How to approach structured securities
We think a disciplined, research-driven approach across maturities and capital structures can create securitised bond portfolios designed to produce stable, long-term income and total return. In particular, we think it is critical to focus on four primary sources of risk:
- Relative/absolute value
Agency MBS are backed by government agencies, which requires applying a rigorous framework to the collateral of the pool of loans. We think it makes sense to look for positions with call protection and favourable servicer behavior that we feel are undervalued.
Documentation is more important for non-agency MBS, as greater understanding of the loan underwriting process and structural complexities of the private label market grow in importance.
The MBS universe is uniquely positioned today. House price appreciation has slowed, but remains positive. Household formation has been steadily increasing, creating new demand for shelter. Low short-term interest rates also maintain margins for levered buyers of MBS.
Commercial mortgage-backed securities
These asset pools are the least homogeneous, with a single loan varying from approximately 0.5% to 10% of a deal. On a macro level, we suggest modeling a group of loans by geography, property type and leverage to determine the probability of loss. From there we would focus on collateral as we consider idiosyncratic risks to determine specific loan performance.
We generally favour higher asset quality/higher leverage, especially late in the market cycle. Property prices on higher quality assets have historically proven to be more resilient through a downturn, resulting in more attractive stressed loan-to-value ratios.
Currently we like industrial properties — as opposed to retail — particularly existing warehouses in urban areas that can be used to house online shipping facilities.
We analyze the collateral to understand how each credit has performed over a full market cycle. Since information can be scarce, we align our research coverage by broad collateral types to compare deals with common features. Structurally, some deals can be negotiated, so we would examine the specific terms to identify how many items are favourable to investor needs.
Currently we are constructive on the consumer sector of the market, including credit card and auto loans, but continue to avoid the deep subprime areas. We are cautious toward corporate credit risk, as we are seeing more monoline businesses carrying more leverage. Corporate credit risk can come through ABS in a variety of ways, most readily in deals such as whole business, timeshare and CLO.
While structured securities offer clear benefits, building portfolios can be complicated.
Finding opportunities in securitised assets
As we assess the broad market in our search for value, we believe the current environment makes securitised assets an attractive component of a portfolio.
The amount of global bonds offering negative yields continues to rise, amid a dovish pivot from central banks, and now stands at an all-time high of more than $13 trillion. We believe this trend will continue to fuel a search for yield.
As a result, investors seeking yield must either move farther out along the yield curve or down the credit quality spectrum. We don’t think either option is particularly compelling in the current environment, since risk premiums are compressed, meaning investors are not being adequately compensated for duration risk.
Similarly, tight credit spreads versus historical averages mean investors seeking additional yield from lower quality assets will be exposed to spread widening risk in this late cycle environment.
Many securitised credit instruments are rated similarly to Treasuries, with a yield nearly 1.4x higher. The yield per unit of duration of securitised credit is approximately 2.5x of Treasuries and 1.8x of investment grade corporates.
Securitised credit has historically offered, on average, a more attractive yield per unit of risk. Investors are exposed to the consumer and to real assets, as opposed to corporate earnings. In light of international trade disputes and limited corporate earnings expansion, the U.S. consumer remains strong and the U.S. is at or near full employment. This may boost the performance of mortgage loans, credit cards, auto loans, aircraft deals, office building occupancy and apartment or hotel vacancy — all of which support MBS, CMBS and ABS.
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A word on risk
Investing involves risk; principal loss is possible. Debt or fixed income securities are subject to market risk, credit risk, interest rate risk, call risk, derivatives risk, dollar roll transaction risk and income risk. As interest rates rise, bond prices fall. Below investment grade or high yield debt securities are subject to liquidity risk and heightened credit risk. Foreign investments involve additional risks, including currency fluctuation, political and economic instability, lack of liquidity and differing legal and accounting standards. Asset-backed and mortgage-backed securities are subject to additional risks such as prepayment risk, liquidity risk, default risk and adverse economic developments. The value of convertible securities may decline in response to such factors as rising interest rates and fluctuations in the market price of the underlying securities.
1 Data source: Bloomberg, L.P., Bloomberg Barclays U.S. Aggregate Bond Index
2 Data source: Bloomberg, L.P., Bloomberg Barclays MBS Index
3 Data source: Bloomberg, L.P., MBS: Bloomberg Barclays MBS Index; CMBS: Bloomberg Barclays CMBS Index; ABS: Bloomberg Barclays ABS Index
4 Data source: Bloomberg, L.P. Representative indexes: Securitised credit: Bloomberg Barclays U.S. Securitised Index; U.S. Treasuries: Bloomberg Barclays U.S. Treasury Index; Investment grade corporates: Bloomberg Barclays U.S. Investment Grade Corporate Index
A basis point is a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%, or 0.01% (0.0001). Call protection is a protective provision of a callable security, prohibiting the issuer from calling back the security for a specified period of time. The period during which the bond is protected is known as the deferment period or the cushion. Correlation is a statistical measure of how two securities move in relation to each other. Perfect positive correlation (a correlation co-efficient of +1) implies that as one security moves the other security will move in lockstep, in the same direction. Alternatively, perfect negative correlation (a correlation co-efficient of -1) means that securities will move by an equal amount in the opposite direction. If the correlation is 0, the movements of the securities are said to have no correlation; their movements in relation to one another are completely random. Sharpe ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk. Standard deviation is a measure of the dispersion of a set of data from its mean. If the data points are farther from the mean, there is higher deviation within the data set. It is used to measure the volatility of an investment. Term premium is the excess yield that investors require to commit to holding a long-term bond instead of a series of shorter-term bonds. An investment waterfall is a method of splitting profits among partners in a transaction that allows for profits to follow an uneven distribution. The waterfall structure can be thought of as a series of pools that fill up with cash flow and then once full, spill over all excess cash flow into additional pools. Yield is the income return on an investment, such as the interest or dividends received from holding a particular security.
Bloomberg Barclays Asset-Backed Securities Index is the ABS component of the U.S. Aggregate index and includes credit and charge cards, autos and utilities. Bloomberg Barclays CMBS ERISA-Eligible Index is the ERISA-eligible component of the Bloomberg Barclays CMBS Index. This index, which includes investment grade securities that are ERISA eligible under the underwriter’s exemption, is the only CMBS sector that is included in the U.S. Aggregate Index. Bloomberg Barclays Global Aggregate Negative Yielding Debt Market Value Index measures the stock of debt with yields below zero issued by governments, companies and mortgage providers around the world that are members of the Bloomberg Barclays Global Aggregate Bond Index. Bloomberg Barclays Government-Related Index represents the agency portion of the Bloomberg Barclays U.S. Aggregate Bond Index. Bloomberg Barclays U.S. Agency Index measures agency securities issued by U.S. government agencies, quasi-federal corporations, and corporate or foreign debt guaranteed by the U.S. government. Bloomberg Barclays U.S. Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes USD-denominated securities publicly issued by U.S. and non-U.S. industrial, utility and financial issuers. Bloomberg Barclays U.S. Corporate Investment Grade Index is a broad-based benchmark that measures the investment grade, fixed rate, taxable corporate bond market. Bloomberg Barclays U.S. Mortgage-Backed Securities Index covers agency mortgage-backed pass-through securities (both fixed-rate and hybrid ARM) issued by Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC). Bloomberg Barclays U.S. Treasury Index includes public obligations of the U.S. Treasury. Treasury bills are excluded by the maturity constraint but are part of a separate Short Treasury Index. In addition, certain special issues, such as state and local government series bonds (SLGs), as well as U.S. Treasury TIPS, are excluded. STRIPS are excluded from the index because their inclusion would result in double-counting. Bloomberg Barclays U.S. Securitised Index is comprised of predominantly MBS Agency securities, but also includes ABS, CMBS and covered securities. ICE BofA Merrill Lynch U.S. Corporate Index tracks the performance of U.S. dollar denominated investment grade corporate debt publicly issued in the U.S. domestic market. ICE BofAML U.S. High Yield Constrained Index contains all securities in the ICE BofAML U.S. High Yield Index rated BB+ through B- by S&P (or equivalent as rated by Moody’s or Fitch), but caps issuer exposure at 2%. Index constituents are capitalization-weighted, based on their current amount outstanding, provided the total allocation to an individual issuer does not exceed 2%. Russell 3000® Index includes the 3,000 largest U.S.-traded stocks.
This information represents the opinion of Nuveen, LLC and its investment specialists and is not intended to be a forecast of future events and or guarantee of any future result. Information was obtained from third party sources which we believe to be reliable but are not guaranteed as to their accuracy or completeness. There is no assurance that an investment will provide positive performance over any period of time.
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