Beyond bonds, the potential benefits of long securitized assets
- While complex, heterogeneous and often misunderstood, long-duration securitized assets offer liability-driven investment (LDI) portfolios many options for diversification and potentially enhanced yield without sacrificing credit quality.
- Long securitized assets may provide superior performance vs. high quality long corporate bonds; collateralized mortgage obligation (CMO) spreads widened half as much during the March 2020 market turmoil. Long securitized investments may also provide return enhancement vs. Treasury bonds by offering a greater yield with a similar credit rating.
- We recommend agency commercial mortgage-backed securities (CMBS) and CMOs as the cornerstone for allocations; their long interest rate and spread duration, stable cash flows with agency guarantees and reasonable spread volatility make them suitable substitutes for long corporate or Treasury bonds.
- The sheer diversity of the long securitized universe and structures that can be challenging to analyze mean selection opportunities. In this market, managers with expertise and a proven process are essential.
Long-duration securitized investments are increasingly in focus among pension plans as they continue to de-risk and their fixed income allocations grow, as tools for diversification and yield enhancement. Yet the breadth of types, and complexity, of long-duration securitized instruments mean the asset class is often misunderstood. The space also lacks reliable benchmarks. Taken together, these challenges suggest that simply carving out an allocation to this sector would likely not be enough to effectively meet plans’ investment objectives.
Here, we explore the key attributes of several types of long securitized investments, the benefits they can offer a liability-driven investment (LDI) strategy and the unique role they can play in diversifying LDI portfolios reliant on allocations to corporate bonds and Treasuries. A portfolio constructed with a variety of long securitized investments can result in more attractive duration and yield characteristics than a portfolio that focuses on just one such investment. Introducing a different type of spread risk offers attractive diversification benefits without sacrificing credit quality. We also consider why expertise in this market and a proven process are essential.
A variety of options for diversification and potentially enhanced yield
Among the wide variety of long securitized investments, agency commercial mortgage-backed securities (CMBS) and agency collateralized mortgage obligations (CMOs) would likely make up most of an allocation to the space, given their natural long interest rate duration and spread duration. But investors should keep other securities in mind as well (Exhibit 1).
Often overlooked and misunderstood, long-duration securitized assets can add diversification and enhance yield for an LDI portfolio
EXHIBIT 1: Overview of types, characteristics and roles of long-duration securitized assets
Agency CMBS and CMOs
When many investors think of “mortgage-backed securities,” they assume the term refers to agency pass-throughs, generally with durations of two to six years, often with negative convexity. Those are the securities most often covered in the financial press and included in broad fixed income benchmarks. Agency CMBS and agency CMOs, while less familiar, are based on a pass-through structure but are not standard pass-throughs; they carry the same principal and interest guarantees as agency pass-throughs but can often be found with durations of 10 to 15 years and positive convexity. With their varying structures, they can be challenging to analyze and understand.
U.S. agency CMBS and agency CMOs provide natural long interest rate and spread duration, so they would likely make up most of an allocation, supplemented by smaller allocations to other securitized subsectors.
Agency CMBS: A deep dive
Agency CMBS have been around since the 1990s. A turning point came after the 2008 credit crisis, when the MBS market dried up and government-sponsored enterprises (GSEs) stepped in to support the housing market, and made up for the lack of liquidity with a surge of MBS issuance. The ballooning market—of securities generically called “agency CMBS”—primarily promoted affordable multi-family housing as renting increased vs. buying. Fannie Mae was the most active issuer, followed by Freddie Mac and Ginnie Mae (Exhibit 2).
Issuance of agency CMBS ballooned following the 2008 credit crisis
EXHIBIT 2: Agency CMBS outstanding ($ millions)
Agency CMBS are an excellent diversifier because payments are guaranteed by GSEs, providing stable cash flows, and the securities are characterized by reasonable spread volatility. The market has many intricacies, however, highlighting the importance of security selection skills. For example, apartment buildings are the most common underlying collateral type, but the collateral may be rural, senior, cooperative, manufactured, student or military housing. The most common agency CMBS sectors have other important differences (Exhibit 3).
Agency CMBS provide stable cash flows and less spread volatility, and vary by originators, structure and guarantees
EXHIBIT 3: Main agency CMBS instruments
Case study: Fannie Mae DUS bonds
Next, we explore one CMBS type in depth—Fannie Mae DUS bonds—for simplicity, and also because these securities have been around since the 1990s and make up a large portion of the agency CMBS outstanding (Exhibit 4).
Origination: Fannie Mae’s DUS program originates and finances multi-family mortgage loans. DUS-authorized lenders are carefully screened and underwrite and deliver loans according to Fannie Mae’s strict underwriting criteria. Single-loan deals can be purchased by investors and assembled into a diversified portfolio or packaged into megas and ACES.
Long DUS structures may have a final maturity of up to 20 years (yield maintenance period 19.5 years)
EXHIBIT 4: Sample characteristics of long-duration single-loan DUS securities
Prepayment protection: DUS securities are structured to provide investors strong prepayment protection and thus positive convexity, accomplished through loss sharing and prepayment penalties. DUS lenders have an incentive to carefully underwrite deals because they are contractually obligated to share in credit losses. This approach has been highly effective, helping to keep loan delinquency rates down and to minimize prepayments due to defaults (Exhibit 5). Yield maintenance provisions add further prepayment protection.1
Fannie Mae DUS securities are structured to keep delinquency rates low
EXHIBIT 5: Serious DUS delinquencies (% of instruments outstanding)
Spreads: Because of the Fannie Mae guarantee, DUS securities will typically trade tighter than similar nonagency CMBS. Spreads on DUS bonds are often attractive relative to U.S. Treasuries, agency debentures and certain high quality corporates. As might be expected, spreads increase as maturities/durations increase. Spread volatility, measured by standard deviation, is favorable vs. high quality corporates and similar indices. This was evident during the COVID-19 bond market meltdown of March 2020, when 12/11.5 DUS spreads2 widened about 29 basis points (bps) vs. 81bps for the Bloomberg Barclays Long Corporate A or Better Index. This lower spread volatility also prevails over prolonged time periods (Exhibit 6).
DUS spread fluctuation tends to be less volatile than leading bond benchmark spreads
EXHIBIT 6: DUS spreads vs. benchmark bond index spreads, jan 2015–sept 2020
Freddie Mac’s K-Deal program
Another long securitized agency asset type worth noting is Freddie Mac’s K-Deal program, which issues structured pass-through certificates with unique characteristics that cause their long duration; they are backed by multi-family mortgage loans. Freddie sources these loans from a network of approved multi-family seller/servicers. Unlike the Fannie DUS program, Freddie Mac itself underwrites and approves the loans. Another difference: Freddie K-Deals typically offer guaranteed and unguaranteed tranches.
Long-duration agency CMOs are another overlooked portfolio diversifier, in part due to the vast variety of structures available and a lack of standardization. Certain attractive tranches can provide superior performance relative to high quality corporate bonds. CMOs date to the 1980s; their outstanding issuance presently exceeds $1.3 trillion.
Cash flow payments: Like agency pass-throughs, agency CMOs pay out cash flows from pools of underlying mortgages and are agency guaranteed. However, unlike pass-throughs, CMOs segregate those cash flows into tranches to reallocate prepayment risk. Various tranches’ cash flows differ in terms of their timing (e.g., first pay, final pay or something in between), composition (principal only, interest only or a combination) and risk (e.g., degree of exposure to prepayment risk). We explore these intricacies further below.
Spread performance: Since the CMO market is so heterogeneous and model dependent, it is difficult to generalize or even find reliable benchmarks. In March 2020, during the COVID-19 pandemic market disruption, using as a proxy the CMO positions in one of J.P. Morgan Asset Management’s long-duration vehicles, we find agency CMO spreads widened about 42bps vs. 81bps for a comparable long corporate bond index (Bloomberg Barclays Long Corporate A or Better Index).
Duration: Long CMO tranches can have a duration of 10 years or more and can be structured to make cash flows more predictable and less subject to prepayment risk. A range of examples of CMO tranches is shown in (Exhibit 7).
CMO tranches are diversifying tools structured for predictable cash flows with limited prepayment risk
EXHIBIT 7: Long-duration CMO tranche classes
The challenge of selecting CMOs
Long CMOs are designed to offer better cash flow predictability vs. pass-throughs but retain some prepayment risk because pass-throughs serve as underlying collateral. Significant increases in prepayment speeds, should they persist, can lead to a deterioration in the structural protection. Because there are thousands of different CMO securities, each with a unique CUSIP number, they must be evaluated independently. This highlights the opportunity for security selection: Skilled investment managers can model potential outcomes under a variety of scenarios.
An essential for managers analyzing CMO tranches is understanding each CUSIP’s position within a CMO’s larger structure—and how changes in volatility and/or interest rates may impact the expected payment schedule. This analysis culminates in a relative value assessment, typically comparing the projected total return and option-adjusted spreads (OAS) of a particular CMO to the spread on a similar-duration corporate bond, U.S. Treasury or other mortgage under various interest rate environments.
An example of how an attractive PAC tranche can outperform a comparable high quality corporate bond across a variety of interest rate scenarios over the next 12 months is illustrated in (Exhibit 8).
PAC tranches can outperform comparable high quality corporate bonds
EXHIBIT 8: PAC tranche vs. a corporate bond—a 12-month stress test
Putting it all together
Although long-duration securitized assets may be complex and heterogeneous, they can play an important role in LDI portfolios. An allocation introduces different types of spread risk, offering attractive, high quality credit diversification benefits without sacrificing credit quality. As discussed, agency CMBS and CMOs may particularly enhance LDI portfolios with these qualities, as well as reasonable yields and improved risk-adjusted returns.
Realizing the potential LDI advantages of securitized assets is likely to require more than a simplified approach. For example, long-duration mortgages may represent better relative value than some corporate bonds at certain points in time, given the market’s assessment of corporate event and credit risk. Certain long-duration agency mortgages may be able to provide quality roughly equivalent to that of a Treasury security but with a higher expected return. The sheer diversity of the long securitized universe provides selection opportunities, putting a premium on skilled investment know-how and making market expertise and a proven investment process essential.