After the global financial crisis, securitized credit was left with a bad reputation, but it may be time for investors to look at how the asset class has changed and the opportunities it offers, says Noah Funderburk, vice-president and portfolio manager at Amundi Pioneer.
At its essence, securitized credit is a fixed income security with cash flows backed by a specific asset held in a trust; for example, a mortgage-backed security. However, the asset class is much more diverse, he adds, noting it can also include consumer and corporate loans, as well as very specialized assets like airplanes, internet data centres and cell phone towers.
While the mortgage-backed security was invented in the 1980s, he notes, it became infamous in the global financial crisis. However, the current landscape for securitized credit is very different than it was at that time. “So much has changed and yet so many investors are still looking in that rearview mirror because one thing that hasn’t changed is the name.”
A key development is the Dodd Frank Act, which requires all lenders in the U.S. to consider a borrower’s ability to repay the mortgage. “That doesn’t sound like a law that we should have needed, but history suggests otherwise and now it is a law,” says Funderburk.
Further, issuers of securitizations are now generally required to have skin in the game, securitization structures are designed with a different worst-case scenario in mind and capital market contagion risk has been greatly reduced, he notes.
And when pension plan sponsors incorporate securitized credit into their portfolios, it’s typically part of their fixed income or alternative buckets, depending on the type of risk and return being targeted.
“The role in most scenarios of securitized assets is to provide diversification and income enhancements to the broader portfolio context,” says Funderburk. “For example, in most scenarios, the cash flows, from a pool of auto loans in the southeastern United States, would have a low correlation with the global growth, global monetary policy, the kind of big risk factors that drive the equities and bond allocation returns in their portfolio. At the same time, these are assets that generally offer higher income potential as well. So it’s either a complement to that core portfolio positioning that offers diversification, or enhanced income or somewhere in between.”
In addition, while investors have always focused on diversification, the focus might shift to income in the current environment. “What we’ve seen over the past 30-plus years — but past 12 months, especially in the United States — is a massive change in the amount of income potential that’s available on treasury securities. So I think that that’s likely to become more of the focus in the coming years as investors move from the shock and awe of 2020 to the reality of the forward-looking need for return and income.”
Funderburk also outlined how the coronavirus-related fallout is impacting different asset classes that underlie securitized credit. For instance, with interest rates at historic lows, mortgage rates in the U.S. are also at all-time lows. Generally, when interest rates decline, homeowners can refinance to take advantage of the lower rates.
“We’re currently seeing the fastest mortgage repayment rates since 2004 on residential mortgages. And that’s generally bad news for the large and liquid and high-profile agency-MBS market,” he says, noting it’s also generally good news for non-agency mortgages because those pre-payments de-lever the risk.
More broadly, the interest rate environment has changed the outlook for securitized assets and the pandemic is causing permanent shifts resulting in winner and losers, he adds. “One big winner is the U.S. housing market, particularly detached single-family homes in the suburbs, where prices are now rising at a rising rate.”
On the other hand, Funderburk notes the outlook for commercial real estate is much more uncertain. While the impact of changes related to widespread working from home are yet to be fully determined, other trends are clearer, like the transition from brick and mortar to digital retail.
The sector is also very location-specific and price is a key consideration. “Being able to buy fixed income instruments at a discount-dollar price backed by assets that you expect to be resilient, even if you think that the broader outlook for commercial real estate overall is poor, this is still an environment that has security selection opportunities that are capable of overwhelming that higher-level trend.”
The most common question from pension plans sponsors interested in securitized credit is how to measure success in the space with the absence of a benchmark, he says, noting the asset class doesn’t have publicly available benchmarks that match the risk and return potential of securitized credit sectors.
Benchmarks that are available focus on the agency mortgage-backed securities market, which are viewed as not having credit risk, or triple A-rated assets, which have minimal credit risk, he adds.
Absent a benchmark, plan sponsors can measure the success of the strategy by its ability to meet the intended objective, such as if it delivered income or diversification, says Funderburk. Further, he suggests they compare the returns and correlations of the strategy to comparably-rated corporate credit or use peer group comparisons to look at how much value-add stems from asset allocation decisions and how much can be tied to manager implementation.
Pension plan investors are also concerned about timing and whether they’ve “missed the bus” for investing in the asset class. But Funderburk doesn’t think they have. “Our thesis around the housing market is playing out as we speak and the fact that risk premiums are wider, despite that the housing market is stronger, suggests to us that this is the right time to be adding to that type of exposure.”