Structured debt stands out for its low correlation to other sectors of fixed income. This makes it a useful component for unconstrained managers in achieving a range of outcomes unrelated to standard benchmarks. It can perform well in a rising rate environment.
What is Structured Debt?
A structured debt security holds a pool of loans or mortgages that provide a stream of interest or loan repayments. Typically, these pools of loans are structured into securities by financial institutions, such as investment banks or agencies. The main subsectors of the asset class are residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS) and more general asset-backed securities (ABS), which may contain student loans, auto loans or credit card receivables. Within these subsectors the range of securities are highly diverse in terms of structures, yields, maturities and collateral type.
For the unconstrained manager the asset class offers greater opportunities for either protecting or adding value in a rising rate environment due to the floating rate origin of many securities.
Yields for asset backed securities
Source: Western Asset as at 31 March 2018. Yield can fluctuate and is not guaranteed to continue.
An overlooked asset class
And yet, the asset class is somewhat overlooked by investors. Its reputation was hurt due to the low standards of securitization, mortgage lending and credit ratings up to 2008 which led to many investors not fully recognizing the risks of the instruments. Valuations were hit during the sharp downturn in the economy and housing market that year.
The asset class is much reformed. The Dodd-Frank Act 2010 requires lenders to ensure borrowers can afford to repay their loan. So, income now needs to be fully verified, while a borrower’s FICO Score (a credit measure), which records payment history and debt, is another hurdle for the borrower.
In addition, the type of mortgage on offer in the US market has become more conservative. At the peak of the housing bubble in 2005, adjustable-rate mortgages accounted for 42% of new mortgage originations, with teaser rates or negative amortization common. Whereas now 30-year fixed-rate mortgages constitute the vast majority of new originations.
Finally, there are also higher standards for issuers of structured debt who now must retain a 5% economic risk in any debt they issue to better align their interests with bondholders.
The key benefit of structured debt is its low correlation to other fixed income sectors. Here is how such low correlation can work for investors:
Lower sensitivity to rising rate environment: Most structured debt is made up of floating rate securities, where the income paid out should increase or decrease with interest rates. This feature provides some immunity for investors’ portfolios in a rising rate environment for certain types of asset backed security. The following graph shows how the valuation of asset backed securities have changed during four of the most recent sharp rises in US 10 year Treasury yields.
How a jump in US Treasury yields impacts structured debt
Source Bloomberg, April 26th 2018.
Enhanced yields: In the fixed income universe the risk return profile of structured debt is one of the most attractive, due to its new safeguards being often misunderstood. Notably it offers a lower volatility in price to similar yielding securities such as high yield debt.
Modest US growth is enough for strong returns: The market value of structured debt is linked to the likelihood of borrowers paying back the loans within each security. A good way of gauging this is to look at the overall health of the US economy where most of the loans that back structured debt emanate from. If growth and employment are modestly improving then it should have a positive impact on valuations. Similarly, modest improvements in construction rates and house prices will positively impact on confidence for mortgage backed securities.
The ability to tailor securities: Fund managers such as Western Asset that have a mixture of scale and structured debt specialists can choose to tailor new structured debt securities directly with banks and mortgage companies. In such situations the fund manager will look at every single loan behind the security with the freedom to reject loans that do not meet its requirements. If the security is split into tranches of loans according to their time to maturity, then a fund manager can choose a particular tranche to suit their needs. Such deals aid managers that specialise in having a suitably diverse mix of risks in their portfolios.
Faced with a changing and more challenging backdrop as interest rates rise and volatility spikes higher, fixed-income investors with an unconstrained approach can add value and reduce risk to portfolios by including structured debt investments to the mix. Significant improvements in lending and borrowing standards from a decade ago, coupled with the introduction of regulatory safeguards, and an economy and consumer on solid footing, make a compelling case for investing in the structured debt sector.