A Higher Quality Loan Sector

Fixed Income

A Higher Quality Loan Sector

Increased banking regulation and constrained lending makes a strong case for investment opportunities in residential, commercial and consumer loans. Anup Agarwal, head of agency and structured products at Western Asset, explains why.

I see a number of investment opportunities in securities backed by residential, commercial and consumer loans. These are dislocated sectors that offer attractive total return relative to other sectors in the fixed income market.  They also offer attractive income and stable total returns on a risk adjusted basis, while providing investors with low sensitivity to interest rates, diversification in portfolios and relatively low correlations to other fixed income sectors.  These benefits are often misunderstood but I believe they will reward investors over the long term.

The fundamentals of the sector start with a lack of capital caused by a banking regulatory framework that has impacted all residential and commercial mortgage and consumer lending sectors in the US and in Europe. Bank lending standards continue to be very constrained and are not expected to loosen materially in the near term.

Furthermore, I believe the U.S. will remain in a slow growth environment and fundamentals for U.S. real estate and consumers remain constructive. The U.S. consumer continues to be the strongest part of the economy. U.S. house prices are projected to grow at 2%-3% over the next 12-24 months and commercial price appreciation is expected to slow but remain positive.  This provides a strong fundamental backdrop for a sector that offers attractive income, stable returns that are uncorrelated to other fixed income sectors. 

The sector has evolved since the global financial crisis with better underwriting and loan quality leading to a higher quality asset class over recent years. I see the lending trends first hand from the originators and banks we are buying the loans from. I continue to see banks being selective on where they are lending, requiring borrowers to put down significant equity and this has resulted in strong collateral performance. I expect this trend to continue and do not expect banks to loosen underwriting standards materially, which is supportive for the asset class going forward.  

The key in navigating the sector is having an experienced team and platform that can examine the full spectrum of opportunities in the market and avoid downside risks by shifting the portfolio as relative valuations change. Our team’s robust due diligence process and being involved directly to create opportunities allows us to drive terms and covenants on the assets that we are buying. The goal is to construct a portfolio by making larger allocations to sub-sectors that we believe offer the most attractive risk and liquidity adjusted returns while minimizing interest rate duration.

Looking forward as broader macro risks remain and investors continue to search for returns, I believe the attractive income, stable total returns and low correlations to other spread sectors will draw more investors to the asset class. Based on my experience, active management in these sectors will benefit the most and help investors maximize long term returns with lower risk.

IMPORTANT INFORMATION: All investments involve risk, including loss of principal. Past performance is no guarantee of future results.

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not  take into account the particular investment objectives, financial situation or needs of individual investors.

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