The traditional role of fixed income in an investor’s portfolio is to provide risk mitigation, stable income, and a low correlation with risk assets, such as equities. Structured securities—namely asset-backed securities (ABS) and agency mortgage-backed securities (MBS)—can help achieve that by optimizing a portfolio’s risk-reward profile. The enhanced income, improved diversification, and comparatively lower volatility offered by pooled receivables make it a very compelling asset class.
Agency MBS, offers compelling diversification benefits, as the credit market and MBS market are driven by different economic and market dynamics; business fundamentals versus interest rate volatility. Interest rate movement has the largest impact on MBS relative performance, due to its influence on the timing of cash flows through the repayment of principal.
The primary risk to agency MBS securities emanates from the borrower’s ability to prepay their mortgage at any time without penalty. For example, when interest rates decline, borrowers are incented to refinance their mortgage. While the borrower reaps a clear benefit to refinancing, this transaction results in a prepayment to the MBS investor at par, which then causes the investor to reinvest those proceeds at lower rates. Conversely, when rates rise, there is no incentive for borrowers to prepay their mortgage, thus delaying the repayment of principal at a time when interest rates have become more attractive.
Fortunately, for MBS investors, there are friction costs for mortgage borrowers that makes this “call” feature relatively inefficient. Additionally, prepayment risk is partially mitigated by the diversification benefits associated with the securitization process, as hundreds if not thousands of loans are aggregated to form a pool. Each mortgage pool has its own unique attributes (e.g., loan type, term, loan balance, age, geography) that can significantly impact cash flow variability. This presents security selection opportunities for MBS investors who can utilize robust analytical models to forecast cash flows based on various interest rate and prepayment scenarios to assess risk and relative value.
Perhaps a much less understood market than agency MBS, the ABS sector offers similar diversification benefits relative to credit, but has very little exposure to prepayment volatility and thus relative performance is not interest-rate driven. Asset-backed securities are commonly secured by financial assets, such as auto loans, equipment loans, and credit card receivables. The securitization process allows lenders to diversify their sources of funding while providing investors access to a high-quality asset class that can satisfy a variety of maturity and risk preferences.
In addition to a diverse pool of underlying collateral, ABS transactions incorporate a variety of credit enhancements and structural features. These come in different formats and amounts depending on the ABS type. Auto and Equipment ABS typically have a structure that incorporates a series of sequential classes in which investors of the respective classes are repaid in order of maturity and seniority. Other features include credit enhancements, such as a cash reserve, overcollateralization, and/or subordination, which serve to insulate investors at the top of the capital structure from losses. Credit Card ABS securities typically have a senior/subordinate structure, as well as internal triggers designed to protect the investor in the event of a deterioration in the quality of the pool or seller/servicer.
When selecting appropriate ABS, it is important to focus on strong sponsors with solid industry track records and consistently strong underwriting criteria. Furthermore, investors should assess the structure/credit enhancements, as well as the collateral characteristics and historical repayment trends to validate the quality of the underlying assets.
In the context of risk-adjusted portfolio optimization, the diversification benefits attained by incorporating MBS and ABS enable a portfolio to move further out the efficient frontier. Our historical analysis over the past 20-plus years shows a low correlation between structured securities and credit sectors. Moreover, MBS and ABS have exhibited significantly less volatility of excess return than credit sectors over the same time period. This is largely due to the high-quality nature and shorter duration profile of structured product sectors relative to the overall credit index.
The diversification benefit provided by incorporating structured securities in portfolios can be further illustrated by comparing two indexes, one consisting solely of government and credit sectors (Bloomberg Barclays Government/Credit Index) and the other that includes structured products (Bloomberg Barclays Aggregate Bond Index). As shown in the table below, adding structured products to a government-credit portfolio over the same period would have produced an enhanced average annual excess return, a reduction in return volatility, and a higher modified information ratio.
|Period from January 1997 to August 2019|
|Average Excess Return (% per year)||Volatility (% per year)||Modified Information Ratio|
|Bloomberg Barclays U.S Government Credit Index||0.30||1.18||0.26|
|Bloomberg Barclays U.S Aggregate Bond Index||0.34||1.06||0.32|
We exclude the time period between June 2008 and September 2009 from the return series due to the exceptional volatility and correlations of excess returns exhibited at that time. During this times period, primary fixed-income sectors experienced return periods that were multiple standard deviation events relative to the historical evidence of the past 40 years.
Source: Bloomberg Barclays Indices, PNC Capital Advisors Analysis
Thus, we believe in many cases structured securities should be an integral component of fixed income strategies that seek to optimize risk-adjusted performance. However, given their perceived complexities, it’s understandable why some investors may be reticent to incorporate structured securities in their portfolios. We caution against painting structured securities with too broad a brush, as this misconception could result in suboptimal asset allocation, particularly when it comes to the tradeoff between risk and return.
To learn more about how we can bring ideas, insight and solutions to you, please contact your Relationship Manager or fill out a simple Contact Form and we’ll get in touch with you.