Brett S. Kozlowski, CFA, fixed income portfolio manager at Putnam Investments, explains the diversification advantages of securitised debt.
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 US rates, indications of US dollar strength, and uncertainty surrounding US trade policy.
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? Securitised debt is a sector that may be less familiar to many, but it offers the diversification and potential performance profile investors seek.
Exposure to US household balance sheets
Securitised debt includes sectors with exposure to the balance sheet of US 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 US households have significantly repaired their balance sheets during the nine-year recovery, credit risk here now compares favourably to sovereign and corporate sectors.
Agency mortgages and beyond
While securitised 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 over £5.2trn as of 31 December 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 collateralised mortgage obligations (CMO) and non-agency residential (RMBS) and commercial MBS (CMBS).
CMOs | £200-£250bn subsector
Agency collaterised mortgage obligations (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.
CMBS | £780bn subsector
Commercial mortgage-backed securities (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 RMBS | £650bn+ subsector
The non-agency residential mortgage-backed securities (RMBS) sector consists of securities backed by residential mortgages that lack a guarantee from the US 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 US subprime crisis in 2007-08, 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.
Over £1trn in securitised portfolio-building opportunities
Together, the securitised 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.
The Fixed Income team at Putnam Investments has more than 30 years of expertise in securitised 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.
As of 19 June 2018. For use with institutional investors and investment professionals only. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument, or any Putnam product or strategy. References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice. This material does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. Investors should consult a financial advisor for advice suited to their individual financial needs. Putnam does not guarantee any minimum level of investment performance or the success of any investment strategy. Actual results could differ materially from those anticipated. Past performance is not a guarantee of future results. The information provided relates to Putnam Investments and its affiliates, which include The Putnam Advisory Company, LLC and Putnam Investments Limited®.
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