United Kingdom
- Capturing the opportunity from the sharp rise in short-term rates
- Current spreads more than compensate for the risks
- The outlook for secured finance in 2023 remains positive
Capturing the opportunity from the sharp rise in short-term rates
Bond markets appear to be approaching a peak in yields after a steady rise in central bank policy rates over the past 18 months. Headline inflation has fallen from its peak, as has core inflation (albeit still well above policy targets). This suggests we are nearing the end of the current cycle of policy rate hikes.
For investors looking to benefit from the sharp rise in short-term rates, we believe one of the most attractive opportunities is for secured finance securities.
There is typically a spread premium for such secured finance instruments over corporate bonds with a similar credit rating, primarily due to the complexity and illiquidity of the asset class. However, this additional premium is at its widest level over the past eight years.
As one measure of this gap, the assets within Insight's Secured Finance Fund have an average 324bp spread over BBB-rated UK credit with a three- to five-year maturity at the end of February 2024. At the end of 2021, the premium was only 195bp and five years prior to then, it was 217bp. Together with higher levels of short-term cash rates the overall yield on secured finance is over 10%, which is above the historic long-term return from equities1.
Figure 1: Secured Finance Fund spreads remain at long term highs2
Source: Insight, Bloomberg. Between 31 December 2001 to 31 December 2022 the average annual return of the MSCI World Index (GBP hedged) was 8.00%.
We believe current spreads more than compensate for the risks
Secured finance assets offer the potential for attractive carry with greater levels of control and seniority in the capital structure compared to unsecured bonds. This carry should also help offset any modest further spread widening that may occur. These instruments gain additional protection relative to the underlying credit risk of the underlying borrowers by being secured against ring-fenced assets or by over-collateralisation.
Most areas of secured finance are well placed to withstand further economic weakness that may result from the policies implemented by central banks to slow growth and reduce inflationary pressures. The areas we feel remain most at risk are the buy-to-let residential mortgage-backed and commercial real estate. The former is primarily impacted by higher mortgage rates, regulatory changes and falling house prices, the latter facing the additional pressure of tighter lending standards in the wake of US regional banking woes from earlier this year.
Secured finance instruments are backed by a wide range of underlying collateral. By entering into bilateral agreements with borrowers, investors can benefit from a greater level of control on the nature of the collateral and the protection afforded by the structure itself.
The outlook for secured finance in 2023 remains positive
We believe the market continues to benefit from strong fundamentals and robust technicals. Despite the year-end rally, we believe secured finance is poised for the potential to see further gains owing to strong technical, dovish central bank signals and attractive value relative to corporate debt.
For more information, read our Secured Finance primer.
