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Related Insight

The Case for Structured Securities

Consistent with our view that fixed income should serve as a lower-risk, diversifying anchor of an investor’s portfolio, we believe structured securities—namely asset-backed securities (ABS) and agency mortgage-backed securities (MBS)—can play an important role in optimizing a portfolio’s risk-reward profile. By applying the requisite expertise and due diligence necessary to incorporate structured securities in our clients’ investment strategies, we believe we can meaningfully enhance overall investment results. Accordingly, our investment approach often emphasizes MBS and ABS in portfolio construction, particularly in shorter-duration investment strategies. In our view, the enhanced income, improved diversification, and comparatively lower volatility offered by pooled receivables make it a very compelling asset class.

In the case of agency MBS, we believe the sector offers compelling diversification benefits, as the credit market and MBS market are driven by different economic and market dynamics; business fundamentals versus interest rate volatility. Interest rate movement has the largest impact on MBS relative performance, due to its influence on the timing of cash flows through the repayment of principal.

The primary risk to agency MBS securities emanates from the borrower’s ability to prepay their mortgage at any time without penalty. For example, when interest rates decline, borrowers are incented to refinance their mortgage. While the borrower reaps a clear benefit to refinancing, this transaction results in a prepayment to the MBS investor at par, which then causes the investor to reinvest those proceeds at lower rates. Conversely, when rates rise, there is no incentive for borrowers to prepay their mortgage, thus delaying the repayment of principal at a time when interest rates have become more attractive.

Fortunately, for MBS investors, there are friction costs for mortgage borrowers that makes this “call” feature relatively inefficient. Additionally, prepayment risk is partially mitigated by the diversification benefits associated with the securitization process, as hundreds if not thousands of loans are aggregated to form a pool. Each mortgage pool has its own unique attributes (e.g., loan type, term, loan balance, age, geography) that can significantly impact cash flow variability. This presents security selection opportunities for MBS investors. Accordingly, we utilize robust analytical models to forecast cash flows based on various interest rate and prepayment scenarios to assess risk and relative value in each security we consider.

Perhaps a much less understood market than agency MBS, the ABS sector offers similar diversification benefits relative to credit, but has very little exposure to prepayment volatility and thus relative performance is not interest-rate driven. Asset-backed securities are commonly secured by financial assets, such as auto loans, equipment loans, and credit card receivables. The securitization process allows lenders to diversify their sources of funding while providing investors access to a high-quality asset class that can satisfy a variety of maturity and risk preferences. Our investment strategy focuses on securities at the highest level of the capital structure that are AAA-rated.

In addition to a diverse pool of underlying collateral, ABS transactions incorporate a variety of credit enhancements and structural features. These come in different formats and amounts depending on the ABS type. Auto and Equipment ABS typically have a structure that incorporates a series of sequential classes in which investors of the respective classes are repaid in order of maturity and seniority. Other features include credit enhancements, such as a cash reserve, overcollateralization, and/or subordination, which serve to insulate investors at the top of the capital structure from losses. Credit Card ABS securities have a senior/subordinate structure, as well as internal triggers designed to protect the investor in the event of a deterioration in the quality of the pool or seller/servicer.

FAVORABLE CHARACTERISTICS OF ABS

  • Large and diverse pools of consumer obligations providing predictable cash flows
  • Bankruptcy-remote assets from the underlying seller-servicer
  • Short-term exposure – weighted average life of generally less than three years
  • Credit enhancement features that contribute to the durability of the individual structures
  • Consistent performance in terms of charge-offs and delinquencies
  • Stable ratings with very few downgrades among the highest quality sectors

When selecting appropriate ABS for our client portfolios, we focus on strong sponsors with solid industry track records and consistently strong underwriting criteria. In addition, our analysis utilizes a “belt and suspenders” approach whereby we assess the structure/credit enhancements, as well as the collateral characteristics and historical repayment trends to validate the quality of the underlying assets.

In the context of risk-adjusted portfolio optimization, we believe the diversification benefits attained by incorporating MBS and ABS enable us to move further out the efficient frontier in portfolio construction. Our historical analysis over the past 20-plus years shows a low correlation between structured securities and credit sectors. Moreover, MBS and ABS have exhibited significantly less volatility of excess return than credit sectors over the same time period. This is largely due to the high-quality nature and shorter duration profile of structured product sectors relative to the overall credit index.

Additionally, to assess the risk/return trade-off of MBS and ABS, we calculate a modified information ratio (MIR) by dividing realized excess returns relative to duration-matched U.S. Treasuries by the volatility of those excess returns. We use this metric to compare sectors with distinct investment risks and characteristics. The table below highlights the compelling MIRs (higher indicates better relative risk-adjusted return) and low correlations relative to corporate credit.

Period from January 1997 to August 20195
Table 1
Average Excess
Return (% per year)
Volatility
(% per year)
Modified
Information Ratio
Correlation to
Corporate Credit4
MBS 30-Year1
0.44
1.29
0.34
0.45
MBS 15-Year2
0.32
1.07
0.30
0.41
AAA ABS – Credit Card and Auto3
0.56
0.51
1.09
0.49

(1) As measured by the ICE BofAML U.S. FHLMC and FNMA 30-Year MBS Index.
(2) As measured by the ICE BofAML U.S. 15-Year MBS Index.
(3) As measured by the market-weighted ICE BofAML AAA U.S. Fixed Rate Credit Card ABS Index and ICE BofAML AAA U.S. Fixed Rate Auto ABS Index.
(4) ICE BofAML U.S. Corporate Index.
(5)We exclude the time period between June 2008 and September 2009 from the return series in this paper due to the exceptional volatility and correlations of excess returns exhibited at that time. During this time period, primary fixed-income sectors experienced return periods that were multiple standard deviation events relative to the historical evidence of the past 40 years.

Source: BofAML Merrill Lynch Global Bond Indices, PNC Capital Advisors analysis

The diversification benefit provided by incorporating structured securities in portfolios can be further illustrated by comparing two indexes, one consisting solely of government and credit sectors (Bloomberg Barclays Government/Credit Index) and the other that includes structured products (Bloomberg Barclays Aggregate Bond Index). As shown in the table below, adding structured products to a government-credit portfolio over the period 1997 to 2019 would have produced an enhanced average annual excess return, a reduction in return volatility, and a higher modified information ratio.

Period from January 1997 to August 20191
Table 2
Average Excess
Return (% per year)
Volatility
(% per year)
Modified
Information Ratio
Bloomberg Barclays U.S. Government/Credit Index
0.30
1.18
0.26
Bloomberg Barclays U.S. Aggregate Bond Index
0.34
1.06
0.32

(1) We exclude the time period between June 2008 and September 2009 from the return series in this paper due to the exceptional volatility and correlations of excess returns exhibited at that time. During this time period, primary fixed-income sectors experienced return periods that were multiple standard deviation events relative to the historical evidence of the past 40 years.

Source: Bloomberg Barclays Indices, PNC Capital Advisors analysis

Thus, we believe in many cases structured securities should be an integral component of fixed income strategies that seek to optimize risk-adjusted performance. However, given their perceived complexities, it’s understandable why some investors may be reticent to incorporate structured securities in their portfolios. We caution against painting structured securities with too broad a brush, as this misconception could result in suboptimal asset allocation, particularly when it comes to the tradeoff between risk and return.
Indexes

Various market indices may be referred to in these materials. Please see following for a brief description of these indices and comparisons. Indices are unmanaged and not available for direct investment. The performance of an index does not reflect expenses associated with the active management of an actual portfolio.

The ICE BofAML US Mortgage Backed Securities Index tracks the performance of US dollar denominated fixed rate residential mortgage pass-through securities publicly issued by US agencies in the US domestic market. 30-year, 20-year and 15-year fixed rate mortgage pools are included in the Index provided they have at least one year remaining term to final maturity and a minimum amount outstanding of at least $5 billion per generic coupon and $250 million per production year within each generic coupon. Hybrid, interest-only, balloon, mobile home, graduated payment and quarter coupon fixed rate mortgages are excluded from the index, as are all collateralized mortgage obligations.

The ICE BofAML Conventional 30-Year Mortgage backed Securities Index is a subset of ICE BofAML US Mortgage Backed Securities Index including all 30-year securities issued by Fannie Mae and Freddie Mac except for interest-only fixed rate mortgage pools and hybrids.

The ICE BofAML US 15-Year Mortgage Backed Securities Index is a subset of ICE BofAML US Mortgage Backed Securities Index including all 15-year securities except for interest-only fixed rate mortgage pools and hybrids.

The ICE BofAML AAA US Credit Card Asset Backed Securities Index is a subset of ICE BofAML US Fixed Rate Asset Backed Securities Index including all asset backed securities collateralized by credit card loans and rated AAA.

The ICE BofAML AAA US Fixed Rate Automobile Asset Backed Securities Index is a subset of ICE BofAML US Fixed Rate Asset Backed Securities Index including all securities collateralized by auto loan receivables and rated AAA.

The Bloomberg Barclays US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate pass-throughs), ABS and CMBS (agency and non-agency).

The Bloomberg Barclays US Government Credit Bond Index is a broad-based flagship benchmark that measures the non-securitized component of the US Aggregate Index. The index includes investment grade, US dollar-denominated, fixed-rate treasuries, government-related and corporate securities.

The ICE BofAML US Corporate Index tracks the performance of US dollar denominated investment grade corporate debt publicly issued in the US domestic market.

Important Disclosures

This publication is for informational purposes only. Information contained herein is believed to be accurate, but has not been verified and cannot be guaranteed. Opinions represented are not intended as an offer or solicitation with respect to the purchase or sale of any security and are subject to change without notice. Statements in this material should not be considered investment advice or a forecast or guarantee of future results.

© The PNC Financial Services Group, Inc. All rights reserved.

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