Portfolio Q&A: Multi Income Fund
A quick look at how the Fund is positioned as recession risks loom and financial conditions tighten.
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Securitised debt is one of the key components of the fixed income market. But the subprime mortgage crisis, which started in 2007 and triggered the Global Financial Crisis, gave securitisation a bad name.
A decade on, the securitisation market has regained much ground. We see opportunities and are using our expertise to harvest yield and manage risk. It’s not as devastating after all.
Then
Weak loan underwriting process
- The US mortgage market was tilted to focus on speed, costs, efficiency and customer satisfaction.
- Loans were made to home buyers with poor credit scores and who struggled to repay debts. In this regard, these loans were so named subprime mortgages.
- Many subprime mortgages were pooled into mortgage-backed securities (MBS) because they offered relatively higher interests which were attractive to investors.
Now
Enhanced loan underwriting standards
- More stringent underwriting requirements.
- The Consumer Financial Protection Bureau issued the Ability to Repay and Qualified Mortgage Rule in January 2013, requiring lenders to acquire enough information to assess the repaying ability of borrowers before making a residential mortgage loan.
- Regulators also require banks to meet much higher standards in the amount and quality of capital on their balance sheets and in the ways they assess and manage their financial risks.
US borrowers struggled to repay mortgage
- Mortgage delinquencies surged by 625%1 from 2003 to 2010. The increase was the highest among auto loans (up 124%), credit cards (up 51%) and student loans (up 45%).
US household leverage declines
- US household debt payments only accounted for 9.9% of disposable income as of the first quarter of 2019, compared to the peak of 13.2%2 in the fourth quarter of 2007.
Structural flaws in the market
- Lack of consistent loan-level information: investors often did not have enough information about the underlying loans and such information was often presented differently across deals.
- Misalignment of interests between securitised debt creators and investors: In general, banks will make sure they extend loans to quality borrowers as they hold the loans on their own balance sheets. With securitisation, banks can sell their loans as securitised debt to investors and transfer the risk of non-payment to them. In this regard, some banks may no longer be incentivised to ensure the quality of their loans.
New regulatory frameworks
- The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act is among the new regulations enacted for issuing simple, transparent and standardised transactions in the securitised debt market.
- The US Securities and Exchange Commission adopted rules in 20143 to standardise asset-level information for securitised debt backed by various assets including residential mortgages, commercial mortgages and auto loans.
- Credit risk retention requirement3 requires securitised product creators to retain no less than 5% of the aggregate credit risk of the assets they securitise, seeking to align the incentives of securitised product creators and investors.
What is securitisation?
Securitised debt4 in the current context of fixed income investing
An unconstrained strategy invests opportunistically across sectors and geographies in the fixed income universe, allowing investors to go beyond traditional bonds in their search for yield. For example:
ABS
- Significant asset diversity (auto and consumer loans). The US consumer is well-supported by low unemployement and continued economic growth
Agency MBS
- Residential mortgages with US government backing
Overall, it is worthwhile for investors to be mindful of the risks before investing in the securitised debt market. Nonetheless, investment risks could be managed through diversification with the help of an active manager.
1 Source: “The rebirth of securitisation: Where is the private label mortgage market?”, Urban Institute, September 2015.
2 Source: FactSet, FRB, J.P. Morgan Asset Management, Bureau of Economic Analysis. Data include households and non-profit organisations. First quarter 2019 figures for debt service ratio is J.P. Morgan Asset Management estimates. Past performance is not a reliable indicator of current and future results. Data reflect most recently available as of 31.03.2019.
3 Source: US Securities and Exchange Commission (http://www.sec.gov/spotlight/dodd-frank/assetbackedsecurities.shtml).
4 For illustrative purposes only, exact allocation of portfolio depends on each individual’s circumstances and market conditions.
Investment involves risk. Investors should consult professional advice before investing. The opinions and views expressed here are those held by the author as of the date of this publication, which are subject to change and are not to be taken as or construed as investment advice.
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