Securitized debt: Building blocks of a diversified portfolio

Brett S. Kozlowski, CFA

Brett S. Kozlowski, CFA
Portfolio Manager, 01/24/19

  • Securitized bonds may be used to create diversified portfolios through various risk exposures
  • Investors can use structures to achieve specific risk-and-return targets
  • We believe monthly cash flows from securitized debt make them attractive building blocks in a cash flow-driven investment strategy

Securitized debt can be an important foundation for any asset allocation framework. We believe investors should diversify their portfolios because of the opportunities available across the fixed-income spectrum. In traditional fixed-income markets, there are four primary risk premiums: term structure, credit, prepayment, and liquidity. Government and corporate securities provide investors’ exposure to term structure and corporate credit risk premiums, respectively.

The securitized debt sector earns returns from other risk premiums, primarily mortgage credit and prepayment risk. What’s especially attractive is that securitized debt can complement, and even replace, exposure to corporate, government, and other types of traditional fixed-income investments. By adding these securities, investors can diversify and balance their portfolios, hedge against market volatility and likely improve returns.

A changing landscape

Investors seeking to diversify their fixed-income portfolios and expand their sources of returns may be comfortable investing in more familiar high-yield and emerging-market bonds. But, many investors are reluctant to invest across the securitized debt landscape. This is understandable given the experience some institutions had with certain types of mortgage-backed securities (MBS) during the 2008 financial crisis. However, the sector is different today as changes in regulations in the United States governing how loans are underwritten, packaged and sold mean that overall risks to the sector are lower.

Securitized bonds bundle various types of loans, such as residential mortgages, auto loans, and commercial property debt. These loans are packaged and sold as securities, either as stand-alone debt or as part of a broader deal structure. Sectors include commercial mortgage-backed securities (CMBS), non-agency residential securities (RMBS), agency credit risk transfer (CRT), and agency collateralized mortgage obligations (CMOs). Investors are repaid from the principal and interest cash flows collected from the underlying loans.

Because of the underlying assets involved, investors who buy securitized debt gain exposure to fundamentally different and diversified risks compared with corporate and sovereign bonds. More importantly, securitized issues also offer investors exposure to the balance sheets of U.S. households.

U.K. markets and pension funds

Many U.K. institutions are trying to find ways to develop and build portfolios with specific cash-flow characteristics, and we believe the securitized sectors can be important building blocks. The diversity of loan types that can be packaged within the securitized universe, and the bond structures that can be created via the securitization process, allow for portfolios to be tailored to specific objectives, whether it is return- or liability-based. For example, investors who seek liquidity and loss protection can emphasize liquid, senior bonds that sit at the top of the bond capital structure. Alternatively, return-seeking allocators can invest in structures with more fundamental loss risk but that pay attractive yields to meet return targets. For a pension scheme with a specific liability stream, a portfolio of bonds can be structured with a shorter cash flow life (for example, through front pay) or with securities that provide longer spread durations.

Historically, U.K. pension schemes have only modestly allocated to stand-alone securitized mandates, perhaps because securitized debt has remained largely a North American phenomenon. In the United States, 70% of residential debt is securitized and sold into the capital markets. Globally, the U.S. model has not gained traction. Nonetheless, the U.K. securitized market is becoming more interesting. We continue to monitor specific sectors such as equity release mortgages, which enable U.K. homeowners to tap into the value of their property without the need to sell up or move out.

Tapping growth potential

In summary, we believe securitized debt is an effective strategy for structuring portfolios to meet investor needs. Portfolios can be built with specific objectives such as timing of cash flows, spread duration, or credit quality.

Since the financial crisis, underwriting standards for U.S. residential loans have improved, making cash flows generally more robust. In addition, we believe at this point in the economic cycle, spreads in many sub-sectors of the securitized market look favorable compared with other fixed-income assets. We will continue to monitor the potential growth of the sector in the United States and globally.