2020 economic and market outlook - alloya corp · 2020 economic and market outlook living in a low...

2020 Economic and Market OutlookLiving in a Low Rate World

Tom Slefinger, Alloya Investment ServicesBilly LaFavor, CU Investment Solutions (ISI), LLC

www.alloyacorp.org/invest

Long Term Outlook


Wall Street Economists: A Perfect Record…of Being Wrong!


Lower for Longer

# Lower Growth# Lower Inflation# Lower Interest Rates


The Longest Ever…


But the Weakest Recovery Ever!


Living in a Low‐Flation World


The Secular Bull Market in Bonds Continues


Four Reasons for Low Rate Environment

# Excessive Debt# Ageing Demographics and Declining Productivity# Overcapacity vs. Demand # Wealth Inequality


Debt

GDP

Sustainable?

$75T

$19T

Total Credit Market Debt vs. Real GDP

$8T

+838%

138%


Demographics


U.S. Labor Force is Down… And Not Getting Back Up


Productivity Continues to Trend Lower


No Economic Boom: It’s Math!

(Growth in Labor Force + Growth in Productivity = GDP)


Wealth Inequality


The Greatest Wealth Inequality Since the Gilded Age


The Rise of Socialism in America?


Q1 Economic Update


GDP Has Peaked for this Cycle

Trump Tax Cuts


Without Massive Deficits, Economy Would be in a Recession


The Tale of Two ISMs


“Economic Boom???”


The S&P 500 vs. Corporate Profits (After Tax)


Profit Margins Are Mean Reverting


CEOs Have Turned Gloomy


As the Consumer Goes, so Goes the Economy


Lowest Unemployment in 50 Years!

Source: Bloomberg Finance L.P.

Bullish

Bearish


The Consumer is Showing Signs of Stress


The Wealth Effect


Where to From Here?


Road Map to Rates


Have Fed Funds Peaked?


Has Inflation Peaked?


What the Market Thinks


How Will the Fed Fight the Next Recession?


“If the U.S. economy entered a recession soon and interest rates fell in line with levels seen during the moderate recessions of 1990 and 2001, yields on even longer‐dated Treasury securities could fall to or below zero.”

– Senior Fed Economist, Michael Kiley – January 20, 2020


What Does History Tell Us?

During a recession, the Fed cuts rates:Average 500 basis points

and…

Never less than 200 basis points


Stay Invested… Do Not Forecast!


Market Outlook and Portfolio Strategy 1. Most leveraged economy ever. 2. Demographics are a major headwind.3. Corporate profits are slowing.4. We are in the late cycle – growth and inflation are slowing.5. Recession: not if, but when.6. Do not forecast!7. Minimize excess cash balances.8. Maintain risk appropriate diversified ladder strategy – don’t be a one sector investor.

9. Underweight agency sector – overweight spread products.10.Take advantage of sell‐offs.


Security Sector Allocation

What Looks Attractive in a Low Rate World?

Billy LaFavorChief Operating Officer

CU Investment Solutions, LLC


Agency Debenture Market Overview• Agency bullets look very rich at the moment

• Bullet spreads are currently at tightest levels in past 7+ years (<5 bps to UST’s in 2‐5‐year term)

• Agency callables don’t look much cheaper• Callable spreads aren’t appealing either, despite increased call risk ($298b called in 2019)• For example, a 5nc1yr quarterly new issue structure just priced at 1.75%, +30 bps to the bullet ‐> not a bad spread, but historically tight spread given the increased call risk


Transitioning from Agency Debentures to Freddie K’s• Quick Overview of Freddie K’s

• Regularly issued structured pass‐through securities backed by multi‐family mortgage loans.• Pools structured with large sizes (deal sizes typically around $1 billion) and usually contain 50‐100 loans.• Multi‐tranche sequential securities that contain an A1 and A2 tranche. We recommend A2 tranches as a nice bullet alternative.

• More on the A2 tranche… • Makes up a majority of the deal balance (at least 80‐90%).• Will maintain a 1.0 factor for the majority of the life of the bond because of call protection features such as yield maintenance premiums and defeasance.*• The greater the % of defeased loans the better – the principal payments from defeased loans usually go to maturity.

*Defeasance• Defeasance – permits the borrower to obtain the release of the property from the mortgage lien with the pledge of securities that are U.S. Treasuries or debt obligations issued by

Freddie Mac, Fannie Mae and/or Federal Home Loan Banks.• The securities used must provide for payments that equal or exceed the scheduled interest and principal payments due under the related mortgage notes, including balloon

payments at maturity.• Defeasance protection usually runs until around four months prior to maturity.


Freddie K Market – Key Points• Pick‐up of 15‐30 bps to agency bullets, even yielding more than new issue callables in many cases

• Active secondary market so they are relatively liquid

• History has proven that prepays are minimal, but you can have a little variability in the average life• Loans are open to prepay penalty‐free approximately 4 months prior to loan maturity, that is when a majority of the cash flows occur• 122 total A2 securities outstanding, only 15 securities have amortized ‐> the majority are 0.95% or higher so very little principal cash flow

• Supply is limited • Only new issuance is 7‐ and 10‐year final maturities which come approximately once a month

• Overall thought – the yield pickup on these structures seem worth it for the small avg. life variability


Freddie K Example2.6 Year Freddie K

• 2.6 Year Freddie K with $102‐handle price – 1.65% yield at 0 CPY / 1.564% yield at 100 CPY• Collateral consists of 81 loans, good geographic diversification, 2.15x DSCR and 31.36% of the balance is defeased! • Beats a comparable bullet by 25 bps and is right on top of new issue callable yields (1.60‐1.65%)


Agency CMO/MBS Market

• Still offer good value over agency debenture market

• Prepayment risk is obviously a big risk in this sector, and has been a growing concern the past 6‐9 mo. with prepays elevating; however there are ways to reduce this risk:• Large underlying loan counts – typically 1,000 or more• Seasoning/Loan Age – the higher the WALA (weighted average loan age) the better• Low loan balances (LLB) – i.e. $110k max loan size collateral reduces the economic benefit of refinancing• Good geographic diversification• Beware of servicers that exhibit volatile and typically fast prepay speeds (Quicken, Provident, United Shore, Broker Solutions, Freedom Mortgage, etc.) – prefer bank versus non‐

bank serviced loans• Avoid higher WAC (weighted avg. coupon) collateral – compare to national avg. rate (current 30‐year national average is 3.62%, via Bankrate)


Agency CMO/MBS Market (cont’d)

• Generally speaking, we prefer CMOs to MBS pools for greater variety of average life/duration/coupon options• If you are looking to invest in the 2‐6‐year part of the curve, 10‐15‐year MBS pools are the only MBS options, however they only make‐up only ~12.7% of outstanding MBS balance:

• CMOs give us access to bonds structured off 30‐year cash flows, giving us more options

• However, if you are looking in the 4‐6‐year part of the curve, 15‐year MBS pools offer good value compared to CMOs:

MBS Pool/CMO Price Base I/Spread Loan Count Base Yield Base WAL Up300 Yield Up300 WAL Dn300 Yield Dn300 WALNew 15 Year 2.0% $100‐08 +52/c 490 1.93% 5.23 1.94% 6.39 1.83% 2.282% Pac‐1 CMO $100‐01 +56/c 3,862 1.97% 4.47 1.98% 6.40 1.95% 3.06

New 15 Year 2.5% $101‐30 +63/c 9,828 2.02% 4.65 2.14% 6.20 1.48% 2.102.5% Pac‐1 CMO $101‐21 +65/c 624 2.05% 4.19 2.20% 6.54 1.75% 2.49

New 15 Year 3.0% $103‐12 +72/c 5,222 2.11% 4.25 2.37% 6.15 1.44% 2.343% Pac‐1 CMO $103‐05 +74/c 2,432 2.14% 4.11 2.44% 6.47 0.93% 1.64


Agency CMO Example #11.8 Year Discounted SEQ CMO

• Risks – very little (no premium risk and limited extension risk).• Nice features – short average life profile with a stable yield in all scenarios. Collateral consists of seasoned 30‐year Harp collateral (114% WA LTV), and collateral looks clean – good

geographic diversification (leading geo is CA – 16.9%), large underlying loan count (3,972 loans) and good avg. FICO scores (736).• Summary – this is a low risk CMO option with stable yields that will provide a yield pick‐up over agency debentures.


Agency CMO Example #22.8 Year 2.5% Pac‐1 CMO

• Risks – some prepay and premium risk. Collateral is new 30‐year loans with high loan balances ($333.2k wavg curr loan size) and the WAC (4.387%) is in‐the‐money for refinance. At a premium of $101‐12+ the yield varies in different prepay scenarios.

• Nice features – has a relatively short average life profile and offers a nice yield pick‐up of ~20 bps over previous CMO example. Also has clean collateral – good geographic diversification (leading geo is CA – 13.6%), large underlying loan count (3,834 loans) and good avg. FICO scores (745).

• Summary – this bond has a nice average life profile and offers a yield pick‐up over more conservative structures in exchange for taking on more premium and prepay risk.


Back to Agency Debentures – Other Considerations/Alternatives

• If you are looking to build your agency bullet ladder, consider Farmer Mac debentures • GSE that carries 20% risk weighting• Issue relatively small deal size bullets, callables and floating rate notes • Offers a yield pick‐up of a few bps to comparable term debentures issued by Fannie Mae, Freddie Mac, FHLB, and FFCB

• If you think Fed is on hold, maybe a short uncapped floating rate note makes for a nice bullet alternative• An example is this 2.5‐year FFCB uncapped floating rate note that’s available at Prime – 304, currently a 1.71% yield. It resets daily, pays quarterly• Comparable bullet (FNMA 1.375 9/6/2022) currently yielding 1.41%, so the FRN is currently picking up 30 bps

THANK YOUTom SlefingerSenior Vice President, Institutional Fixed Income SalesAlloya Investment [email protected](630) 276‐2753

Billy LaFavorChief Operating OfficerCU Investment Solutions (ISI), LLCblafavor@cu‐isi.org (913) 912‐5237


2020 economic and market outlook - alloya corp · 2020 economic and market outlook living in a low...

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