Securitized Products An Overlooked Source of Income March 26, 2014 Michael S. Nguyen, Managing Director, Liquidity Management Scott Cabalka, Vice President, Institutional Portfolio Manager RBC Global Asset Management (U.S.) Inc. 100 South Fifth Street, Suite 2300 Minneapolis, MN 55402-1240 612-376-7000 800-553-2143 www.rbcgam.us
Brief Overview of Securitized Market
Securitization: What, Who, Why and How? What: Repackaging of financial assets/loans (cash flows) into securities Who: Issuers of securitized products are wide ranging: banks, auto companies, corporates, GSEs, home builders Why: Securitization occurs for numerous reasons but primarily to free up capital and transfer risk to institutional buyers/investors How: Assets transferred to bankruptcy remote trust with servicer responsible for allocating payments to investors 3
US Structured Finance Market Size ($10Trillion) Student Loans, 228.4 Automobile, 161.5 Credit Card, 124.5 Equipment, 22.6 Housing-Related, 34.6 Other, 705.9 RMBS, 1,054.5 CMBS, 624.7 Agency CMO, 1,134.0 Agency MBS, 5,905.6 As of 12.31.13 Source: SIFMA 4
Varying Forms and Flavors SF/MF loans, commercial and business loans, auto loan, credit cards, student loans, leases Alphabet Soup MBS, CMO, CMBS, ABS, RMBS, CDO, CLO, CBO Structure Class/Tranches - Senior, subordinated, mezzanine Collateral/Underlying quality of loan Loan Terms Credit Risk Credit enhancement Optionality 5
Organization to Distribution Source: Goldman Sachs 6
Residential MBS Single family residential mortgage backed securities are bonds secured by a collection of underlying mortgage loans. Issuers include GSEs or non-agency private entities (private label). Agency mortgage pass-throughs most common. Source: Goldman Sachs 7
Sources of Risk Prepayment Risk (or option risk) is the chance that borrowers prepay their mortgages more quickly or slowly than expected, thereby affecting the investment s average life and perhaps its yield. Market/Duration Risk is the risk that the price of the security may fluctuate over time. Term Structure Risk Convexity Risk Credit Risk is the risk that the investor may not receive all or part of the principal invested because the borrower of the underlying mortgage loan defaulted on its financial obligations. Agency vs. Non-Agency Collateral 8
GSE Securitized Products
Agency Issuers Ginnie Mae Fannie Mae Freddie Mac Small Business Administration Federal Home Loan Banks USDA Federal Farm Credit Banks 10
Basic Pass-Throughs MBS Mortgage Loans Lending Banks GSE Agency Hold 25 bps Lend at 5% Sell at 4.75% Financial Guarantees Mortgage Pool Cash Flow Coupon Pays 4.5% Pass-Through Securities 11
Cash Flow Effect and Yield Measured in CPR (Constant Prepayment Rate) or PSA Curve (SIFMA s Prepayment Model) Coupon Price Paid 0% PSA No Prepayments 100% PSA 300% PSA 500% PSA 2.5 98-19 2.6074 2.6598 2.7763 2.8898 3.0 102-23 2.7962 2.6766 2.4118 2.1530 3.5 105-11 3.0875 2.8498 2.2986 1.7204 4.0 106-14 3.4781 3.1714 2.4102 1.5189 Yield is affected by the price paid for the investment and the timing of the security s cash flow. An earlier than expected return of principal generally increases the yield on securities purchased at a discount. Purchased at a premium, an earlier than expected return of principal reduces yield. Example provided for illustrative purposes only and may not be reflective of current conditions 12
Cash Flow Effect and WAL Because principal is returned throughout the life of the investment, the concept of a weighted average life (WAL) must be used to measure the length of time until principal is returned. 6000 PRINCIPAL AND INTEREST OF $100,000 MORTGAGE WITH PREPAYMENTS 5000 Interest Prepayment Principal 4000 PAYMENT 3000 2000 1000 0 0 3 6 9 12 15 18 21 24 27 30 33 36 39 42 45 48 51 54 57 60 TIME (MONTHS) 13
Collateralized Mortgage Obligations (CMOs) Collateral Pool of MBS Cash Flow Principal Interest Class A Class B Class C 14
Classes or Tranches Sequential Pay Classes (SEQ) Planned Amortization Classes (PACs) Targeted Amortization Classes (TACs) Accrual Classes (Z) Interest Only and Principal Only Classes (IO/PO) Floating Rate and Inverse Floating Rate Classes (FLT/INV) 15
Agency CMBS Multifamily Mortgage Business Apartment projects Seniors housing financing for properties that include skilled nursing, independent living and assisted living facilities Cooperative apartments financing for cooperative corporations Manufactured housing parks financing of land-leased manufactured parks and related amenities Student housing financing for apartment complexes built exclusively for students, located near major colleges and universities Affordable housing financing for housing that is rent-restricted and subsidized by federal, state or local government DUS Bonds, K Deals, GEMS, ACES 16
Security Description Source: Bloomberg For informational purposes only and should not be construed as investment advice. 17
Structured Paydown Source: Bloomberg For informational purposes only and should not be construed as investment advice. 18
Yield Table Source: Bloomberg For informational purposes only and should not be construed as investment advice. 19
Deal Summary Source: Bloomberg For informational purposes only and should not be construed as investment advice. 20
Loan Summary Source: Bloomberg For informational purposes only and should not be construed as investment advice. 21
Property Description Source: Bloomberg For informational purposes only and should not be construed as investment advice. 22
Selecting Securitized Products Cash flow requirements balanced against their liabilities Average investment life requirements that fit asset/liability matching strategy Expectations of the interest rate environment and economic factors that can lead to prepayments, and Other factors affecting portfolio strategies 23
Case Study
Case Study Assumptions An Investment Portfolio for Public Fund Assets High Quality Emphasis; AA Overall Credit Quality 5 Year Final Maturity (Short to Intermediate Duration Portfolio) 1.5-2 Year Portfolio Duration Eligible Investments: U.S. Treasury Notes U.S. Agency Notes and Agency Securitized Municipal Securities (Rated AA/A) Corporate Securities (Rated AA/A) Case study for illustrative purposes only and should not be construed as investment advice. 25
Case Study Considerations Yield, Income, and Return Across Sectors Risk/Return and Price Volatility Shock Analysis of Agency Securitized Alongside Other Assets 26
RBC GAM-US Fixed Income Short Core Income by Sector Total % of Income Earned by Sector vs. Average Sector Weight as of December 31, 2013 50.0% 45.0% 42.9% 40.0% 35.0% 30.0% 28.3% 25.0% 20.0% 20.8% 18.9% 18.9% 21.4% 15.0% 10.0% 5.0% 0.0% 13.6% 8.8% 9.9% 8.3% 6.4% 0.7% 1.1% 0.0% Cash CP Corporate Agency Municipal Securitized Treasury Total Income Earned (%) Average Sector Weight (%) Past performance is not indicative of future results. 27
RBC GAM-US Fixed Income Short Core Yield by Sector Estimated Yield by Sector as of December 31, 2013 1.20% 1.00% 1.09% 1.00% 0.80% 0.79% 0.60% 0.55% 0.40% 0.33% 0.20% 0.00% 0.02% 0.09% Cash CP Corporate Agency Municipal Securitized Treasury Yield Past performance is not indicative of future results. 28
RBC GAM-US Fixed Income Short Core Sector Returns Short Core Sector Returns vs. Average Sector Weight Sector 3 year 12/31/2013 1 Year 12/31/2013 1 Year 12/31/2012 1 Year 12/31/2011 Total Return 1.52 0.56 1.63 2.37 Treasury 0.67 0.45 0.33 1.23 Average Sector Weight 18.2% 21.4% 16.7% 15.2% Agency 1.12 0.46 1.08 1.84 Average Sector Weight 23.3% 8.3% 25.2% 36.1% Municipal 1.44 0.55 1.32 2.46 Average Sector Weight 12.7% 18.9% 14.0% 4.3% Corporate 2.09 0.92 2.53 2.83 Average Sector Weight 29.1% 28.3% 29.0% 28.5% Securitized 2.46 0.33 2.64 4.25 Average Sector Weight 14.4% 13.6% 14.5% 14.5% 29
Stress Scenarios Sector % Sector Allocation Effective Duration 25 bp Rate Shock (%) 50 bp Rate Shock (%) 100 bp Rate Shock (%) Corporate Notes: Financial Institutions 12.9% 2.47-0.62% -1.23% -2.47% Industrial 15.5% 2.34-0.59% -1.17% -2.34% Utility 1.3% 1.80-0.45% -0.90% -1.80% Commercial Paper 8.8% 0.13-0.03% -0.06% -0.13% Taxable Municipal 13.1% 1.72-0.43% -0.86% -1.72% Agency Notes 3.9% 2.63-0.66% -1.32% -2.63% Agency Secured 13.5% 1.69-0.42% -0.84% -1.69% US Treasury Notes/Bonds 29.9% 2.15-0.54% -1.07% -2.15% Total 100% 1.93-0.48% -0.96% -1.93% Scenario provided for illustrative purposes only and should not be construed as investment advice. 30
Disclosures This document (the Presentation ) is being provided by RBC Global Asset Management for educational purposes only. This Presentation is subject to change without notice and is qualified by these disclosures and the disclosures and definitions contained, may not be reproduced in whole or part, and may not be delivered to any other person without the consent of RBC Global Asset Management. This Presentation is not a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any investment strategy and should not be construed as tax or legal advice. RBC Global Asset Management is the name used in the United States for certain investment advisory subsidiaries of the Royal Bank of Canada. RBC Global Asset Management (U.S.) Inc. ( RBC Global Asset Management US or RBC GAM-US ) is a federally registered investment adviser founded in 1983. Past performance is not indicative of future results. There can be no guarantee that any investment strategy discussed in this Presentation will achieve its investment objectives. As with all investment strategies, there is a risk of loss of all or a portion of the amount invested. With respect to goals, targets, objectives, expectations and processes discussed in the presentation, there is no guarantee that such goals, targets, objectives or expectations will be achieved or that the processes will succeed. Any risk management processes discussed refer to efforts to monitor and manage risk but should not be confused with and does not imply no or low risk. The use of diversification within an investment portfolio does not assure a profit or guarantee against loss in a declining market. No chart, graph, or formula can by itself determine which securities an investor should buy or sell or which strategies should be pursued. This Presentation contains the opinions of RBC Global Asset Management as of the date of publication and is not intended to be, and should not be interpreted as, a recommendation of any particular security, strategy or investment product. Not all products, services or investments described herein are available in all jurisdictions and some are available on a limited basis only, due to local regulatory and legal requirements. Unless otherwise indicated, all information and opinions herein are as of December 31, 2013 and are subject to change without notice. These materials may contain information collected from independent third party sources. For purposes of providing these materials to you, neither RBC nor any of its affiliates, subsidiaries, directors, officers, or employees, has independently verified the accuracy or completeness of the third-party information contained herein. Although RBC GAM-US is registered as an investment adviser with the SEC, such registration in no way implies that the SEC has reviewed or approved the investment portfolio and does not imply that RBC GAM-US has achieved a certain level of skill or training. RBC Global Asset Management ( RBC GAM ) is the asset management division of Royal Bank of Canada ( RBC ) which includes RBC GAM-US, RBC Global Asset Management Inc., RBC Global Asset Management (UK) Limited, RBC Alternative Asset Management Inc., BlueBay Asset Management LLP and BlueBay Asset Management USA LLC, which are separate, but affiliated corporate entities. / Trademark(s) of Royal Bank of Canada. Used under license. 2013 RBC Global Asset Management (U.S.) Inc. 31