The unrecognized diversification profile of securitized debt

Brett S. Kozlowski, CFA

Brett S. Kozlowski, CFA
Portfolio Manager, 07/11/18

  • Traditional sources of fixed-income diversification may be encountering headwinds as interest rates rise
  • Securitized debt offer low historic performance correlation to equities and corporate credit
  • Providing exposure to the U.S. household balance sheet, securitized debt offers ample investment opportunities in diverse subsectors

Pursuing performance objectives is becoming more challenging as the high-yield and emerging-market debt (EMD) sectors, where many institutions have traditionally sought return and diversification, encounter headwinds. Although corporate defaults remain low, their yield spreads have narrowed during the risk rally. Meanwhile, emerging markets are buffeted by higher U.S. rates, indications of U.S. dollar strength, and uncertainty surrounding U.S. trade policy.

Consider securitized as an alternative for diversification

High yield and EMD have traditionally provided high performance correlation with developed market investment-grade debt. What if better diversification could be found in another asset? Securitized debt is a sector that may be less familiar to many, but it offers the diversification and potential performance profile investors seek.

Exposure to U.S. household balance sheets

Securitized debt includes sectors with exposure to the balance sheet of U.S. households. This makes segments of the broad sector fundamentally different from high yield, which is exposed to corporate balance sheets, and EMD, which provides exposure to corporate and sovereign balance sheets. Since U.S. households have significantly repaired their balance sheets during the nine-year recovery, credit risk here now compares favorably with sovereign and corporate sectors.

Agency mortgages and beyond

While securitized debt is less widely owned than more traditional alternatives, it is nonetheless a large asset class, with the biggest component being agency mortgage-backed securities (MBS). At $7.0 trillion as of December 31, 2017, agency MBS represent a significant weighting of the Bloomberg Barclays Global Aggregate Bond Index. Several subsectors also offer substantial size and opportunities for portfolio building: agency collateralized mortgage obligations (CMO) and non-agency residential (RMBS) and commercial MBS (CMBS).

Agency collateralized mortgage obligations | $250–$350 billion subsector

Agency CMOs use defined rules to distribute cash flows from pools of home mortgages to specific securities. This practice creates a variety of securities that can be more desirable for specific investor needs. For instance, the streams of principal and interest payments on the mortgages may be distributed to two different classes of CMO interests in “tranches.” Each tranche can have different principal balances, coupon rates, prepayment risks, and maturity dates. A CMO may be highly sensitive to changes in interest rates and any resulting change in the frequency at which homeowners sell their properties, refinance, or otherwise prepay loans.

Commercial mortgage-backed securities | $1 trillion subsector

CMBS are secured by the loan on a commercial property and the property that is mortgaged. This market may be more familiar to some investors, as it has been part of the Global Aggregate since the late 1990s. However, only a portion of the universe — less than 1% — conforms to index rules. Given the structure and subordination in the CMBS market, the CMBS Index is dominated by AAA-rated securities. However, some of the more attractive return opportunities exist in lower levels of the credit structure.

Non-agency residential mortgage-backed securities | $850+ billion subsector

The non-agency RMBS sector consists of securities backed by residential mortgages that lack a guarantee from the U.S. federal agencies (Fannie Mae, Ginnie Mae, or Freddie Mac). In addition, RMBS include subsectors offering variety in credit quality and interest-rate sensitivity. These subsectors felt negative impact from the U.S. subprime crisis in 2007–2008, but today they are smaller and securities trade at wider spreads. Also, this market is gradually shrinking due to no material issuance. However, the credit risk transfer (CRT) sector provides a type of new-issue market. Fannie Mae and Freddie Mac have been bringing CRTs to market since 2013 as they look to distribute housing market risk through the private capital markets.

Portfolio-building opportunities

Together, the securitized subsectors highlighted here have shown low correlation to investment-grade bonds as well as high yield and emerging markets. Interestingly, the subsectors have also shown a tendency to perform independently from each other.

Securitized mortgage sectors have had lower correlations to equities and corporate credit than HY and EMD

The Fixed Income team at Putnam Investments has over 30 years of expertise in securitized sectors. In our experience, many investors lack a clear understanding of the role this sector can play in a broader asset allocation framework. As active investors, we see this as a signal of an inefficient market opportunity that offers potential return and diversification.