January 24, 2020
It is often said that those who ignore the past are doomed to repeat it. For many scarred by the Great Financial Crisis, instruments like RMBS and CMBS became Wall Street’s version of four-letter words. Short for Residential Mortgage-Backed Securities (RMBS) and Commercial Mortgage-Backed Securities (CMBS), along with their close relative Asset-Backed Securities (ABS), the bonds fall into a category called securitized products that might still carry some emotional baggage. While we would certainly not advise ignoring history, it may come as a surprise that Red Cedar would gladly accept a repeat of the past performance in much of this asset class. It seems that memory tends to paint with a broad brush when it comes to traumatic events. As we will demonstrate, many securitized products performed as intended.
Why Consider Securitized Products?
Superior Risk-Adjusted Returns
Inefficiencies in this market combined with complexity and stigma have created attractive historical risk-adjusted returns when compared to other investment grade bond sectors.
Sharp Ratio (Excess Return/Risk)
Sources: Bloomberg, ICE BofAML. Sharpe ratio data goes through 12/31/19
Our focus is to capture returns over a long-term horizon, yet we acknowledge that the 10-year return history now excludes the financial crisis. Extending the horizon to include the crisis period would increase the standard deviation of returns during that time and lower the Sharpe Ratio. We would contend that the volatility in prices during that period reflected extreme fear and a misunderstanding of the sector. The ultimate collateral performance of the asset class, specifically AAA rated ABS and CMBS, was exceptional.
Quality and Stability
Everyone has heard of the piles of subprime mortgage debt that were given AAA ratings only to subsequently be downgraded to junk and wiped out when house prices plummeted in 2008. In contrast, the senior most bonds in ABS and CMBS with original AAA ratings experienced actual losses of less than one half of one percent.
% Cumulative Loss by Loan Balance
Source: Bloomberg. *Securities issued 2005-2010
Why was ABS and CMBS performance so different from the massive loss experience of the subprime residential mortgage market? A great starting point would be the lack of outright fraud in commercial mortgage and consumer loan underwriting. The same cannot be said for subprime residential mortgages. Often termed “liar loans” in the mortgage industry, job and income verification was not required to obtain a loan. Therefore, the problem began with poor underwriting and spiraled.
In addition, ABS and CMBS securities were designed to be resilient with various structural features to increase credit enhancement and withstand significant amounts of stress. One such feature ensures that as time goes on, the leverage in the securities is naturally reduced through the payment priority. Therefore, all things equal, the simple passage of time lifts the quality of the bonds.
As shown below, ABS credit ratings have been remarkably stable over time. On the other hand, CMBS experienced downgrades during the financial crisis yet sustained few losses at the senior most level. AAA ratings were maintained on over 60% of the CMBS universe.
Source: Bloomberg Barclays
Source: Bloomberg Barclays
The ratings stability is best demonstrated when contrasted with alternatives such as corporate bonds. Not only have the ratings in ABS and CMBS been more stable, but the securitized market is one of the few remaining areas of fixed income where AAA rated securities can still be sourced. Meanwhile, the ratings quality of the corporate bond market has continued to deteriorate since the financial crisis. The BBB rated portion of the Bloomberg Barclays U.S. Corporate Index is approaching nearly 50%.
% Corporate Index
Source: Bloomberg Barclays
Opportunities in an Inefficient Market
Blockchain, algorithms, high frequency trading and machine learning are now common buzz words in finance as technology has transformed financial markets. One corner of the market that remains relatively untouched by automation is securitized products. There are a multitude of reasons for this: the complexity of the bonds, the sheer number of non-fungible securities involved and inconsistent access to underlying data, just to name a few.
Red Cedar believes that the drivers of inefficiency are the very characteristics that make the securities attractive. We do not believe in unnecessary complexity and prefer the Occam’s Razor version of bond trading: when given equal alternatives, the simplest bond is the best. With that in mind, however, complexity does often create opportunity. Red Cedar can target bonds with desirable characteristics and pay far less than what we believe to be fair value. Also, the lack of readily available data can pay handsomely for those willing to find the information, roll up their sleeves and crunch the numbers.
This inefficiency can also lead to a lag in trading levels relative to alternatives such as corporate bonds. As shown below, over the course of 2018 and 2019, ABS spreads consistently lagged corporate bond spreads and were far less volatile. This creates opportunity to sell overvalued bonds and rotate into more attractive opportunities that may not yet fully reflect market events.
1-3 Year AA Corporates vs. AAA Fixed Rate ABS
What About RMBS?
Residential mortgages were at the epicenter of the financial crisis. The above analysis regarding low losses at the AAA level, ratings stability and structural protections do not apply. Yet, a lingering paranoia regarding the U.S. housing market creates opportunity. First, unlike CMBS and ABS, the residential mortgage market required a total makeover. The overcorrection in response to the financial crisis means that mortgage credit now only flows to the highest quality borrowers. Second, new RMBS securities issued today contain drastically improved structural protections. Finally, the rating agencies are now much slower to upgrade. Burned by the crisis when AAA rated RMBS securities necessitated subsequent downgrades to junk, they are in no hurry to award higher ratings after issuance. This creates opportunity to purchase mis-rated bonds and await the overdue rating change and forthcoming spread tightening.
The market remains on bubble watch as many await the next crisis that always seems to be lurking just around the corner. Fears have come in different shapes and sizes since the crisis. They have ranged from another wave of home foreclosures, to a commercial real estate bubble, the Fiscal Cliff, the downgrade of U.S. Treasury debt, Greece leaving the Eurozone and even the inverted yield curve in mid 2019. None of these have developed into the next version of the crisis and we feel confident that U.S. housing will not be at the center of the next Armageddon either.
Why Red Cedar?
Managing securitized products is in the DNA of the firm. With a combined 75 years of experience trading this market, most of the team began their careers in securitized products. The structured market is complex and constantly evolving. Anyone who has read The Big Short knows that investors have been burned by purchasing bonds that they did not fully understand in the search for yield. Red Cedar managed through the financial crisis together as a team trading the full menu of products mentioned in this insight. The process in place today involving rigorous scenario analysis and capital structure evaluation has been in place since long before 2008.
The securitized market is not homogenous. Opportunity for outperformance exists due to the many nuances that create inefficiency. Often those features exist in small corners of the bond market. It may be difficult for the largest asset managers to focus in those areas due to their sheer size. The dollar value of the opportunity simply would not move the needle. Red Cedar is well positioned to seize those unique opportunities.
Red Cedar strives to focus in areas where we are best positioned to serve our clients well. Those areas come at the intersection of specific expertise held by members of the team and segments of the market where we think active management makes sense. Specifically, we favor markets where we believe that a competitive advantage can be gained. Securitized products are one such example where that combination of in-house experience and opportunity exists.
Investors should carefully consider the investment objectives, risks, and charges and expenses of the fund before investing. The prospectus contains this and other information about the fund, and it should be read carefully before investing. Investors may obtain a copy of the prospectus by calling 888-626-2575.
Red Cedar Investment Management, LLC (Red Cedar) is an investment adviser registered under the Investment Advisers Act of 1940. Registration as an investment adviser does not imply any level of skill or training. The information presented In the material is general in nature and is not designed to address your investment objectives, financial situation or particular needs. Prior to making any investment decision, you should assess, or seek advice from a professional regarding whether any particular transaction is relevant or appropriate to your individual circumstances. Although taken from reliable sources, Red Cedar cannot guarantee the accuracy of the information received from third parties.
The opinions expressed herein are those of the author and do not represent the opinions of Red Cedar Mutual Funds and Ultimus Fund Solutions, LLC. This information is current as of the date of this material and is subject to change at any time, based on market and other conditions. The mention of specific securities and sectors illustrates the application of our investment approach only and is not to be considered a recommendation by Red Cedar. The specific securities identified and described above do not represent all of the securities purchased and sold for the portfolio, and it should not be assumed that investment in these securities were or will be profitable. There is no assurance that the securities purchased remain in the portfolio or that securities sold have not been repurchased. Charts, diagrams and graphs, by themselves, cannot be used to make investment decisions. Past performance is no guarantee of future results.
Investments in mortgage-related and other asset-backed securities are subject to the risk of significant credit downgrades, illiquidity, and defaults to a greater extent than many other types of fixed-income investments. The liquidity of mortgage-related and asset-backed securities may change over time. During periods of falling interest rates, mortgage- and asset-backed securities may be called or prepaid, which may result in the Fund having to reinvest proceeds in other investments at a lower interest rate. During periods of rising interest rates, the average life of mortgage- and asset-backed securities may extend, which may lock in a below-market interest rate, increase the security’s duration and interest rate sensitivity, and reduce the value of the security. Enforcing rights against the underlying assets or collateral may be difficult, and the underlying assets or collateral may be insufficient if the issuer defaults.
The fund is distributed by Ultimus Fund Distributors, LLC. (Member FINRA)