Impact Blog

The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Calvert disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Calvert are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Calvert fund. References to individual companies for Engagement or Research purposes are provided for illustrative purposes only and may not be representative of the results of all of Calvert’s engagement efforts. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results.

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      By Vishal Khanduja, CFA, Calvert Fixed Income Portfolio Manager and Brian S. Ellis, CFA, Calvert Fixed Income Portfolio Manager

      Boston - Many investors worried about rising interest rates are favoring bonds with shorter duration as a potential cushion against higher rates. We believe asset-backed securities (ABS) are currently an attractive option for investors looking for a combination of attractive yield and lower sensitivity to interest rates than other credit-sensitive securities.

      Our constructive view on ABS revolves around two main themes. First, we expect the U.S. economy will continue to strengthen in 2018 and that consumer balance sheets will remain strong. Also, the structural features of ABS can provide significant protections to bondholders (which we will explain) and a relatively short duration.

      Regarding the U.S. economy, our baseline view is that strong economic performance will carry into 2018. Tax reform will be a tailwind, while tight labor market conditions should eventually spill over into wage gains. All of this bodes well for the U.S. consumer, and in our view should more than offset the impact of higher interest rates. ABS can provide direct credit exposure to the consumer balance sheet.

      Playing defense

      We believe we are in the later stages of the economic growth and credit cycle, and that continued economic strength will lead the Federal Reserve and other central banks to continue to pull back on policy support. We think this means the continuation of further rate hikes and balance-sheet contraction from the Fed in 2018. While other central banks have remained in net easing mode, we believe they will likely continue to reduce accommodation, and markets will look for signaling on plans for eventual tightening.

      We see a faster pace of rate hikes, combined with reduced monetary easing globally, as a key risk that is still underpriced by markets. This could provide upward pressure on global rates and may result in the return of volatility as well. Therefore, we believe investors should be aware of rate risk embedded in their fixed-income allocations.

      At the same time, credit spreads are near the tightest they have been after the financial crisis. We believe fixed-income investors are not being appropriately compensated at current valuations. In our view, now is an appropriate time to favor higher-quality and shorter-duration credit positions.

      Secured assets

      This defensive posture on rate and credit risks is one reason why we prefer an allocation to ABS now.

      Unlike most corporate bonds, ABS are secured debt -- secured by a pool of assets that generates periodic cash flows, rather than simply a company's promise to pay back the loan from future cash flow. Since ABS are secured assets, they may be more protected against credit risks, especially since the underlying assets are located inside a bankruptcy-remote trust that is separate from their sponsor.

      Structural protections embedded in ABS transactions can provide additional credit-positive characteristics. Credit enhancements come in the form of overcollateralization, subordination, sequential payment structures and reverse-sequential loss allocations. In addition, many structures include performance triggers, which protect bond holders from losses arising from a deterioration in credit metrics of the pool of assets backing the ABS. If a trigger is tripped, cash flow from the collateral can be trapped and used to build reserve accounts or immediately deleverage the transaction by paying down principal.

      Senior-most tranches tend to benefit the most from these features as they enjoy the most credit enhancement and seniority in the principal payment waterfall. Importantly, when these tranches begin to amortize (receive principal paydowns in addition to coupon payments), credit enhancement can build relatively quickly, which further reduces credit risk. This often results in ratings upgrade potential.

      Tranches that are currently or close to amortizing will also have much lower sensitivity to changes in interest rates and credit spreads. In addition, in a rising rate environment, proceeds from paydowns can more quickly be reinvested at higher yields.

      Of course, securitized assets such as ABS and mortgage-backed securities (MBS) were in the headlines during the financial crisis. Asset-backed securities as a sector suffer from the perception of being complex, which likely is a large contributor to its wider spreads relative to other credit-sensitive sectors. However, we believe this creates opportunity for investors who have appropriate research and modeling tools to understand all the risks, including structural, economic and corporate risks. We believe a disciplined approach with an experienced team is key to success in this sector.

      Bottom line: Securitized assets offer a unique, dual advantage of higher yields and lower sensitivity to interest rates than some comparable credit-sensitive investments. Many securities, particularly those at the senior-most part of the capital structure, benefit from high levels of credit enhancement (structural protection) and a relatively short duration. In addition, these securities typically have immediately amortizing cash-flow profiles, which means principal payments are made on a monthly basis in addition to interest. In a rising-rate environment, this characteristic allows cash flows to be reinvested at higher yields.