Ask the Manager: Daniel Lucey Jr. on How to Find Yield in Securitized Credit

In this edition of Ask the Manager, we spoke with Daniel J. Lucey Jr., CFA, Senior Managing Director and Senior Portfolio Manager at SLC Management about how Fed policy, macro themes, and securitized assets shape their outlook—and where they see opportunities in short duration fixed income.

How are you interpreting recent Fed communications in terms of the path forward for interest rates, and what does that mean for fixed income investors?

We view recent commentary indicates a more dovish outlook for front end rates and likely a 25-basis point (0.01% of 1%) rate cut in September, particularly through comments made by Fed Chair Jay Powell at Jackson Hole.

Though inflation remains persistent, markets predict the Fed may cut rates 2-3 times in the coming six months.

How do macro themes like deglobalization, fiscal expansion, and reshoring influence your fixed income outlook moving forward?

SLC Management’s U.S. Total Return Fixed Income team concentrates on deep value opportunities through bottom-up analysis.

The team continues to see relative value through securitized sectors, particularly within asset backed securities (“ABS”), commercial mortgage-backed securities (“CMBS”), and collateralized loan obligations (“CLOs”) while considering all macroeconomic factors.

Particularly, we work to source attractive securitized debt with favorable collateral valuation and a spread/yield pickup versus comparable corporates and treasuries held within the Bloomberg U.S. 1-3 Year Gov/Credit Index, the benchmark against which the AAM SLC Low Duration Income ETF (Ticker: LODI) is managed.

What are some misconceptions investors might have about securitized assets?

Many investors may vividly recall 2008 and the events that led to the Global Financial Crisis, resulting in a sense of trepidation surrounding securitized sectors.

This environment serves as a strong cautionary tale as the 2000s were marked by overleverage in banks and securitized subsectors alike, particularly within non-agency residential mortgage-backed securities (“RMBS”).

However, what is often omitted from this narrative is that the events of 2008 triggered a restructuring of the sector to withstand much higher levels of loan distress with higher loss cushions, resulting in significant mitigation during the market volatility that occurred as a result of the COVID pandemic.

Though COVID placed immense pressure on credit markets, securitized credit markets held in very well from a principal protection standpoint.

While there was extreme price volatility as expected, there was relatively little ultimate principal losses across the major securitized subsectors within investment grade tranches, including CLOs, ABS, Non-Agency RMBS, and even CMBS.

Looking ahead, where do you see opportunities (or risks) in the short duration credit space over the next 6-12 months?

Given existing market conditions, we anticipate continuing to favor CMBS and ABS over the next 6-12 months, as these sectors currently exhibit the most attractive spreads and relative value in the short duration space.

Can you walk us through the process SLC Management uses to identify attractive relative value opportunities in the corporate and securitized sectors?

Our philosophy in identifying attractive relative value is rooted in three pillars of analysis as follows:

1. Bottom-up fundamental analysis: We start by evaluating the underlying credit fundamentals at the issuer and security level, including collateral strength, quality of underwriting (ie. leverage, cash flow stability) and structural protections embedded in the trust. This allows us to identify securities where risk adjusted value may be underappreciated by the market.
2. Marrying credit fundamentals with bond valuation: We combine our credit assessment with rigorous pricing analysis by evaluating relative spreads on an issuer, subsector, and cross-sector basis to identify mispriced opportunities.
3. Mean reversion analysis: We analyze historical relationships of subsector credit spreads to identify dislocated areas of the market that have attractive risk adjusted yield profiles and are pricing wide to their historical trading patterns.

Relative Value Example:

In late 2022/early 2023, we identified the ABS sector as trading wide relative to its own historical range and increased our exposure across strategies in the +400bps yield spread over Treasuries area for BBB rated classes.

A year later, those spreads had tightened roughly 150-200 bps. As these bonds deleverage, they get upgraded and their spreads tighten. When that occurs, we look to sell and rotate into positions at wider spreads. Additionally, these bonds typically trade wide relative to corporate bonds comparable by either duration or ratings.