Channel 11 Episode 28: BofA Securities’ Chris Flanagan on Base and Downside Outlooks and Securitized Products

Chris Flanagan, Managing Director and Fixed Income and Securitized Products Strategist at Bank of America Securities, joins DoubleLine’s Ken Shinoda on March 2, 2022, to discuss (0:27) the BofA team’s base-case outlook for the U.S. economy and interest rates, and what those scenarios would mean for the housing market and different securitized product markets. Then Mr. Flanagan explores forces of deglobalization that have fueled inflation and fragilized the world’s financial system (34:35), leaving the economy and that base case vulnerable to geopolitical and other shocks.

BofA Securities’ base case (5:00) calls for a mild three-quarter recession beginning in the third quarter of 2023 and inflation moderating to 2.3% quarter-over-quarter in the fourth quarter of 2023. Turning to the mortgage sector and the housing market, Mr. Flanagan notes that the significant spreads of mortgage rates relative to Treasuries should tighten “as the Fed’s path becomes a little bit more certain,” with the Freddie Mac survey rate dropping to 5¼%. From housing’s price peak (9:21) in the second quarter of 2022, BofA Securities expects a peak-to-trough drop of 5.4% 2Q2022 to 2Q2023 on a national average, with 0% change over the full 2023 calendar year. While exceptions will occur in specific geographic markets, Mr. Flanagan says, “This year we’re going to see home prices basically flat and next year as well.”

Given spread tightening in non-Agency residential mortgage-backed securities (RMBS) such as AAA non-qualified mortgage RMBS (19:36), Mr. Flanagan favors Agency MBS. That said, technicals (22:42), he notes, are supportive of private-label mortgage securities, gross mortgage loan production having declined from $4 trillion to $4½ trillion in the last couple of years to $1½ trillion to $2 trillion. Mr. Shinoda adds (25:47) that “while spreads on securitized have come in, spreads on corporates have come in even more.” 

Mr. Flanagan expresses reservations about down-in-credit commercial mortgage-backed securities (27:00), in particular exposure to the office sector. Regarding asset-backed securities (ABS) (28:11), he notes that investors remain attracted to the front-end exposure and protections for the top of the capital structure. He advises caution with respect to subordinate classes, in particular, subprime auto BB ABS. “The credit metrics around the subprime borrower are not pretty at all,” says Flanagan, and given pandemic stimulus and forbearance measures during the COVID-19 lockdowns, borrowers who gained access to credit at the low end of the credit spectrum might be “weaker borrowers than their FICO scores suggest.”

Technicals in AAA collateralized loan obligations, he says, look good. A key question will be “around the fundamentals of the leverage loan market and the capacity to continue to service floating-rate debt in the context of a Fed that has at least three more rate hikes if not more” and keeps “rates at an elevated level for an extended period of time.”

Mr. Flanagan concludes with a discussion (34:35) of BofA Securities’ downside risk scenario. After 40 years of globalization and disinflation, the world appears to have entered a period of fragmentation, signaled by the Russian invasion of Ukraine, with the follow-on effects of sanctions against Russia, and Russia and other countries pursuing de-dollarization. Furthermore, he notes that in the U.S., the effects of stimulus have been poorly understood. Geopolitical shocks or domestic surprises, such as the Biden administration’s pursuit of student loan debt forgiveness (a skeptical Supreme Court notwithstanding), could overturn expectations on inflation and the Fed’s future path on interest rates.