Featuring:
Greg Handler
Portfolio Manager and Head of Mortgage and Consumer Credit
Western Asset Management
Whether Fed adjustments lead to a soft landing or further easing, mortgage securities’ diversification benefits and potential for higher yields with reduced volatility make them an attractive option for income-oriented investors. Discover Western Asset Management’s unique approach to the strategy with the Western Asset Mortgage Opportunities Fund (DMO) and 2025 fixed income outlook below.
A Franklin Templeton company, Western Asset Management is the investment advisor for the Western Asset Mortgage Opportunities Fund (DMO). Learn more about the Fund here.
Transcript
CEFA:
Welcome to CEF Insights, your source for closed-end fund information and education, brought to you by the Closed-End Fund Association.
Today, we are joined by Greg Handler, Portfolio Manager and Head of Mortgage and Consumer Credit with Western Asset Management. Western Asset Management is the investment advisor for Western Asset Mortgage Opportunities Fund, symbol DMO.
We're happy to have you with us today, Greg.
Greg Handler:
Thanks for having me.
CEFA:
Greg, I mentioned the Western Asset Mortgage Opportunities Fund. Can you discuss the investment strategy as well as the key objectives?
Greg Handler:
Yes. So, the Western Asset Mortgage Opportunities Fund, ticker DMO, was launched in early 2010 to take advantage of some of the dislocations in the residential real estate market following the great financial crisis. The portfolio seeks to offer attractive income with a low correlation and volatility to other fixed income sectors. And the team takes an active approach across all sectors of the residential, commercial and consumer markets.
The strategy utilizes opportunistic leverage to enhance returns. The strategy invests significantly in floating rate assets, seeking to minimize sensitivity to changes in interest rates, and the firm deploys multiple diversified strategies that benefit in different environments so no one strategy dominates the performance, helping to dampen volatility. We do believe this is a pretty unique vehicle and we're very proud of the long-running performance.
CEFA:
Are there unique characteristics to mortgage securities that provide a degree of diversification to an income portfolio that investors may not get from treasuries or corporates?
Greg Handler:
Yes, there certainly are a lot of differences. We do see pretty significant issuance in the market. So, the overall market is about $2.3 trillion and this year in 2024, we'll have over $600 billion in gross issuance. So, there's a lot of ways of participating in the market and they do tend to have their own technicals and fundamentals that deviate somewhat from just the traditional fixed income markets.
You could think of mortgage credit as being more impacted by overall lending credit conditions within the banking sector as well as the non-bank financials. So, it'll be maybe a little more correlated to the financial parts of the corporate market. But also, you're getting distinct mortgage pools, so these tend to be structured as bankruptcy remote. So, unlike a corporate, these are independent of the banks that are originating these loans. So, I like to think of it as more akin to the private credit market.
So we do compete, we're involved in several of similar deals as to what real estate private credit funds would be invested in. So, these types of investments do fall outside of a traditional fixed income benchmark. So, we believe they're an attractive diversifier from the traditional fixed income markets, the treasuries and the corporates. And they do, because it's a little more unique of an asset class, they do tend to trade a little bit wider and offer higher yields. And so, we do see over time, a significant premium to the traditional debt markets, but also lower sensitivities, lower beta too as well.
CEFA:
What is your process to evaluate the broad range of mortgage securities and then make specific security selections and allocate those positions as you build your portfolio?
Greg Handler:
So Western Asset's a long-term fundamental value investor, and we always start from the top down, and we think about the outlook for the economy, for interest rates, for inflation and asset prices, and we have sort of a firm-wide base case that we stress test. But in terms of thinking about where we are within the cycle, what the near-term and long-term trends are, we do come up with forecasts for things like home prices and commercial real estate, sectors that we think will either benefit or potentially face headwinds.
And then we apply that top-down perspective to the bottom-up fundamental security research and screening. So, from the bottom up, we're focused on the low-level data, we're looking at the understanding, the underwriting of the loans, understanding the specifics of the borrower, understanding the lending standards that are being applied, understanding how we expect those to trend.
So, we have the benefit now of several decades of historical performance. So, we've seen obviously how mortgages have performed through multiple cycles, and we can apply those scenario analyses to these securities and stress tests and see how they would perform under a variety of scenarios. But overall, it's a comprehensive process that we do. And after making an investment decision, we're not just sitting and waiting, we're monitoring the ongoing performance and adjusting our scenario analyses in real time as we see changes in the market.
CEFA:
What factors, issues, or events would lead you to sell a particular portfolio security or significantly change your portfolio allocation?
Greg Handler:
There could be a variety of reasons why we would want to sell or exit a position. First of all, if the expected return has already been achieved and we've seen a spread tightening and the yield has come in, that's a positive reason. Also, we're always looking at relative value. So, if we think we can buy better risk adjusted yield investments elsewhere, we will be rotating across different investments over time.
And then clearly if we do see some of the risk factors increasing or we do have a significant change to our assumptions, we're not afraid to sell down and take a loss if necessary to exit a position that we don't feel as strong, highly convicted about. And then I'd say lastly, just the monitoring, the overall risk level of the portfolio. So, to the extent a position is outsized or that we are trying to decrease or shift the risk in the portfolio, that would be another reason why we might want to exit a position.
CEFA:
Greg, the Federal Reserve has been easing rates, the rate of inflation has improved, and economic growth has been resilient. We have significant geopolitical tensions and a new administration taking office in the US. Where do you see the fixed income markets currently and what is your outlook for 2025?
Greg Handler:
Yeah. So, we're kind of viewing this as a mid-cycle adjustment per the Fed. Clearly, they raised rates to highly restrictive levels, and so they have a lot of room to cut and they've begun that process. But also, and I think we view this as more of a mid-cycle adjustment, like what they did in 95, 96 during what was also a pretty significantly strong economic background. And we are seeing similar high levels of productivity increases.
So overall the economy seems really strong, but the Fed has room to cut. So that's the good news. And it's also good news that the Fed's a little more balanced in their dual mandate. So obviously inflation still on the higher side of what they would like to see, but coming down. And the employment side looking a little bit weaker.
So the good news is for like a 60/40 portfolio where you have a balance of credit and the balance of fixed income, we do view 2025 to be a healthy environment where you want to have some hedges, some interest rate risk exposure in the event there is a more significant downturn and the Fed is going to be in that scenario, required to be much more accommodative and take rates down significantly.
Or if it is just this mid-cycle adjustment, I think having the credit exposure in your portfolio and having high carry and having a yield advantage makes a lot of sense. So, we do feel that this is a very good backdrop for investing in a strategy similar to this mortgage opportunities fund because we do see that we think the consumer's in really good shape here.
We think overall home prices are probably going to be a little bit under pressure here just given the higher mortgage rates. But again, as the Fed is I think acutely aware of how restricted they've been, we still see room for mortgage rates to fall and for home prices to grow, albeit at a modest pace in 2025.
CEFA:
Within the mortgage segment, are you finding valuations to be broadly at attractive levels?
Greg Handler:
Yes, we are. There's definitely been a lot of uncertainty given this significant tightening cycle that the Fed underwent. Home prices did cool off but have since rebounded a little bit. We've seen definitely a lot of concerns for segments of the commercial real estate market, which have not recovered as significantly from the COVID shutdowns, particularly things like office.
So overall, it's interesting, we look at spreads today versus where they were pre-COVID, and we see still a pretty healthy risk premium being priced into the security. So, unlike traditional fixed income markets, investment grade credit, high yield credit, which are trading well through at much lower spreads than where they were pre-COVID, we actually still see a nice healthy risk premium being priced into the mortgage markets, most notably in things like commercial real estate for some of the reasons I outlined.
But overall, we do think that you're getting compensated for that mortgage risk. And yeah, while we might be cautious on things like office in the commercial real estate market, overall, the traditional parts, the other segments of the commercial real estate market are doing quite well. Things like hospitality, multi-family rents still continue to grow. Even retail, which has been much maligned and underwent some significant de-risking in the mid 2010s, we've seen very strong retail performance.
Actually, some of the highest yearly rent increases in decades, so. And occupancy at some of the lowest levels or highest levels in recent years. So overall, we think there's a lot of positive fundamental trends. Things like e-commerce are benefiting, logistics and warehouse distribution, and even new segments in the market like data centers have really. So, we've found a lot of new ways and attractive ways of sourcing credit risk and finding new venues to invest in.
CEFA:
What are the most significant risks you consider in the current environment?
Greg Handler:
Yeah. So, we're obviously mindful of just the risk of higher interest rates on things like commercial real estate and residential. You do have some rollover risk where we do see borrowers may be having difficulty being able to refinance into a higher rate environment. But overall, we view the risks as balanced today.
We also see the risk to the downside. If the consumer fundamentals were to deteriorate or if we were to see a big spike in unemployment, that could be a headwind, potentially seeing an increase in default rates and in delinquencies. And while we don't see either of those risks being outsized in today's environment, we are always mindful of that and we do utilize interest rate hedges and credit hedges to protect the portfolio.
CEFA:
How is the DMO portfolio currently positioned?
Greg Handler:
So overall, the fund is about two-thirds focused in residential real estate. It's a healthy mix of some of the legacy pre-GFC residential securities that are still outstanding, performance that has stabilized significantly, and we've seen the benefit of the stronger home price growth over the many years. So, we still like that segment of the market, but that was much more significant in the portfolio when it was launched in 2010.
Today, it's around 18%. The other parts of the residential market that we focus on are the newer issued securities. So those are things that have come out post-GFC. So, parts of the market that are usually not guaranteed by Fannie and Freddie. Those might be things like jumbo mortgages, non-qualified mortgages. And in some cases, we're actually getting pre-GFC, what's called now re-performing loans, where those loans might have gone through some form of delinquency and were maybe modified, brought current.
And either the banks that owned them or other sources had been able to repackage them into new securities. So that's about 25% of the market. And then we're also involved in the Fannie Mae, Freddie Mac risk transfer market, which is the non-guaranteed portion of the guaranteed Fannie Mae, Freddie Mac program. So, these are securities that are issued regularly by Fannie and Freddie.
We've been involved in this market since its inception back in 2013. Performance has been quite strong as you can imagine. The delinquency levels have remained very low, and a lot of the programs that the GSEs have instituted since the GFC, have really helped to minimize losses, giving borrowers multiple opportunities to become current. So even during a crisis like the pandemic, a lot of these programs really, the oversight from Fannie and Freddie have really benefited the performance of the loans.
And so outside of the residential market, our next biggest allocation is commercial real estate. We have about a 25% allocation to commercial real estate. I'd say our biggest focus there tends to be on the large loan credit market, which is about 18% of that, and that's going to be what we would consider the best properties, really the lowest loan to value, the highest quality.
Typically, there we're getting really A-plus type assets with very strong institutional sponsorship. We do like that segment of the market because we do have great insights into the performance of the asset. It also tends to be floating rate in nature, and it's a section of the market where we can really do our bottom-up research and really get comfortable with the credits and really pick our names and pick our spots. The other 10% or so is a mix of consumer and corporate credit, which tends to be mortgage related.
On the consumer side, our biggest exposure is to student loans, but that's just about one and a half percent. We do, again, view the consumer as strong in this environment, and we like taking some consumer credit risk, but we do avoid things like unsecured consumer credit, marketplace lending or subprime lending is not an area that we like to focus on just given the volatility and the unsecured nature of those credits.
CEFA:
Where are you seeing the best opportunities to put new capital to work?
Greg Handler:
Yeah. I'd say we're focused still on the residential and the commercial real estate markets. In the commercial space, we still see, I'd say the most outsized yield advantage, but again, we're being very cautious with our credit selection. We do think that you're getting the benefit right now of some of the best underwriting that we've seen.
So, we like the new issue market for that reason because newly underwritten loans are being underwritten to what we would consider very conservative, some of the highest debt yields, lowest loan to values that we've seen on record going back over 20 years. So, we like that market.
And then on the residential side, we do view the risks as attractive here. So those are our main focuses. And a little bit to the corporate credit side where we have invested in some REITs recently where we think that some of these REITs are also trading at pretty significant discounts and look attractive to us.
CEFA:
Greg, how do you see an allocation to a fixed income strategy focused on mortgages and mortgage-backed securities like DMO best positioned in an income-oriented investor's portfolio?
Greg Handler:
Yeah. We think this is a great strategy for income-oriented investors. Current distribution on market price is right around 13%, and the interest rate exposure is quite low. We ran the historical correlations of this fund versus broad indexes of fixed income and versus the ten-year treasury, this has had a negative 0.01, basically a zero correlation to the ten-year treasury. To the overall Barclays index, it's had about a 0.23 correlation. And the highest correlation is to high yield and investment grade credit, but that's with a beta of just around 0.5 to 0.6.
So, we do think it's a nice diversifier within a portfolio, and I think this could also be viewed as a way of gaining private mortgage credit, real estate credit exposure for individual investors without having to lock up your money in a private credit vehicle. So, we think it's an attractive investment for a variety of reasons, and we do think that the opportunity set continues to grow and that it's going to be a strategy that can continue to perform.
CEFA:
Greg, thank you so much for taking the time to join us today.
Greg Handler:
Thank you very much. I really appreciate your time.
CEFA:
We want to thank you for tuning into another CEF Insights podcast. For more educational content, please visit our website at www.cefa.com.
Podcast recorded December 2023.
Disclosure
This material is not, and is not intended as investment advice, an indication of trading intent or holdings, or the prediction of investment performance. All fund-specific information is the latest publicly available information. All other information is current as of the date of this presentation. All opinions and forward-looking statements are subject to change at any time.
Western Asset Management disclaims any responsibility to update such views and/or information. This information is deemed to be from reliable sources; however, Western Asset does not warrant its completeness or accuracy. This presentation is not intended to and does not constitute an offer or solicitation to sell or a solicitation of an offer to buy any security, product, investment advice, or service, nor shall any security product, investment advice or service be offered or sold in any jurisdiction in which Western Asset is not licensed to conduct business and/or an offer, solicitation, purchase or sale would be unavailable or unlawful.