Even the most highly rated part of the MBS market in the US is not secure enough in the face of changing macro and monetary policy to allow investors to allocate with confidence.
That is the view of Citywire AA-rated Michael Collins, who oversees several funds at PGIM Fixed Income, which runs $650 billion in assets under management.
Speaking to Citywire Selector, Collins said traditional AAA-rated MBS issued by US government agencies – notable Fannie Mae and Freddie Mac – is a firm fixture in many of his counterparts’ portfolios.
However, Collins is decidedly more cautious. ‘We are significantly underweight these securities in our Core Plus strategies,’ he said.
‘Only because we believe they offer poor relative value with option-adjusted spreads in the 40 basis point area, and they may experience spread widening as the Fed begins to reduce their holdings.’
Collins, who previously discussed his surprise at the Federal Reserve seemingly discussing the tapering of bond buying at its June meeting, said the overall changing market conditions meant the investment case for MBS was under threat.
‘As lending standards begin to ease up, which is possibly due to de-regulation, re-financing risk may increase, which is bad for investors. There is a chance that the government agencies are ultimately privatised, which could undermine the government support for these bonds.’
Looking at the broader securitised debt market, Collins said he does hold AAA-rated commercial mortgage-backed securities (CMBS) and collateralised loan obligations (CLOs). This has steadily increased since the financial crisis.
‘Other investors have opted to invest in the lower-rated, or mezzanine, tranches because they have the potential to deliver higher returns. However, we believe there are scenarios under which these tranches can lose substantial value through credit losses in the underlying collateral.
‘Moreover, these smaller tranches will generally have poorer trading liquidity. The systemic risk that these lower rated tranches present is likely to be limited. The downside is more likely to be manifested via losses in portfolios that hold sizable positions in these riskier tranches.’
Collins currently ranks fifth out of 205 on a three-year absolute return basis in the Bonds – US Dollar Short Term sector. He has returned 6.7% against a 2.8% average manager return.