A surprising shift in bond markets - what’s driving investors to rethink their strategies?
Money managers traditionally focused on collateralized loan obligations (CLOs) are increasingly turning their attention to collateralized mortgage obligations (CMOs) as spreads between the two tighten.
According to data from Citigroup, spreads on floating-rate CMOs backed by entities such as Fannie Mae and Ginnie Mae are now nearly equal to those of top-rated CLOs. A Bloomberg report noted that, historically, CLO spreads have been significantly wider. However, with CMOs becoming more attractively priced, investors are shifting their focus.
Asset management firms, including TCW Group and Columbia Threadneedle, are actively increasing their exposure to mortgage-backed debt. Both financial instruments pay floating rates, are backed by loans, and hold top-tier credit ratings, making them comparable investment options.
Liza Crawford, co-head of global securitized credit at TCW, noted that the shift in relative value among market sectors has driven her firm to increase its CMO holdings while reducing its exposure to AAA CLOs. “Bond markets live and breathe, and if you remain in silos then you’ll miss out,” Crawford said.
Ankur Mehta, head of spread products research at Citigroup, expects institutional investors to continue moving away from CLOs if CMO spreads remain at their current levels or widen further. Since CLOs account for roughly two-thirds of all high-risk corporate loans, a significant reduction in demand for these products could drive borrowing costs higher for private equity firms engaged in leveraged buyouts.
TCW has largely concentrated its CMO investments on those backed by Ginnie Mae, while Columbia Threadneedle has turned to CMOs as a means of reducing exposure to other high-quality securities, including CLOs, according to Jason Callan, the firm’s co-head of structured assets.
Converging market trends
Over the past two years, the spreads of CLOs and CMOs have been steadily converging. CLO risk premiums have tightened as investors increasingly buy exchange-traded funds (ETFs) linked to CLOs. Citi projects that assets in CLO ETFs will grow to $55 billion by 2029, up from previous estimates of $35 billion.
Meanwhile, spreads on CMOs have widened as a result of broader mortgage-backed security (MBS) market trends, influenced by the Federal Reserve’s retreat from the sector and decreased demand from commercial banks.
“These two markets happened to run into each other,” Walt Schmidt, a strategist at FHN Financial, said in an interview with Bloomberg. He pointed to a combination of CLO spreads narrowing and underlying mortgage bond prices declining just before the Fed began cutting rates in late 2024.
Beyond their relative value, CMOs have also seen a surge in issuance, Bloomberg noted. In both 2023 and 2024, sales of floating-rate agency CMOs outpaced those of CLOs, with $140 billion of CMOs issued last year compared to $105 billion in AAA-rated CLOs, according to Citigroup.
Banks, in particular, have emerged as major players in the CMO market. The sharp rise in interest rates in 2022 drove banks to favor floating-rate products over fixed-rate bonds, further fueling demand for CMOs.
Do you think CMOs will continue to outpace CLOs in investor interest? Share your thoughts in the comments below.
