Viewing securitized debt as an alternative

Michael V. Salm

Michael V. Salm
Co-Head of Fixed Income, 10/27/14

For fixed-income investors, diversification can be hard to find if you confine your view to the Barclays U.S. Aggregate Bond Index. Once you expand your view outside the index, however, the possibilities for better diversification begin to proliferate.

To that end, looking at a correlation matrix of excess returns from the various sectors within the corporate bond market, the hard-currency emerging-market debt (EMD) sector, and the residential and commercial securitized sectors is a revealing exercise (see illustration below).

Credit categories have been highly correlated since 2008 Significantly, corporate credit correlations were relatively high in the five years ended December 31, 2013. The primary driver of this, we believe, is the fact that the Great Recession of 2008 had the effect of clearing the ground of weaker credits. Since that time, corporations have, by and large, conservatively managed their balance sheets, which has kept default rates near historic lows. This indicates that a “systemic” credit factor has exerted a strong influence on returns in recent years and caused correlations between credit buckets — from investment-grade bonds to high-yield and emerging-market debt — to increase.

Diversify your risk with securitized debt Our illustration also includes four distinct subsectors or strategies within the securitized markets: non-agency residential mortgage-backed securities (NA RMBS), prepayment strategies (Prepay), commercial mortgage-backed securities (CMBS credit), and agency MBS (MBS). According to our research, the various subsectors of the securitized market have a relatively low correlation to both corporate credit (investment grade and high yield) and emerging-market debt, and also a significantly lower correlation to the equity market than these other two fixed-income asset classes. In addition, it is particularly noteworthy that the intra-securitized sector correlations are remarkably low, and in the case of CMBS versus prepayment strategies, negatively correlated (see data in bold in lower right of table).

In our view, these data strongly indicate the presence of systematic securitized risk factors that differ from those found in various types of corporate credit risk. It is also notable that our investigation of the most recent three-year period through December 2013 does not materially change the correlation picture, with two exceptions: CMBS credit does appear to track equivalently rated corporate spreads, and somewhat more closely, the CMBS subsector tracks non-agency RMBS.


Financial professionals: Download the Putnam white paper, The future opportunity in securitized mortgages

Diversification does not assure a profit or protect against loss. It is possible to lose money in a diversified portfolio. The Barclays U.S. Aggregate Bond Index is an unmanaged index of U.S. investment-grade fixed-income securities. Securities in the fund do not match those in the indexes and performance of the fund will differ. It is not possible to invest directly in an index.

* The indexes shown are Barclays U.S. Aggregate: AAA; Barclays U.S. Aggregate: AA; Barclays U.S. Aggregate: A; Barclays U.S. Aggregate: BBB; Barclays U.S. Aggregate: BB; Barclays U.S. Aggregate: B; Barclays U.S. Aggregate: CCC; Barclays U.S. Corporate Index (investment-grade corporate bonds); Barclays U.S. Mortgage Backed Securities Index (MBS); Barclays Investment Grade CMBS Index (CMBS credit); JPMorgan Developed High Yield Index (high yield); Barclays U.S. High-Yield Loans Index (bank loans); Barclays EM Hard Currency Aggregate Index (EM USD); S&P 500 Index. Non-agency RMBS is estimated using an average market level of a sample of below-investment-grade securities backed by various types of non-agency mortgage collateral (excluding prime securities).