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Structured Product Investment Highlights 2020 JUL Structured Product The Structured Product composite returned 0.46% gross of fees for the Attribution month of July 2020. Representative Portfolio Jul 2020 (%) NARMBS Performance Review Fannie Mae/Freddie Mac Credit Securities -0.57 During the month, non-agency residential MBS (NARMBS) credit risk Pre-2007/Other NARMBS 0.58 transfer (CRT) securities issued by Fannie Mae and Freddie Mac detracted from performance as spreads widened, while NARMBS legacy securities CMBS contributed to performance. Legacy securities remain difficult to source. Legacy CMBS -0.09 Recent data on housing and mortgage applications has surprised to the New Issue CMBS 0.11 upside for the most part, while mortgage lending rates reached all-time ABS 0.05 lows leading to tighter spreads and higher prices for structured securities. Credit Hedge 0.00 By many metrics, housing has already experienced a V-shaped recovery Treasury 0.13 but spreads have lagged due to continued uncertainty and less direct Other 0.00 Federal Reserve (Fed) intervention. Within commercial MBS (CMBS) new- issue securities contributed while legacy ones detracted. Lawmakers Accounting Difference 0.00 introduced a bill to provide cash to struggling hotels and shopping centers Total 0.20 that weren’t able to pause mortgage payments after the coronavirus shut Source: Western Asset. As of 31 Jul 20 down the US economy. The legislation would create a temporary liquidity facility using unsecured preferred equity investments for up to 10% of the outstanding mortgage balance. It is currently unknown if, or when, remain up for debate. The previous round of stimulus, which included the bill might be passed and enacted, but if it becomes law it would be extended weekly unemployment benefits, expired at the end of July. very positive for the CRE/CMBS markets. Last, the portfolio’s ABS exposure and Treasury holdings contributed to returns. The 2Q20 US GDP release showed -32.9% on an annualized basis and was largely in line with market expectations, so it had limited impact Market Review on sentiment. Weekly US jobless claims during the month continued to During the month of July, COVID-19 cases continued to rise in the US; top one million per week, but the market appeared to push past these however, the worsening news about the spread of the virus was met with numbers and focus on improvements in business activity and retail sales. a number of positive progress updates regarding vaccine development. Though July was an overall positive month for sentiment, potential head- An increasing probability that a vaccine might be ready by as early as the winds arose in the form of rising geopolitical tensions between the US end of this year, coupled with additional policy accommodation abroad and and China. Rhetoric between the two nations escalated throughout the data releases that were either positive or at least in line with expectations, month, culminating in the Trump administration’s decision at month- further fueled a rally in risk assets over the month. end to close down the Chinese consulate in Houston. China retaliated by ordering the US to close its consulate in Chengdu. Globally, policy continued to be exceedingly accommodative. In Europe, the European Central Bank unveiled a groundbreaking new fiscal stimulus During July, risk assets continued their rally. The S&P 500 rose 5.5% and package, featuring a €750 billion fund and a €1.074 trillion seven-year credit spreads tightened, especially for high-yield. Structured product budget to aid the recovery and revive growth. The deal included provi- spreads were mixed as lower-rated tranches underperformed. USD- sions for bonds that would be the obligation of the European Union denominated emerging market (EM) bond spreads tightened and local collectively (as opposed to individual countries) and grants to poorer EM yields fell. US Treasury (UST) yields fell across the curve and the long member nations hit hardest by the pandemic. In the US, the Fed changed end outperformed with the curve flattening. The yield on the 10-year very little in its official statement following its late July meeting, maintaining UST ended the month at 0.55% (from 0.66% in June). WTI oil rose $1.00/ its extraordinarily accommodative stance. Following the Federal Open barrel (+2.6%) to $40.27 and the US dollar generally weakened versus Market Committee meeting, the Fed kept rates on hold, pledged to use its most developed market (DM) and EM currencies. “full range of tools” to support the economy, and cautioned that “the path of the economy will depend significantly on the course of the virus.” With Valuations respect to fiscal stimulus in the US, negotiations were ongoing between CRT markets closed the month with spreads widening by 132 basis Republicans and Democrats on another round of stimulus, with the market points (bps) to 637 bps, representing a yield of 6.65%. The subsector pricing in a new deal eventually being confirmed, though certain terms returned -2.4% (source: JPMorgan) during the month, with lower quality Structured Product underperforming higher quality. Legacy mortgages, on the other hand, Positioning Changes tightened by 25 bps to 343 bps, with a yield of 3.84%. Legacy securities The portfolio’s positioning was not changed materially during the month. remained difficult to source and returned 1.4% (source: JPMorgan) during the month with higher quality outperforming. The S&P CoreLogic Case- Investment Outlook Shiller 20-City Home Price Index increased by 0.1% in May compared to The COVID-19 pandemic has created unprecedented market conditions 0.4% the prior month. The year-over-year increase was 3.7% compared and disruption not seen since the global financial crisis (GFC). The pricing to the prior month’s 3.9%. of securities is discounting severe scenarios last seen during the GFC. We believe that there are many reasons to be optimistic that that is not the The Bloomberg Barclays Non Agency CMBS Index posted a total return of most likely scenario. The GFC was the direct result of an inflated housing 1.55% for the month, with lower quality securities generally outperforming. market fueled by a credit bubble in mortgage lending, with subprime The option-adjusted spread of the index was 18 bps tighter for the month, lending defining its pinnacle. We do not see these conditions present reaching 160 bps. RCA reported that commercial property prices were flat today, housing is in a much more stable place with record low levels month over month but increased by 3.6% for the year in June, down from of construction and extremely tight credit standards. Aggregate US a 4.9% increase the prior month. The effects of the COVID-19 crisis have consumer fundamentals went into the COVID-19 pandemic in a much begun to catch up with commercial real estate. Prices continued rising stronger position with debt as a percentage of income at the lowest in many property types, with the industrial sector having the strongest level in over a decade. increase for the year at 7.6%. Meanwhile office/central business district (CBD) and retail were the weakest property types, with 0.8% and -0.7% Western Asset views current non-agency MBS valuations favorably relative for the year, respectively. The COVID-19 crisis has severely impacted the to fundamentals. We believe this backdrop and the investments available commercial real estate (CRE) market as properties have been forced to in the MBS and ABS market offers compelling value opportunities. Looking shut down, rents are down as some tenants are not paying and owners forward longer term, we believe mortgages secured by real estate assets are facing liquidity challenges in servicing debt. CMBS delinquencies with significant equity in the properties and our focus on higher quality increased significantly following the shutdown, with single-asset/single- credit will continue to perform. A severe and prolonged global economic borrower (SASB) collateral performing better than conduit MBS. As the slowdown will certainly impact most spread sectors negatively and we economy has been slowly reopening over the past few months, we have may see increased levels of delinquencies and write-downs that will begun to see some improvement in property cash flows and collateral start negatively affecting the bottom tranches of different transactions. performance. The amount of payments less than 30 days late has steadily However, this is not our base case scenario at Western Asset. Commercial decreased over the past three months, but still remains elevated. real estate has benefited from a lack of construction and improved demand. We remain mindful of areas in the CMBS market that will be The JPMorgan Asset-Backed Index was up 0.79% for the month. Floating- more exposed to COVID-19 risks, most notably hotels and retail properties. rate ABS returned 0.76% while the fixed-rate ABS returned 0.81%. Spreads These deals are also more soundly structured today, and our focus is on were generally tighter for the month, with lower qualities tightening more Class A properties with well-capitalized sponsors capable of withstanding than the higher quality ones. short-term disruptions. For more information on Western Asset, visit westernasset.com. © Western Asset Management Company, LLC 2020. This publication is the property of Western Asset and is intended for the sole use of its clients, consultants, and other intended recipients. It should not be forwarded to any other person. Contents herein should be treated as confidential and proprietary information. This material may not be reproduced or used in any form or medium without express written permission. Past results are not indicative of future investment results. This publication is for informational purposes only and reflects the current opinions of Western Asset.
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