The past few months have seen asset managers encouraging investors to look at securitised credit (MBS / ABS). Their pitch in a nutshell: diversification from conventional fixed income, healthy returns over the past 15 years (GFC aside), value in an “unloved” sector while traditional bonds are rich, and a complexity premium given that the instruments are famously difficult to value. Investors are told that pre-‘GFC’ problems in MBS have been addressed: reliance on credit ratings has decreased with more loan-level analysis and third-party due diligence; misaglined compensation practices in mortgage origination have been tackled by risk-retention rules; loans are underwritten to a more conservative standard.
Yet there are notable headwinds in play. The Federal Reserve is beginning to unwind its Agency MBS purchases. Valuations are tight. The level of issuance in non-Agency RMBS remains low thanks to tighter lending standards and banks’ preference for agency loans in their portfolios, although shortage of supply can be positive for pricing. Interest rate volatility can be detrimental to for MBS performance, although the key relationship – that between prepayment risk and rates – is exceptionally hard to model.
The sector has seen substantial changes since 2013. While Non-Agency RMBS issuance has dried up due to reduced origination of these mortgages, managers have turned their attention to newer sub-sectors such as GSE Credit Risk Transfers (CRT), Re-REMICS, RPLs/NPLs and SFRs. Not everyone is on board: certain managers claim to stay away from CRTs, arguing that high demand has made them expensive and that they have not been tested through a housing downturn.
Within the universe of managers, the large differences between US and European securitised credit strategies persist, with the US market enabling a large number of standalone Agency MBS offerings while European managers invest across a range of ABS and MBS. One notable development since 2013 is the rising number of unconstrained fixed income strategies covering government and corporate debt as well as securitised credit, providing investors with another way to get their feet wet in this asset class.
The time seems right for a fresh examination of the sector. What do investors need to know about securitised credit now? What are the key questions for manager selection? How should investors cope with the lack of appropriate benchmarks and the difficulty of assessing performance? This paper offers a brief introduction. Further questions would be welcome.
Pass-through MBS vs. Collateralised Mortgage Obligation
When securitised, cashflows from a pool of mortgages can be passed through in their entirety (pass-through), or – for a CMO – sliced into tranches. Structures include: Sequential (highest-rated tranche gets cashflows first, the next-highest next, and so on, in sequence), Planned Amortisation Class (PAC tranche protected from prepayment variability, ‘support’ tranche absorbs it), and Interest-Only / Principal-Only tranches. Managers can use them to manage rate sensitivity, prepayment risk etc.
Prepayment risk and negative convexity
Interest rate volatility is unhelpful for MBS. Falling rates may encourage mortgage prepayments (more incentive to over-pay / re-mortgage), reducing overall returns (negative convexity). But rising rates discourage prepayment, lengthening duration precisely when duration becomes unappealing. Prepayment risk is famously hard to model: it is not only rate-dependent but interest rate path-dependent, and linked to the consumer cycle, unemployment etc.
Asset-Backed Securities (ABS, the majority of which are Mortgage-Backed Securities) may look and behave rather like bonds. Yet they are fundamentally different.
A bond is a security issued by a government or company, usually with an interest component (coupon) and a principal repayment at maturity. ABS, on the other hand, are issued by a third party/parties based on the cashflows derived from a collection of underlying loans: mortgages, car finance, credit card debt et al. Most of these loans amortise (debtor simultaneously repays interest and principal) over their lifetime. Some, particularly residential mortgages, are subject to “prepayment risk” – the risk that the debtor will repay their mortgage early, reducing duration and interest paid.
Depending on the underlying loans, the primary collateral for the security may not be the “real assets” against which cash is borrowed: what are being securitised are contractual cashflows, with varying guarantees depending on structures, issuers and counterparties. They can be passed straight on (“pass-through”) or sliced and diced to meet different needs, as with CMOs (see right). They can be securitised and re-securitised, again and again.
These differences make agency MBS and securitised credit both attractive and challenging in fixed income portfolios. They provide diversification, largely due to prepayment risk and exposure to the financial health of the consumer and the housing market rather than the corporate credit cycle.
• 4.19%: Annualised return of US Agency MBS, Jan ‘06 – Sept ‘17. Duration fluctuated between 1.29 and 5.62 years.
• $7.4 trillion: size of US residential MBS market (Agency and Non-Agency).
• €1.2 billion: size of European ABS market (60% of which is MBS).
• $450 billion: size of global Commercial MBS market.
• 40: number of managers with dedicated Agency MBS strategies.
• 10% in 2017 vs. 36% in 2007: Non-Agency slice of US residential MBS market. Agency MBS represent 98% of recent issuance.
• $10-15 billion: recent annual issuance volume, Credit Risk Transfer (CRT) market.
It is often said that securitised credit can deliver a “complexity premium” (a higher potential return due to the difficulties involved). The “premium” can be uncertain, but is no doubting the “complexity.” This is a morass of securitisations and re-securitisations with various types of instrument delivering different interest rate risk, pre-payment risk and credit risk characteristics.
There is no widely accepted benchmark for MBS, ABS or other securitised credit. There are indices for Agency MBS and some other sectors (Investment Grade CMBS, non-mortgage ABS etc), but the market structure makes this very different to traditional fixed income where an investor could ascertain their strategic asset allocation based on the different benchmarks’ market capitalisation.
MBS are notoriously difficult to value, in part because prepayment risk is exceptionally hard to estimate; various sources of MBS pricing data use different models that give very different valuations.
It is also hard to judge excess returns. Since the duration of an MBS portfolio/index swings wildly, it is usual to compare it to a portfolio of Treasuries whose duration is reset on a monthly basis to match the duration of the MBS portfolio at that time – a highly artificial comparison.
Securitised credit offers great scope for creativity and customisation. While there are plenty of pooled funds (in Agency MBS, at least), segregated accounts are widespread. Managers generally require at least $50 – $100 million – to do this.
In Agency MBS, managers primarily seek to identify the price bracket (e.g. ‘on the run’ vs ‘premium’) or the coupon stack (e.g. 30yr vs 15yr) with the most value. Duration management, sometimes involving derivatives, is a secondary source of returns. Managers can also use CMOs to adjust the duration and convexity profile of their portfolios, i.e. they could dabble in Interest-Only CMOs ahead of expected rises in yields.
In the US, it is more common to find dedicated MBS strategies, given the sheer size of the market compared to Europe. Agency MBS are part of core portfolio for US fixed income investors and the existence of this sector has been a driver in the larger number of dedicated managers compared to the European market, where most funds invest in a broad universe of MBS and other ABS.
In this space, infrastructure, experience and dedicated resources are critical given the importance of loan-level analysis and cashflow modelling. Additionally, it is valuable for managers to leverage expertise across different dimensions of risk, such as duration and credit.