Three potential benefits of MBS
The liquidity of agency MBS is topped only by U.S. Treasuries. Agency MBS represent almost 30% of the Bloomberg Barclays U.S. Aggregate Index, and the sector’s significant trading volume and low transaction costs provide professional asset managers with the ability to adjust and scale portfolio positions efficiently.
2. Risk-adjusted returns
Agency MBS have delivered higher Sharpe ratios over the intermediate-and long-term relative to other major index sectors (Figure 2). This attractive risk-adjusted performance is generated through low volatility, excess spread and higher yield versus comparable U.S. Treasury securities.
Non-agency MBS typically offer additional spread and enhanced return potential along with correlation benefits. The attractive return characteristics are meant to compensate for credit risk and greater variance between pools, structures and issuers. Non-agency MBS are not included in the Aggregate Index.
MBS have different performance drivers than other fixed income sectors, which provide important diversification benefits. For instance, agency MBS returns are more sensitive to issues such as mortgage rates, housing prices or lending activity. Agency MBS offer additional spread to compensate investors for uncertain timing of principal repayment.
Non-agency MBS add a credit element to their return drivers, which can be structured to leverage attractive characteristics. Hence, non-agency MBS exhibit a low correlation to agency MBS. The credit element of non-agency MBS may also help enhance returns in traditional core fixed income portfolios during times of credit outperformance.
What are mortgage-backed securities?
Backed by loans for residential homes, MBS are broken into agency and non-agency securities.
Agency securities are issued by government-related enterprises like Fannie Mae, Freddie Mac and Ginnie Mae. Securities issued by Ginnie Mae are backed by the full faith and credit of the U.S. government, similar to Treasuries. Fannie Mae and Freddie Mac are government-sponsored entities and considered among the highest quality below Treasury securities. Non-agency securities are issued by private entities that have no government affiliation.
Four ways CMBS can enhance a portfolio
1. Risk-adjusted returns
An allocation to the sector has historically enhanced overall portfolio performance and information ratio with strong risk-adjusted returns (Figure 2).
The performance of a CMBS bond is mainly determined by the performance of the underlying loan pool. Idiosyncratic factors such as regional differences and property types heavily influence credit performance of individual bonds, which can provide some additional diversification. These drivers are unique to CMBS and can even be loan-specific, creating a low correlation to other fixed income sectors and asset classes.
CMBS structures allow exposure to a specific pool of commercial mortgages at a particular credit level and duration. Investors may earn excess returns per credit rating as compensation for taking identified non-homogenous and idiosyncratic risks. Excess return may be achieved by identifying securities with underlying property cash flows that may outperform underwriters’ expectations (Figure 3).
Excess return may be achieved by identifying securities with underlying property cash flows that may outperform underwritten expectations.
Strong protections from loan pre-payments provides for more predictable bond cash flows. This relative certainty allows investors to select investments that reflect certain duration views or satisfy specific cash flow needs.
What are commercial mortgage-backed securities?
CMBS are similar to non-agency MBS, with securitized cash flows and loans secured by real estate. However, CMBS have some differences:
- Backed by loans on commercial properties, and the underlying loans are less prone to early principal repayment, reducing the prepayment risk.
- Larger loan sizes, which tend to have higher loan-specific credit risk.
- Typically structured with a more simplistic principal and interest cash flow waterfall.
Three reasons to consider ABS
1. Risk-adjusted returns
An allocation to ABS has offered investors higher Sharpe ratios over the intermediate- and long-term relative to other major index sectors (Figure 2). ABS can diversify a multi-sector portfolio and help provide better risk-adjusted results, with potentially lower return correlation to other securitized sectors and the broader capital markets (Figure 4).
By investing in ABS as part of a broader multi-sector portfolio, an asset manager could potentially increase allocations into less liquid, higher return potential sectors.
The wide array of collateral types and structural options allows asset managers to select ABS deals with the most appropriate cash flow and duration alternatives. This pool of attractive potential investments provides greater latitude to construct portfolios, determine sector and asset allocation weightings and help manage risk.
The ABS market offers a wide variety of short-duration, highly liquid investment options. This is due to structural flexibility and the existence of short-term underlying loans, such as credit card receivables or auto loans. Structuring the cash flows provides investors with regular, stable investments that trade efficiently. Investing in ABS as part of a broader multi-sector portfolio allows an asset manager to increase allocations to sectors that are less liquid with higher return potential.
What are asset-backed securities?
ABS are securities collateralized by a pool of non-mortgage assets such as loans, leases, credit card debt, royalties or receivables. A multitude of collateral types, structures and sponsors make up this market. The most common ABS collateral types are credit card receivables, auto loans and student loans.
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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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