The securitized asset class, once overshadowed by the global financial crisis, has evolved with regulatory improvements and may offer diversification benefits and counter-cyclical performance, making it a potentially valuable addition to portfolios with varying risk/return objectives.
The "Ice Wall" continues melting
It is hard to imagine a sector in the long duration space that has been less loved than securitized and for understandable reasons. For many investors the complexities of the securitized asset class are hard to overcome. In addition, memories of the global financial crisis (GFC) fueled by the housing market meltdown continue to linger on investors' minds. An "Ice Wall" surrounded the asset class post-GFC akin to the one seen in the TV series Game of Thrones and its 3-, 4-letter acronyms have been banished from financial vocabulary.
However, the securitized market has come a long way since the GFC. Notably, the regulatory changes passed by Congress (Dodd-Frank Wall Street Reform and Consumer Protection Act) materially improved the underwriting, safety and stability of the asset class. The sector also had an opportunity to redeem itself during material risk off environments in the 2010s. Eventually, as corporate credit spreads tightened near to their all-time lows post-COVID, more investors decided to re-visit securitized markets, which still offered historically attractive valuations.
Why Long Duration Securitized
An allocation to long duration securitized, as the description implies, will typically concentrate on securitized bonds that have longer natural durations, though it may also include shorter duration securities with a Treasury futures overlay. This primarily includes agency backed (Fannie Mae, Freddie Mac and Ginnie Mae) bonds such as Agency Commercial Mortgage-Backed Securities (ACMBS), Agency Collateralized Mortgage Obligation (ACMO) and high quality non-agency backed, securitized credit securities. As a reminder, the agency backing provides a guarantee for timely payment of principal and interest in case underlying borrowers default, practically eliminating the default risk for the bond itself. In contrast, non-agency backed mortgages are not immune from defaults and, as such, provide higher spread as a compensation. To oversimplify, with agency backed mortgages an investor is more often concerned about when they will get their money back (as mortgage borrowers can prepay their mortgages at will) while with securitized credit the primary concern is if they will get their money back.
We believe the securitized asset class possesses particular features that can benefit client portfolios across a range of objectives including portfolios with both conservative and aggressive risk/return objectives in addition to ones with short or longer durations. This is an asset class that includes both fixed and floating rate securities with durations ranging from zero to 20+ years and includes bonds rated AAA all the way down to non-rated or equity tranches. As a matter of fact, AAA-rated securitized is the largest USD denominated AAA sector outstanding (now that the US Government's average rating is AA+).
One of the particular benefits of this asset class is the diversification benefits that it brings to either a traditional fixed income allocation or a portfolio comprised of stocks and bonds. This is, in part, driven by the performance of the underlying collateral. Namely, many securitized credit sectors are not backed by corporate credit or corporate loans and are instead backed by the consumer. This includes securities backed by conventional or private label mortgages, and Asset Backed Securities (ABS) backed by auto loans, consumer loans, credit cards, among others. While the consumer and corporate balance sheets are interconnected and can influence each other, they do not typically move in lockstep, driving potentially diversifying performance outcomes for these two credit sectors over a full market cycle.
Furthermore, and specific to long duration securitized, some of the agency backed securities offer highly desirable attributes complementing traditional Liability Driven Investing (LDI) mandates. Namely, these bonds, unlike negatively convex pass-through mortgages, have positive convexity driven by a) loan level prepayment penalties (in the case of specific Agency CMBS bonds) disincentivizing borrowers to prepay their loans and 2) structural prepayment protections (in the case of Agency CMOs). This results in a better cashflow predictability for these bonds in addition to relatively more stable and higher durations. As such, what we have seen historically is that long securitized assets tend to perform better in a risk off environment but may potentially lag during strong risk on episodes, i.e., they are counter-cyclical. This is illustrated in Figure 1. Long duration securitized* typically outperforms long credit in excess return terms when long credit spreads widen (i.e., risk off periods) and underperforms when long credit spreads tighten (i.e., risk on periods). And this relationship has been quite strong over the past 10 years with correlation of approximately 95% between the two data series. This illustrates the strong diversification characteristics that can help to improve the overall risk/return profile of a broader portfolio.
Looking Forward
In general, we would expect the custom long securitized blend illustrated above to trade tighter than the long credit index in terms of credit spreads (again, because it is primarily agency-backed which is of higher quality and is default remote). That was barely the case around the end of 2023 when the two were more or less equal. The long securitized blend has performed strongly since then and is tighter than long credit is now, but we believe there might be more room to run, particularly in the non-agency sectors, making it relatively more attractive, particularly in the event of market stress or an economic slowdown/recession.
We see clear benefits for a static strategic allocation to long duration securitized in order to reap the benefits of this asset class over a full market cycle and also for an alternative approach, where an active manager has the flexibility to dial up and down the allocation to long securitized within a traditional long duration or LDI mandate. In either case, and as noted earlier, securitized is a complex asset class and it is critical to have a deep research analyst bench that can evaluate individual bonds, a sophisticated and experienced portfolio management team that can underwrite these bonds and a trading team with global scale and relationships to source the desired bonds.