenants. In our view, the current risk premium, implied cap rates and limited upside are indicative of a fully-valued sector. On a selective basis, we are looking elsewhere for better risk/reward. We like transactions on less visible or smaller properties in need of recapitalization where relative value may be derived from the transitional nature or mispricing of the related debt. Based on our cautious view of the broader economy, and the competitive, fully-priced nature of the CRE senior lending and equity markets, we believe the most risk-efficient strategy is currently in distressed and new origination high-yield debt positions.