Real Talk with Denise Crowley of ZAIS Group

Nov 30 2017 | 11:44am ET

Today, we sit down with Denise Crowley, Head of Structured Credit, at ZAIS Group. In our interview, Crowley offers her firm’s take on the state of the fixed income markets (and the future of stimulus flow), an outlook on residential lending heading into the new year, commercial lending risk factors and more.

Crowley serves as Head of Securitized Credit at ZAIS and is responsible for mortgage investments, including Non-Agency RMBS, CMBS, Commercial Real Estate debt and equity and CLO investments across our separately managed accounts and co-mingled funds.

She is also a member of ZAIS’s Management Advisory Committee. Since joining ZAIS, she has been actively involved in the MBS, CLO and CDO security markets since 1999. Previously, Ms. Crowley managed an HY credit fund for ZAIS. Before joining ZAIS in August of 1997, Ms. Crowley worked at JPMorgan in the High Yield Trading Group. Before JPMorgan, she worked for Hon. Daniel P. Moynihan as an economic research analyst. she received a B.A. from Boston College and an MBA. from New York University’s Stern School of Business.

Finalternatives [FIN]: What is your general overview of the fixed income markets right now?

Denise Crowley [DC]: We believe the current macro environment will enable the Fed to stay on a gradual path with respect to rate hikes. Just as importantly, the European Central Bank (ECB) has extended its bond-buying program into much of 2018, and the Bank of Japan (BoJ) continues on its easing path. Easing by the ECB and BoJ is forcing European and Asian investors into U.S. markets, which could further bolster U.S. credit markets.

We view the current moderate economic growth phase, with a relatively benign inflation outlook and no imminent expectation for recession, as good for credit for the foreseeable future. However, we are mindful of some late business cycle phenomena. First, we see more dispersion in credit spreads- although overall corporate credit spreads are tight, we’ve seen a significant uptick in idiosyncratic spread widening in individual issuers across several sectors. This is typically a late cycle phenomenon. Second, traditional assets such as stocks and corporate bonds have rallied with high yield bond spreads, reaching post-crisis lows (they have subsequently widened a bit), and expected returns are likely to be muted in the coming years. The credit curve in high yield and investment grade corporates has flattened such that investors are not earning a large premium for moving out on the risk spectrum.

In light of the current environment, we believe investors should stay invested in a diversified portfolio with underlying corporate, consumer, and mortgage exposures but should assume a more defensive position as we believe the economy will continue to expand near to medium term. Furthermore, while spreads are tight, we believe supply and demand imbalances suggest they may go tighter. However, we are also mindful of the fact that we are likely in the latter part of this economic cycle and volatility and spreads are low. Hence, we think it is important to be very selective in positioning portfolios.

FIN: How would you describe current conditions in commercial real estate lending markets?

 DC: Senior Loan Officer Opinion Surveys on Bank Lending Practices have been indicating that bank lending standards on CRE loans have been tightening while net demand has been weakening for the past several quarters. Agency and private label issuance of CMBS, however, have increased this year and financing costs have come down, especially in the senior parts of the capital structure. There has been a considerable bifurcation of pricing on BBB tranches based on the quality of credit exposure relative to last year with the greater penalization of CMBS with higher retail and hotel property exposure.

Balance sheet lenders’ underwriting standards are expected to further tighten in 2018 as a result of slowing CRE price appreciation and NOI growth. CRE lending volume is expected to be flat or decrease next year, per RELA–Chandan 2017 Survey of CRE lender sentiment. The responders to the survey were predominantly (90%) banks and the balance were agency or conduit lenders. This is likely to result in a lower supply of CRE debt available for investors, and there is still significant cash waiting to be deployed into the sector, so spreads are likely to tighten further on balance, with considerable tiering based on quality.

FIN:  How is the Residential Lending market looking as we head into 2018?

DC: The residential lending market continues to be reasonably healthy. However, new mortgage originations are currently dominated by government-related entities: FNMA, FHLMC and FHA/VA. Collectively these three entities accounted for just under 80% of all mortgage originations in Q1 2017. Portfolio originations account for most of the balance, as private label securitization volumes have been anemic since 2008. While lending standards have been easing at the margins, mortgage underwriting standards continue to be significantly tighter than pre-crisis levels. Lenders have been reluctant to take on the liability associated with non-QM mortgage origination. A byproduct of this tighter lending environment is a decline in the homeownership rate from a peak of over 69% in 2004 to under 64% today. Tighter credit has pushed many former homeowners into the rental market. On a more positive note, residential lending today is being supported by steady HPA gains. The most recent reading on the S&P Case Shiller Home Price Index showed national home prices gaining 6.1% year-over-year as of August. Steady HPA gains are expected to continue as prices are being driven by historically low levels of housing supply in conjunction with healthy levels of demand following a period of lackluster household formations post-crisis. Tight underwriting coupled with solid home price appreciation has produced strong credit performance in post-crisis vintages as default metrics compare favorably to prior vintages.

FIN: How are the leveraged lending and high yield markets and how do you see these markets faring in 2018?

DC: HY Spreads are near post-crisis tights but still approximately 50-75bps off the all-time tights. Default rates are low and trending lower as the overwhelming wall of liquidity continues to support new issue and refinancing across corporate balance sheets. Although HY spreads are tight overall, the market is very bifurcated with select credits in Pharma, telco, retail, hospitals, software, grocers trading at wide levels.

We would expect HY to generate mid-single digit returns (4-6%) in 2018 given current coupons and spread levels. However, the relative value opportunities within HY are plentiful as many credits have been overlooked as dispersion has grown. Sizable returns may be achieved through more tactical trading opportunities in some of the currently disfavored sectors (i.e., telecom, healthcare) as well as the tactical yet prudent use of leverage. The trigger to reduce longs and increase short positions in HY will be signs that the overall, indiscriminating liquidity being provided by overseas investors, as well as domestic investors, begins to slow.

FIN: What could have the biggest impact on fixed income markets in 2018? What could go really wrong?

DC: We believe that the most likely outcome is largely a continuation of what has been the prevailing environment; moderate growth, modest growth in inflation and central banks that move very moderately to remove accommodative financial conditions resulting in a continued hunt for yield among credit products. However, there is the potential for a “melt up” scenario in which the fiscal impact from tax cuts could possibly cause the economy to break out of the 1.5-2% GDP range and sustain a 3%+ pace. The corporate investment could pick up, and in the current low unemployment backdrop, wage and price inflation could pick up significantly, especially for high-income earners where wage inflation has been especially slow to respond to a tight labor market. If inflation shoots up, both in the US and abroad, central banks will need to respond with tightening financial conditions to try to reign in inflation and which will lower returns in fixed income.


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