Portfolio allocation views for securitised credit
Securitised assets are well-positioned to play an important role in all types of portfolios. The composition of the securitised basket and its allocation depends heavily on the risk tolerance and the investment goals of the portfolio.
A market-cap weighted approach may fall short
Investors typically allocate to securitised assets via strategies linked to the Bloomberg Barclays U.S. Aggregate Bond Index (U.S. Agg). However, the securitised credit sub-index within U.S. Agg is heavily weighted toward MBS at 92%.1
And it does not provide a diversified exposure to securitised assets, as the securitised index correlates at around 99% with the MBS sub-index.2
In the case of the securitised index and its MBS sub-index, interest rate risk tends to be the primary driver of returns. Since ABS and CMBS tend to be less sensitive to rate risk and more credit sensitive, ABS and CMBS tend to have a low correlation with MBS (55% or less).3
A broader view may allow for more diversification
Deviating from a market-cap-weighted allocation may allow for more diversified exposure. For example, an allocation of 60% MBS, 20% ABS and 20% CMBS only marginally increased portfolio volatility, but significantly improved the return/risk ratio (Figure 10).
Securitised credit can play an important role in an income portfolio
Not only has securitised credit historically offered more attractive risk-adjusted yield than Treasuries and investment grade corporates (Figure 9), it can also help to diversify sources of income. The income returns of Treasuries and investment grade corporates are highly correlated (91%) compared to securitised credit and investment grade corporates (59%).4 Given the additional yield of securitised credit over Treasuries and its potential to diversify the income return stream on a strategic basis, an income investor could consider shifting some allocation from Treasuries to securitised credit based on factors such as existing portfolio exposures, risk tolerance and portfolio objectives.
Securitised credit may also benefit a growth portfolio
Securitised credit may play a less important role in a growth portfolio, where capital appreciation is the primary objective and equity risk is likely the dominant risk factor. However, a growth investor who is strategically underweight securitised credit may consider increasing the allocation to improve diversification. The correlation between securitised credit and equities is much lower than that between corporate credit and equities (Figure 11).
Opportunities may exist for savvy investors
The securitised sector is a complex, diverse group of investment opportunities. For the astute investor, MBS, CMBS and ABS may offer attractive investments with diversified credit exposure, uncorrelated returns and attractive cash flow characteristics.
We offer investors these summary views:
- The global bond environment and compressed spreads make now an attractive time to invest in securitised assets.
- For income investors, securitised credit has historically offered additional yield over Treasuries and with potential to diversify an income return stream.
- For growth investors, shifting some allocation from investment grade corporates to securitised credit may improve diversification without sacrificing much yield.
We have found that it takes an investment manager with extensive experience to navigate these complex markets.
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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.
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