State Street, Voya Seek Shelter From Default Risk

(Bloomberg) — As rising energy prices and rising inflation fears make corporate bonds increasingly riskier, big money managers like State Street and Voya Investment Management are considering buying mortgage bonds and other securitized debt instead.

Mortgage bonds generally outperform high-grade U.S. corporate debt in “risk-free” markets that investors are increasingly fearing, Goldman Sachs strategist Spencer Rogers wrote in a note this week.

The debt is now getting extra support from Fannie Mae and Freddie Mac after US President Donald Trump ordered companies to buy another $200 billion in bonds in January. It’s worth looking at mortgage bonds that might perform better if rates fall again, Rogers wrote. For example, purchasing specific pools designed to protect against faster prepayment rates means investors can hold on to those cash flows for longer as rates fall.

In the meantime, there is ample reason to worry about corporate debt. Crude oil futures rose after US and Israeli attacks on Iran and Iran’s retaliation against energy facilities in nearby countries. West Texas Intermediate futures hit a range-topping $95 a barrel this week, compared to $57.42 at the end of last year. In other markets, prices are rising even further. Higher energy prices can effectively act as a tax on producers and consumers and put pressure on profits.

High oil prices could also make it harder for the Federal Reserve to continue lowering interest rates. On Wednesday, Fed Chairman Jerome Powell said central banks generally view higher energy prices as temporary, but inflation has been above the Fed’s 2% target for five years, implying the central bank now has less leeway to ignore higher oil prices. Bond traders are no longer pricing in any U.S. rate cuts this year.

If interest rates remain higher for longer than expected, corporate profits could be negatively affected as future borrowing costs increase. That’s at least part of the reason why U.S. high-grade corporate bond spreads have widened about 0.17 percentage points from their Jan. 22 lows. This may also be why bonds have lost value on a total return basis this year.

Meanwhile, mortgage bonds gained some value, according to Bloomberg index data. Matthew Nest, global head of active fixed income at State Street Investment Management, said the securities look attractive in terms of relative value compared to corporate bonds.

The difference between the current production mortgage bond spread and the high-grade corporate bond spread was around 0.33 percent as of Thursday’s close, according to Bloomberg index data. The average spread over the past decade has been negative because current coupon mortgage bond spreads tend to be narrower than higher-grade corporate bond spreads. By this standard MBS is relatively inexpensive.

According to Nest, it makes sense to avoid credit risk during this part of the cycle. Mortgage bonds are more closely associated with interest rate fluctuations, and the extent of that volatility has been decreasing in recent days. The firm has been overweighting mortgage bonds and other securitized debt relative to benchmarks for much of the past year.

“Late-stage, securitized debt tends to look attractive,” State Street’s Nest said.

There are risks in trading mortgage bonds and other securitized debt over corporate debt. Once the war in Iran ends or the Trump administration withdraws from the conflict, subprime credit spreads could pull back quickly and narrow by 0.2 percentage points, said Tony Trzcinka, portfolio manager at Impax Asset Management.

“If there’s one thing we’ve learned from last year, it’s that this administration will do everything it can to gain ground in the markets,” Trzcinka said.

Moreover, many markets may be affected by oil prices in the coming months. As long as energy prices create inflationary pressure and cast doubt on the future direction of interest rates, both corporate and mortgage bonds could take a hit, said Brian Quigley, senior portfolio manager and head of MBS and corporate debt at Vanguard.

“I think you have to be really careful about what kind of correlation you assume there is between MBS and corporate bonds right now,” Quigley said. While there tends to be a low but positive correlation between the two over a long period of time, the connection between them may be closer than usual in the near term, he said.

But credit faces other pressures, including artificial intelligence disrupting software companies and private lenders facing potentially growing losses. These factors were weighing on corporate bonds even before the United States and Israel first attacked Iran.

Given these risks, it may make sense to prefer MBS and other securitized debt over corporate bonds, said David Goodson, managing director and president of Voya Investment Management MBS.

“In a world like we have today, MBS offers an attractive source of diversification,” Goodson said.

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