How Securitized Products Can Enhance Core-Bond Portfolios

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With the significant rise in yields across the fixed income market, investors are rightly re-evaluating their use of fixed income in portfolio allocations. The Bloomberg U.S. Aggregate Bond Index (the “Agg’) is often a reasonable place to start for these allocations, as it’s meant to be a comprehensive collection of liquid, high-quality fixed income. However, in most cases, we think clients can do better than this passive approach. We have previously noted the potential shortcomings of the Agg, including its historically high representation of U.S. Treasury securities, and why that change in composition helps make a strong case for active management in the intermediate term, core-bond space. Treasuries can be a useful holding in any portfolio, but there is also an opportunity cost, as most other asset classes will outperform over time.

A closer look at active intermediate-term portfolios shows that some larger strategies in the core and core-plus space have had significant performance challenges over the last few years. Part of the reason for this underperformance has been managers’ reliance on large macro calls, specifically on the direction of interest rates, to drive performance.

Those that have been on the wrong side of these duration bets have suffered with the significant move in rates since the end of 2021.
We believe an approach more focused on diversified relative-value credit decisions, as opposed to outsized macro calls, will lead to more consistent outperformance, lower volatility, and fewer surprises for intermediate-term bond investors. One way to do that is to include securitized credit in intermediate-term portfolios, allowing for a broader, more attractive opportunity set for these relative-value credit decisions.

Over the long term, credit historically has provided excess returns that have more than compensated for realized losses from defaults. Capturing this excess return from credit exposure requires thoughtful liquidity and risk management. Further, we believe investors can do better than simply earn a credit risk premium. They can diversify exposure to default cycles and liquidity risk by operating in different markets with different counterparties.

The incorporation of securitized products in an intermediate core-bond allocation can help diversify exposure and add additional spread. Here’s a closer look at why it’s possible:

1. Excess Return via Excess Spread

Historically, high-quality securitized products, such as commercial mortgage-backed securities (CMBS), asset-backed securities (ABS), and collateralized loan obligations (CLOs) have provided attractive spread pickup (Figure 1) with minimal credit risk (see Figure 2).

Figure 1. Securitized Products Have Provided Attractive Excess Spreads …

Spreads (in basis points) versus comparably rated corporate bonds as of November 30, 2023

Source: Bloomberg. OAS=option-adjusted spread. BPS=basis points; one basis point equals one one-hundredth of a percentage point. CMBS as represented by ratings-specific subsets of the Bloomberg U.S. CMBS Investment Grade Index. ABS as represented by ratings-specific subsets of the Bloomberg U.S. Asset-Backed Securities Index. CLO as represented by ratings-specific subsets of the J.P. Morgan Collateralized Loan Obligation Index. Corporate bonds as represented by ratings-specific subsets of ICE BofA U.S. Corporate Index. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

Figure 2. … with Very Low Historical Default Rates

Data for indicated ratings categories for CMBS (upper panel) and ABS (lower panel)

Source: S&P Global Ratings Research. Data as of 12/31/21 (latest historical data available). For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

These low historical default rates of high-quality securitized assets can be explained by several factors. First, securitized products provide varying levels of credit enhancement, which protects investors and provides a cushion should the underlying assets of the securitized product perform worse than the initial assumptions. For example, investors in AAA-rated ABS, a tranche with substantial credit enhancement, have never experienced credit losses, even during times of significant consumer stress and rising loan defaults.

Second, securitized products have stronger credit characteristics because they often utilize a pooled asset structure. While a corporate bond is backed by a single corporation’s assets or creditworthiness, CMBS, ABS, and CLOs are generally backed by a broad pool of hundreds, even thousands, of different assets, from mortgages to credit card receivables to bank loans. Pooling various types of assets spreads risk across a wide array of borrowers and asset types. This diversification reduces the impact of any single borrower’s default on the overall portfolio.

2. Diversification Relative to Other Asset Classes

While each individual securitized product mentioned above has inherent diversification benefits within its asset pool, securitized holdings also provide diversification benefits relative to other high-quality asset classes within a broader portfolio.

Figure 3. Correlation Matrix Shows That Securitized Products Offer Effective Diversification

Data for the period December 1, 2003–November 30, 2023

Source: Morningstar. Bloomberg US Agg = Bloomberg U.S. Aggregate Bond Index. Bloomberg US Treasury = Bloomberg U.S. Treasury Index. Bloomberg CMBS IG = Bloomberg U.S. CMBS Investment Grade Index. Bloomberg ABS = Bloomberg U.S. ABS Index. ICE BofA Corporate = ICE BofA Corporate Bond Index. “TR” indicates total return.
Correlation is a statistic that measures the degree to which two securities move in relation to each other. A perfect positive correlation means that the correlation coefficient is exactly 1. This implies that as one security moves, either up or down, the other security moves in lockstep, in the same direction. A perfect negative correlation means that two assets move in opposite directions, while a zero correlation implies no relationship at all.
Past performance is not a reliable indicator or guarantee of future results. The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Investors may experience different results. Due to market volatility, the market may not perform in a similar manner in the future. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

As could be expected, U.S. Treasuries and corporate bonds have a strong positive correlation with the Agg, while CMBS and ABS have a much weaker association with the broader, high-quality fixed-income market. Furthermore, the correlation among these securitized products is also weak, providing further diversification benefits and reducing volatility.

A Final Word

As attractive as securitized products can be on their own, we believe they are best held in the context of a multi-sector portfolio with varied avenues for liquidity. We use these asset classes, along with other fixed-income securities such as corporate and government bonds, to diversify both the risks of each end market and the overall liquidity risk of the portfolio, leaving us in a flexible position to capture attractive relative-value opportunities as they arise.

LCRAX

Class A

Core Fixed Income Fund

The Lord Abbett Core Fixed Income Fund seeks to deliver current income and the opportunity for capital appreciation. View portfolio and performance info.

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LAPLX

Class A

Core Plus Bond Fund

The Lord Abbett Core Plus Bond Fund invests in a wide range of fixed income securities with select allocations to non-U.S. debt securities. View portfolio.

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About the Contributors

Alex Mink, CFA

Product Specialist

Nicholas Bragdon

Product Specialist

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Glossary & Index Definitions

Collateral Loan Obligation (CLO) is a special purpose vehicle (SPV) with securitization payments in the form of different tranches. Financial institutions back this security with receivables from loans. Collateralized loan obligations are the same as collateralized mortgage obligations (CMOs) except for the assets securing the obligation. CLOs allow banks to reduce regulatory capital requirements by selling large portions of their commercial loan portfolios to international markets, reducing the risks associated with lending.

Asset-Backed Security (ABS) is a financial security backed by a loan, lease or receivables against assets other than real estate and mortgage-backed securities. For investors, asset-backed securities are an alternative to investing in corporate debt.

Commercial Mortgage-Backed Security (CMBS) is a type of mortgage-backed security that is secured by the loan on a commercial property. A CMBS can provide liquidity to real estate investors and to commercial lenders. As with other types of MBS, the increased use of CMBS can be attributable to the rapid rise in real estate prices over the years.

Correlation is a statistic that measures the degree to which two securities move in relation to each other. A perfect positive correlation means that the correlation coefficient is exactly 1. This implies that as one security moves, either up or down, the other security moves in lockstep, in the same direction. A perfect negative correlation means that two assets move in opposite directions, while a zero correlation implies no relationship at all.

Spread is the percentage difference in current yields of various classes of fixed-income securities versus Treasury bonds or another benchmark bond measure. A bond spread is often expressed as a difference in percentage points or basis points (which equal one-one hundredth of a percentage point). The option-adjusted spread (OAS) is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is adjusted to take into account an embedded option. Typically, an analyst uses the Treasury securities yield for the risk-free rate.

Yield-to-maturity (YTM) represents the expected return (expressed as an annualized rate) from the bond's future cash flows, including coupon payments over the life of the bond and the bond's principal value received at maturity.

Yield-to-worst (YTW) is the lowest yield that can be paid on a bond, assuming the issuer does not default. The calculation takes into consideration worst-case scenarios in which the bond would be paid prior to maturity. It is assumed the bond will be prepaid if current interest rates are lower than the current coupon rate.

The Bloomberg U.S. Asset-Backed Securities Index is a broad-based flagship benchmark that measures the investment-grade, U.S. dollar-denominated, fixed-rate, taxable bond market. The index only includes ABS securities.

The Bloomberg U.S. CMBS Investment Grade Index measures the market of U.S. Agency and U.S. Non-Agency conduit and fusion CMBS deals with a minimum current deal size of $300 million. The Bloomberg U.S. CMBS 1-3.5 Year Index is a maturity-specific subset of the Bloomberg U.S. CMBS Investment Grade Index.

Bloomberg Index Information

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). Bloomberg owns all proprietary rights in the Bloomberg Indices. Bloomberg does not approve or endorse this material or guarantee the accuracy or completeness of any information herein, or make any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, shall not have any liability or responsibility for injury or damages arising in connection therewith.

The ICE BofA 1-3 Year U.S. Corporate Index is an unmanaged index comprised of U.S. dollar denominated, investment- grade, corporate debt securities publicly issued in the U.S. domestic market with between one and three years remaining to final maturity.

The ICE BofA U.S. Corporate Index tracks the performance of U.S. dollar denominated investment grade corporate debt publicly issued in the U.S. domestic market.

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The J.P. Morgan Collateralized Loan Obligation Index (CLOIE) is the first total return benchmark for broadly syndicated arbitrage U.S. CLO debt. It is comprised of U.S. dollar denominated broadly syndicated arbitrage CLOs.

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