Just before the financial crisis, investing in US mortgage-backed securities (MBS) was like rolling a dice over a green games table: the outcome could have been random as the assets’ publicised characteristics sometimes barely resembled their true fundamentals. Ten years, a major financial crisis and thousands of pages of new regulation later, investing in MBS has radically changed.
The sector has cleansed itself: tougher regulation has imposed more transparency and fairness – banks, for example, are required to keep a slice of the MBS they sell, instead of passing it all onto clients. Fundamentals have also improved: the 100% loan-to-equity ratios seen at the peak of the market, in 2007-08, do now have a bigger equity cushion – an incentive for people to keep and not sell their homes. And credit ratings are not constantly top-notch any more – quite far from it. All in all, the Asset Backed Securities (ABS) sector has left its opacity days behind and turned more “what you see is what you get.”
This is highly relevant because investing in mortgages or other ABS is an indirect but efficient way of investing in the heartbeat of an economy. A country with positive growth, rising employment and controlled price and wage inflation is likely to see its residential and commercial real estate sectors, as well as consumption patterns, mirror that growth. When individuals and companies feel more confident, they spend more on the homes or real estate they own or rent, and also buy more cars or appliances for which they get loans for.
In this sense, the US MBS and ABS universe offers interesting opportunities, especially at a time when rates remain low, but are on a rising path, and uncertainty doesn’t seem to wane. In this environment, the ABS and MBS sector offers:
1) Attractive yield: Despite a pick-up in global growth, developed market yields remain low, also dragged down by structural issues such as aging populations and falling productivity. Ten-year sovereign yields* are at 2.4% in the US, 0.4% in Germany and a meagre 0.04% in Japan. This makes commercial mortgage and consumer loan yields of as much as 10% and 9%, respectively, look attractive.
2) Low Volatility: the nature of the sector, based on regular consumer or corporate payments, means that its natural volatility tends to be lower than other higher-yielding sectors, such as Emerging Markets or High Yield.
3) Low correlation to other asset classes: Traditional US agency-backed mortgage products tend to have a high correlation to US Treasuries, but strategies that include other elements of the ABS and MBS universe can bring that correlation to even negative levels, acting as a diversifier within a fixed income portfolio.
4) Low interest rate sensitivity: The floating rate nature of some products makes them adjust in a rate changing environment, reducing risk. Active strategies that manage duration exposure can also reduce rate sensitivity.
US home prices - up but still below recent heights
Source: Bloomberg as of 20 March 2017. Latest data as of 31 December 2016.
Western Asset has believed in the asset-backed sector since it first invested in US agency-backed Residential Mortgage Backed Securities (RMBS) in 1974. Since then, the Pasadena, California-based asset manager has increased its investment universe within the sector, as new markets and asset classes developed. Now, Western Asset’s solutions are bringing together the manager’s 40-year experience in the asset class, as well as the variety of tools that Western Asset’s active managers use to profit in both up and down markets, such as derivatives.
The asset class warrants such sophistication and specialisation, as it can sometimes be complex, illiquid and under-researched, so thorough collateral analysis is paramount. The Western Asset team see these challenges as an opportunity to find value and ultimately, deliver positive returns to investors.
*As of 23 March 2017