Gregory Finck, head of the Global Fixed Income’s Securitized team at Morgan Stanley Investment Management, highlights asset-backed securities (ABS) as a bright spot amidst the predominantly negative yielding fixed income markets. 'Thanks to the combination of higher interest rates and widened spreads, yield levels for the securitized asset class are significantly higher and offer a compelling value opportunity.'

Finck cites three key drivers of performance that could deliver solid returns from asset backed securities (ABS) and for Morgan Stanley Investment Funds (MS INVF) Global Asset Backed Securities Fund. First, the relatively low interest rate sensitivity of the asset class as many of the loans are floating rate; secondly, the attractive credit quality of the sector with most ABS having a rating of A- or above; finally, the solid credit conditions for the securitized markets which lay the foundation for strong future performance. House prices in Europe and the US have risen roughly 15% and 35%, respectively, over the past two years, household debt levels are at historical lows and savings rates reached record highs during the pandemic. 'You can see ABS as a defensive asset class, offering protection from rising interest rates and inflation. As a result of the sharp rise in interest rates experienced this year, ABS yields have already doubled.'

However, ABS are not immune to the same factors that plague other fixed income classes: the tightening of central bank policies, volatility in inflationary expectations and concerns about economic growth. The impact from higher rates and wider spreads thus far this year has been poor performance across fixed income markets. Securitized credit markets have outperformed many sub-sectors of the fixed income universe due to the lower exposure to interest rate risk and shorter spread durations relative to, for example, corporate bonds. Finck: ‘ABS did not escape the market malaise in the first eight months of 2022 either, but the sector’s returns were less negative compared to many other asset classes¹. We are very excited about the return potential for the remainder of 2022 and 2023 given where yields are, thanks to rising interest rates and widened spreads.'

Many investors however question as to if the optimism is justified. ABS consists primarily of bundled mortgage, consumer and student loans collateralized by homes, cars, and even student and credit card debt, with approximately 80% of the debt outstanding residing in the US and the remainder in Europe and the UK. Consumer fears about the economy are growing in the United States and Europe as energy and food prices are rising sharply. If a recession does occur, it could also lead to higher unemployment. 'We are monitoring these developments closely,' says Finck. 'The financial health of households is slowly eroding and although wages are rising, they are not rising at the same rates as inflation and debt levels. That said, the financial health of households remains near its highest level in 40 years.'

MS INVF Global Asset Backed Securities Fund

The Morgan Stanley Investment Fund (MS INVF) Global Asset Backed Securities Fund takes a global investment approach to the entire spectrum of opportunities presented by securitized credit markets. This strategy, covering both different geographies and securitized asset classes, sets the Fund apart from many competitors, who often focus on a single sector or region. Due to its complexity, the asset class requires in-depth expertise and a rigorous credit analysis process. The investment team uses both macroeconomic and bottom-up analysis for security selection. Each potential investment is analyzed based on individual characteristics and in the context of the entire investment portfolio.

'As the economy weakens in the coming years, sector and security selection will become even more important,' Finck expects. 'Because we cover the total securitized investment universe, we can respond well to investment opportunities or potential risks stemming from sector specific or geo-political events. This year, for example, we started investing more in the US and less in Europe, where we had been overweight in previous years. In the coming years, we believe economic conditions in the United States will be more favorable relative to Europe. We also started investing more in residential related credit and less in commercial real estate; the latter of which continues to struggle in the post-pandemic world.'

The bulk of the Fund’s current investments are in U.S. residential mortgages, a combination of government guaranteed securities issued by the government and quasi-government agencies Ginnie Mae, Fannie Mae and Freddie Mac, as well as non-agency residential mortgage-backed securities. In addition to their overweights to the United States as region and residential loans, the investment team also has a positive outlook for consumer credit.  ‘After several years of record savings rates during the pandemic, consumer balance sheets are generally in good shape and should be able to handle moderate economic stress. ' Finck explains.

Integration of ESG factors

The complex legal structure of securitized bonds requires specialist knowledge to assess Environmental, Social and Governance characteristics of the underlying loans. Integration of ESG factors in ABS portfolios is therefore less well developed than corporate bonds. It also lacks consistent ESG data. Morgan Stanley Investment Management has developed a proprietary framework for ESG integration in ABS portfolios. The positive and negative ESG characteristics of each deal are first analyzed. Each tranche is then assigned an ESG score ranging from very negative to very positive. Finally, each deal is evaluated for its positive or negative contribution to the Sustainable Development Goals, the United Nations' goals for making the world a better place by 2030.

Because the market for 'green' asset backed securities is in a state of flux, Morgan Stanley Investment Management works with ESG research and data providers and the sustainable fixed income team at Morgan Stanley to monitor the availability of new datasets. ‘These resources and the flexible, dynamic architecture allow us to continue to improve our ESG framework. We expect the quality and quantity of data to improve significantly as demand from institutional investors increases. Through our integrated ESG approach we are able to better identify risks and design portfolios with sustainable ABS,' Finck concludes.

The value of the investments and the income from them can go down as well as up and an investor may not get back the amount invested.

¹ ABS and MBS sectors have outperformed many other sectors (IG corporate, high yield, EM, convertibles, etc) over the period. Source: Bloomberg Barclays / ICE Index returns.

Risk Considerations

• The value of bonds are likely to decrease if interest rates rise and vice versa.
• The value of financial derivative instruments are highly sensitive and may result in losses in excess of the amount invested by the Sub-Fund.
• Issuers may not be able to repay their debts, if this happens the value of your investment will decrease. This risk is higher where the fund invests in a bond with a lower credit rating.
• The fund relies on other parties to fulfill certain services, investments or transactions. If these parties become insolvent, it may expose the fund to financial loss.
• Sustainability factors can pose risks to investments, for example: impact asset values, increased operational costs.
• There may be an insufficient number of buyers or sellers which may affect the funds ability to buy or sell securities.
• There are increased risks of investing in emerging markets as political, legal and operational systems may be less developed than in developed markets.
• Past performance is not a reliable indicator of future results. Returns may increase or decrease as a result of currency fluctuations. The value of investments and the income from them can go down as well as up and investors may lose all or a substantial portion of his or her investment.
• The value of the investments and the income from them will vary and there can be no assurance that the Fund will achieve its investment objectives.
• Investments may be in a variety of currencies and therefore changes in rates of exchange between currencies may cause the value of investments to decrease or increase. Furthermore, the value of investments may be adversely affected by fluctuations in exchange rates between the investor’s reference currency and the base currency of the investments.