FIXED INCOME Time to Turn to Securitized Assets July 2013 ManulifeAM.com
Time to Turn to Securitized Assets After thirty years of secular decline in inflation and interest rates, bond investors are facing challenging times in deciding on their fixed income allocations. The Federal Reserve s policies are keeping interest rates and risk premiums at extraordinarily low levels. Yet, as the recovery in the US economy broadens, the day when bond yields start their inevitable trend higher is drawing closer. While predicting the timing of such a move is difficult, certain areas of the fixed income universe, such as securitized debt, offer attributes that may appeal to bond investors for both tactical and strategic reasons. Expanding the options for bond investors The hunt for yield has flattened yield curves and credit spreads over recent years. At present valuations, further price appreciation for many fixed income assets may be limited to security-specific trade ideas, while the risk of capital depreciation if bond yields start to trend higher is an ever-present, and increasing, threat. Against this backdrop, bond investors may be tempted to park assets in safe havens, such as cash or shortterm, highly rated sovereign debt, as they wait for opportunities to capitalize on market weakness. However, the very low level of yields makes this trade unattractive for any but the shortest of investment horizons. In contrast, other investors are looking for opportunities to enhance yields and generate returns in increasingly extreme parts of the credit curve. With lower quality bonds trading at historically low yields, the upside potential of this trade is now questionable, while it also raises liquidity concerns. Indeed, there is an argument that equity assets might be a better higher risk investment than high yield bonds at current valuations. But there is another option: fixed income assets with superior yields (relative to cash or dividend yields), moderate interest rate and spread duration to provide investors with controlled exposure to interest rate risk and reinvestment flexibility. These are known as securitized assets. Securitized Assets: The Opportunities and Benefits Securitized assets are bonds backed by a pool of assets or collateral, such as credit card payments, auto loans and mortgages, both residential and commercial. The credit risk of securitized transactions is a function of collateral quality and the position of each class senior to subordinate bonds in the capital structure. The securitized market is large. The total size of the market is roughly $7 trillion four times the size of the Barclays Capital High Yield and High Yield Loan indices combined ($1,180 billion and $564 billion respectively as at March 2013). Today, the securitized universe is dominated by Agency Mortgage Backed Securities (MBS) issued Securitized assets are bonds backed by a pool of assets or collateral, such as credit card payments, auto loans and mortgages, both residential and commercial. 2
by Fannie Mae and Freddie Mac (Government Sponsored Enterprises) and Ginnie Mae, but other significant segments include Non Agency, or private label, Residential Mortgage Backed Securities (RMBS), Commercial Mortgage Backed Securities (CMBS) and Consumer Asset Backed Securities (ABS), which are backed by credit cards and student loans. In addition, the market is highly segmented and complex. This is demonstrated by the wide variety of sub-sectors and security types, each of which is defined by specified collateral, and an issue structure typically consisting of senior and subordinate bonds. For active bond managers seeking alpha, these attributes are the basis for anomalies, diverse opinions, mispricing and excess return potential. Significant Value-added Opportunities Chart 1: Size of Securitized Markets ($trillions) Agency MBS Residential MBS Commercial MBS ABS Floating Rate (Credit Cards and Student Loans) $0.89T 13.17% $0.10T 1.55% $0.76T 11.24% Source: Amherst, Barclays, BoA Merrill Lynch, March 2013. As an active bond manager searching for valuation anomalies and new investment opportunities, we are attracted to markets that are large, complex and segmented. $4.98T 74.04% Large markets facilitate trading and provide sourcing opportunities throughout the entire market cycle, not just in times when buyers have the upper hand. Complexity, in terms of sector or security-specific attributes, creates an information barrier. This favors fixed income managers with the research capabilities to analyze idiosyncratic risk and risk premiums at the loan level in a limited competition setting. Segmentation by duration, volatility, liquidity or collateral allows active managers the flexibility to make tactical shifts between these different segments or across the risk continuum. As an active bond manager searching for valuation anomalies and new investment opportunities, we are attracted to markets that are large, complex and segmented. The Benefits of Reinvestment Flexibility Unlike conventional bullet bonds generally found in the corporate bond market, securitized debt typically has cash flows consisting of interest, amortizing principal payments and pay-downs. This amortizing characteristic reduces the bond s duration and average life, causing securitized debt to have a shorter tenor than corporate bonds with the same final maturity date. For instance in the Barclays index, CMBS ERISA Eligible assets have an average life of 3.5 years while investment grade corporate bonds have an average life of 10.5 years. This implies that, over any part of the market cycle, the former are expected to turn over three times more rapidly than the latter, implying less potential price risk associated with selling securities. 3
For bondholders, the flexibility provided by this natural cash flow can offer significant benefits. It provides investors with an open option of whether to reinvest the cash flow at propitious entry points or use it to meet liabilities. These attributes can be especially valuable during time of rising interest rates or widening credit spreads. Greater Confidence Should Help to Broaden the Range of Securities It is well known that securitized assets were badly affected by the financial crisis of 2008. The fallout from these events is still being felt across the market which is only just starting to recover in certain segments. One of the key impacts has been on new issuance levels, which have fallen sharply since their pre-crisis levels. Today new issuance of residential securitized debt is dominated by the Agencies (Fannie Mae, Freddie Mac and Ginnie Mae), which have increased their market share in new home mortgages from 40% pre-crisis to currently 95%. 1 Meanwhile, the virtual cessation of new issuance of private label RMBS in the years following the financial crisis has left a sizeable legacy market. These bonds, which were issued prior to the financial crisis, now attract a scarcity premium as these aging assets naturally reduce in size through amortization. Apart from this legacy market, a handful of private label RMBS collateralized by pristine loans were quietly issued in 2010 2012. However, as home prices improve, and representation and warranty risk recedes, it is likely that Agencies will cede market share to the private sector. As and when it happens, this increased supply of new Non Agency securities will provide further choice and a potential source of alpha for investors in securitized assets. In contrast, the CMBS market has continued to see reasonable issuance in the post-crisis recovery period. Although commercial real estate prices fell nearly 40% from the peak in 2007, the financing markets remained open and 2013 issuance for securitized transactions is expected to be robust at $88 billion for Agency CMBS and $65 billion for private label conduit and single property deals. 2 This provides a source of attractively-priced new investments for investors with fundamental loan level research capabilities and quantitative models to analyze and understand the associated risks. Brighter Fundamentals for RMBS For property-related securities, such as RMBS, the recovery in the US housing market, which began to turn in the first quarter of 2012, is supportive for fundamentals and RMBS prices. From the peak in the housing market in mid-2006 to the trough in late 2011, US home prices declined on average 33% and have since recovered about 10%. 3 Furthermore, analysis indicates that national home prices remain below their long-term normal price-to-income ratio and existing homes are still being priced at wide discounts to new homes, suggesting that the current stock remains undervalued. 1 As of March 31, 2013. 2 Source: Bank of America Merrill Lynch, March 2013. 3 Source: CoreLogic, January 2013. 4
Chart 2: In 2012, US Housing Market Showing Signs of Recovery 20% 15% 10% 5% 0% -5% -10% -15% -20% Jan 2001 32% Jan 2002 Jan 2003 Jan 2004 Jan 2005 72% Jan 2006 Jan 2007 Jan 2008 Jan 2009 Jan 2010 Jan 2011 Jan 2012 Jan 2013 S&P/Case-Shiller Composite - 20 City Home Price Index YoY Source: Case Shiller, Bloomberg, January 31, 2013 These attractive valuations coupled with low financing costs and rising incomes mean affordability is approaching record levels, providing a further stabilizing influence on the housing market. Moreover, demand is set to outweigh supply: net new household formation was nearly one million in 2012, which exceeded net new supply by roughly 500,000, helping to absorb existing inventory. 4 Higher home prices help to lower loan-to-value (LTV) levels, an important factor in mortgage default forecasts. Lower LTV s also have salutary effects on voluntary prepayment speeds for borrowers previously shut out from refinancing and, for weaker borrowers, they help to stabilize transition rates and promote better recoveries. These effects can be seen in the following table which shows how the improvement in the housing market is reducing the percentage of borrowers exposed to negative equity and lowering LTV levels. Table 1: Housing Recovery Is Improving RMBS Fundamentals July 2012 March 2013 RMBS Universe % Balance March 2013 Original LTV Current LTV % Negative Equity Current LTV % Negative Equity Always Performing Loans 47% 76.2% 97.6% 42% 90.0% 34% Re-Performing Loans 25% 82.2% 122.0% 63% 109.1% 53% Non-Performing Loans 28% 83.0% 131.8% 73% 119.6% 65% Source: Amherst Securities, March 2013.RMBS Universe includes Prime, Alt-A, Option ARM and Subprime. The recovery, albeit a slower one, in the jobs market is also positive for securitized debt. Higher employment levels tend to raise incomes thus increasing loan affordability, not just for mortgages, but also for credit card payments and auto loans. These brighter fundamentals have been one reason for higher securitized debt prices over the last couple of years. Of course, many areas of the credit universe have also seen spread compression during this time, but not all are backed by a compelling case for stronger fundamentals. In the high yield market, for example, a large and aggressive buyer base have allowed issuers to raise capital at tight spreads and increasingly higher 4 Source: Barclays Research, March 2013 5
corporate leverage levels. Indeed, aggregate statistics that track corporate issuers balance sheet health show weakening trends in net leverage, interest coverage cash-to-debt levels and margin growth. 5 Chart 3: Corporate Leverage Starts to Tick Higher 3.0 2.8 2.6 2.4 2.2 2.0 1.8 1.6 1.4 1.2 1.0 Dec 1990 Dec 1994 Dec 1998 Dec 2002 Dec 2006 Dec 2010 Gross Leverage Wavg Net Leverage Wavg Source: Morgan Stanley, March 2013 Securitized Valuations Compare Favorably with other Fixed Income Assets The bursting of the housing bubble in 2007 and subsequent financial crisis in 2008 caused the structured credit markets (RMBS and CMBS), along with all risk assets in general, to undergo a sharp correction as many investors fled to perceived safer havens. However, over the past four years, the credit market has rebounded with riskier credit assets, such as high yield debt and lower quality corporate bonds, recording the highest gains. 6 Chart 4: Fixed Income Returns since January 2008 Cummulative Total Return Since January 2008 (%) 80% 60% 40% 20% 0% -20% -40% Mar 2008 Mar 2009 Mar 2010 Mar 2011 Mar 2012 Source: Non-Agency data from CoreLogic, Intex, Amherst Securities; all other data from Yieldbook, March 2013 Mar 2013 NON-AGENCY TOTAL A1: Mortgage A2: USBIG, Treasury A3: USBIG, Agency A4: USBIG, Corp. A5: HYCP Capped A6: USBIG, Corp., BBB High yield bonds, in particular, have seen significant spread compression and yields are now trading at, or near, record absolute lows. While, at current valuations, these bonds still offer reasonable carry versus government debt, their upside is relatively limited. 5 Source: Morgan Stanley Credit Strategy, March 2013. 6 As of March 2013 6
In contrast, more attractive yield enhancement and reinvestment opportunities may be found in the securitized market, especially within senior, moderate tenor assets which offer solid carry and the prospect of stable underlying fundamentals. This relative value proposition is related to the dislocations in the housing market, unintended effects of public policy and limited competition for securities due to complexity and information barriers. In conclusion For bond investors, the current depressed levels of yields, which are being kept artificially low by the Federal Reserve s policies, mean that exposure to fixed income markets potentially offers more risk than upside. While the timing is uncertain, the longer term trend is likely to be one of rising bond yields. Knowing where to invest in this environment is difficult. By diversifying into securitized assets, investors can capitalize on large, imperfect and complex markets to seek to generate outperformance, drawing on specialist managers to identify individual bonds with favorable characteristics. In addition, the reinvestment flexibility generated by relatively short tenor assets with high cash flows means securitized assets potentially offer valuable attributes to help investors during uncertain times. Moreover, securitized fundamentals and valuations compare favorably with other diversifying fixed income sectors, such as high yield bonds. This is being driven by the rebound in the real estate market, the aging of legacy transactions and the attendant deleveraging of homeowners and many RMBS structures, even as corporate leverage levels are ticking up. 7
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