Securitized credit—an overlooked source of diversification
A strategic allocation to securitized credit could provide some much-needed diversification to core fixed-income exposure, yet most portfolios don’t have adequate exposure to this part of the market.
Decades-high inflation, rising interest rates, and the growing risk of recession have created a challenging market for fixed-income investors. The Bloomberg U.S. Aggregate Bond Index is experiencing a historic double-digit drawdown, barely buffering portfolios from the pain delivered from equity allocations this year. Volatile markets can be a stark reminder of the importance of diversification—but also that diversification doesn’t end with stocks plus core fixed-income exposure.
While there are several ways to diversify a core fixed-income portfolio, the characteristics of securitized credit make the asset class uniquely positioned to supplement the developed-market government securities and investment-grade corporate bonds that tend to make up the bulk of investors’ fixed-income exposures. Having a strategic allocation to securitized credit has the potential to dampen volatility during a historically difficult time for fixed income, even if interest rates continue to rise and put pressure on fixed-income markets as a whole.
The securitized market is often underrepresented within portfolios
The securitized market is large, totaling nearly $14 trillion and over twice the size of the investment-grade corporate market. The bulk of the securitized market consists of agency mortgage-backed securities (MBS). These securities are issued by three government-sponsored entities—Fannie Mae, Freddie Mac, and Ginnie Mae—and make up the most well-known component of the securitized debt market. But more than $3 trillion is made up of the securitized credit sectors: commercial MBS (CMBS), nonagency residential MBS (nonagency MBS), asset-backed securities (ABS), and collateralized loan obligations (CLOs), each of which has specific features that confer distinct risk/return characteristics. In aggregate, these subsectors make up a substantial portion of the U.S. spread sectors and are larger than the high-yield corporate and bank loan markets combined.
Major U.S. spread sectors
Source: Bloomberg, SIFMA, J.P. Morgan, Manulife Investment Management, June 2022. MBS refers to mortgage-backed securities. CMO refers to collateralized mortgage obligations. IO/IIO are interest-only and inverse interest-only securities. CMBS refers to commercial MBS. ABS refers to asset-backed securities. CLO refers to collateralized loan obligations.
Commonly, investors believe that they’re receiving adequate exposure to this slice of the market through their core or core-plus exposures; however, these types of strategies are usually benchmarked to the Bloomberg U.S. Aggregate Bond Index and are typically limited to index-eligible securitized sectors within their portfolios. This exposure tends to be concentrated in conventional agency MBS, with over 92% of the relative index exposure to this subsector alone.
The broad fixed-income benchmark primarily offers exposure to conventional agency MBS
Securitized exposure within the Bloomberg U.S. Aggregate Bond Index
Source: Bloomberg, as of September 30, 2022. MBS refers to mortgage-backed securities. ABS refers to asset-backed securities. CMBS refers to commercial MBS. It is not possible to invest directly in an index.
In other words, many investors’ core bond exposures are missing out on the inherent diversification potential offered by securitized debt. The overall market includes substantial weightings in other subsectors such as nonagency MBS, CMBS, and consumer ABS. These subsectors can be further divided into a wide range of assets, with ABS including deals backed by a collateral ranging from credit card and auto receivables to student loans, time-shares, container leases, and franchise royalties.
Each of these different types of securitized assets has its own distinct risk exposures and can often trade independently of each other, increasing the potential for diversification by investing across various subsectors of the securitized markets.
Securitized assets tend to have lower correlations with other areas of the fixed-income market
Source: eVestment, J.P. Morgan, as of September 30, 2022. Coloration corresponds to the level of correlation, with darker green being the highest and dark red the lowest. It is not possible to invest directly in an index.
Yet these subsectors often go underused by investors due to their size, perceived complexity, or exclusion from the index. This lack of attention creates an inefficient market, one that’s ripe with opportunity for those who can discern areas of relative value.
Securitized credit in a rising-rate environment
Although rising interest rates have been a factor that’s weighed heavily on the fixed-income markets this year, some types of securitized instruments can still do well against a hawkish monetary policy backdrop should this environment continue. Consider the duration of most securitized assets relative to the broad fixed-income market. While the duration of the Bloomberg U.S. Aggregate Bond Index has been increasing over time and currently stands at just over six years, CMBS tend to have durations of five years or less, and ABS tend to be even shorter duration, generally three years or less, due to the nature of the underlying collateral.
Duration of some securitized assets tends to be shorter than that of the Agg
Source: Bloomberg, as of September 30, 2022. Agg refers to the Bloomberg U.S. Aggregate Bond Index. It is not possible to invest directly in an index.
Many securitized assets also carry optionality and have floating-rate attributes that provide the opportunity for this area of the market to outperform during periods of rising interest rates. Subsectors such as MBS that have collateral closely tied to real estate markets can also help to shield securitized assets from inflationary pressures over the long term.
Things are different from 2008
When considering an allocation to securitized credit, some investors might worry about investing in this asset class, particularly as the potential for a recessionary environment grows. MBS, primarily those backed by subprime mortgages, played a pivotal role in the 2007/2008 global financial crisis, but they represent a very small percentage of today’s mortgage market.
Since then, stricter underwriting standards such as requiring income and employment verification have been put into place, providing a higher level of quality to today’s MBS market. Housing market dynamics are also quite different from 2008, with the recent rise in home prices largely a result of a long-standing mismatch between supply and demand rather than from loose underwriting and speculation. While rising mortgage rates could dampen demand moving ahead, market supply remains at historically low levels, which we think should provide continued support for housing prices moving forward.
Rising home prices have allowed homeowners to accrue significant equity, lowering loan-to-value ratios to a national average of 42%. Currently, only 1.8% of mortgaged homes are underwater compared with a peak of 26.0% in 2009. Further, adjustable rate mortgages (ARMs) make up only 12.8% of all mortgage applications, whereas ARMs accounted for as much of a third of mortgage applications in the years leading up to the financial crisis.
Rising home prices and low housing supply have also given support to the rental market, with single-family rentals being a relatively new and compelling slice of the securitized market. A subsector of the nonagency MBS market that’s excluded from the Bloomberg U.S. Aggregate Bond Index, securities in this sector provide an opportunity to invest in institutional ownership of residential homes with the purpose of renting. We believe this subsector will continue to benefit from positive demographics, the strong jobs market, and home price appreciation.
Strong consumers lend support
Other areas of the securitized market such as CMBS and ABS are reliant on consumer strength, which currently shows no signs of wavering. The labor market remains strong, with unemployment hovering at 3.7%; delinquency rates on credit card loans also remain well below levels seen heading into 2008.
Consumers are still able to pay their debts
Delinquency rate on credit card loans (%)
Source: Delinquency Rate on Credit Card Loans, All Commercial Banks, seasonally adjusted, quarterly, Federal Reserve Bank of St. Louis, as of June 30, 2022.
So far, inflation doesn’t seem to be stopping consumers from fulfilling their debt obligations. With these factors taken into consideration, we believe the investment case for securitized assets is strong, even if interest rates continue their upward trajectory.
The importance of an active and flexible approach
A recession, should one arrive, may provide some challenge to consumer strength and to the securitized credit markets, particularly if unemployment begins to rise. However, we believe that active managers that can conduct thorough bottom-up credit analysis with the flexibility to look for relative value in the underused pockets of the securitized credit space will be well positioned for the market environment moving ahead, providing much-needed diversification to core fixed-income allocations within investor portfolios.
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