Olivia Albrecht: So what are we thinking in terms of our exposure to corporate credit, and where are we finding opportunities today?
Scott Mather: Even though we don't think a true turn on the default cycle is imminent—that would be caused by a recession, which we also don't think is really imminent—there's reason for some caution in the corporate market. And you cited some of the reasons there. One, if you take that spread history and you adjust for the leverage—where we are in the cycle you also adjust for the structural changes in the marketplace—which are it's a lower quality marketplace than it used to be, as is evidenced by the amount of triple Bs and the growth there—and then you further adjust by the change in liquidity—the amount of market making capacity that's there relative to the size of the market.
When you try to do some adjustments for all that, you find out, well, we're really on the tighter side with respect to spreads. And so one shouldn’t be betting on further spread compression. We've had a sharp rebound this year so far correcting for what happened in November and December of last year. It’s the sort of environment we think where people should focus then on reducing their exposure, reducing their duration in corporate credit, focusing on shorter maturities and going up in quality.
Olivia Albrecht: Could you explain why we favor this segment and what we're doing in portfolios today to take advantage of our views on structured credit?
Scott Mather: The point we would make here in the case of residential mortgages is that unlike corporate credit through the cycle there's been a deleveraging event.
So not only as housing prices have gone up, the borrower credit quality has gone up, and the structures themselves that these loans are packaged in have delivered. So it's very different. While the corporate market credit quality has been generally declining year by year, it's actually been increasing with respect to some of these legacy non-agency mortgages.
And people should remember that yes, there'll be some weakness in the next recession that will pressure some of these trends the other direction. But in general it should be a much more resilient sector, nothing like it was in '07-'08 when we had a different host of problems. That's one of the reasons why we expect this sector—the credit related mortgage sectors—to significantly outperform traditional corporate credit in the next true downturn that we get. So yes, favor non-agency mortgages.
We also favor agency mortgages. Obviously, one of the most liquid spread products aside from governments that there is out there. And when you look at those spreads, we're on the cheaper side of long-time fair value. And it's hard to say that with many other spread sectors out there today. So once again, very liquid, high quality sector that gives you a spread pickup relative to government's.
Away from mortgages, it's also the case that we favor a lot of asset backed securities, a lot of structured credit, once again, because of the resilience that those particular securities will have. As long as you stay higher up the credit quality spectrum, in the next true turn of the default cycle they should significantly outperform their corporate counterparts.
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