BY HAFIZAN HAMZAH
Director, Investment Management Group
Many institutions take credit risk in their loan portfolio and avoid this exposure in the bond portfolio. However, adding credit exposure to an investment portfolio gives investors an opportunity to enhance expected returns, as well as diversify risk at the portfolio level. As is the case when underwriting loans, portfolio managers need to properly evaluate potential investments before they are added to the portfolio. And once they have been added, these securities need to be monitored as part of a regular portfolio management process.
Historically, credit-risky assets have some diversification benefit when combined with agency MBS. Exhibit 1 shows the two-year correlations of monthly returns. As the table illustrates, agency MBS have lower correlations with credit-risky assets than they do with Treasuries and agency bullets.
Moreover, the addition of these assets can lead to higher risk-adjusted returns than can a portfolio constructed with MBS and agency bullets and Treasuries. Take, for example, two simple portfolios: one is 50% agency bullets/US Treasuries and 50% agency MBS and the other is 50% investment grade credit and 50% agency MBS. As Exhibit 2 highlights, the portfolio with an allocation to credit not only outperformed on a gross return basis (5-year cumulative returns of 10.85% vs 7.43%), but on a risk-adjusted basis as well; the comparative Sharpe ratios were 0.94 vs 0.56.
Ultimately, cash flows are the backbone of effective credit analysis, as investors are ultimately trying to determine how likely they are to receive their principal back. But credit risk is a broad umbrella, and there are a variety of ways for a portfolio to gain credit exposure; investors cannot take a one-size-fits-all approach when it comes to evaluating credit risk as a part of the investment portfolio. For instance, an investor would use a different set of evaluation criteria for a non-agency RMBS transaction than she would for that of a corporate debenture.
When it comes to evaluating mortgage credit, investors should be cognizant of the fact they are not buying a simple package of loans where principal and losses are shared pro rata across all investors. Rather they are buying a structured transaction in which some investors are senior to others and take priority in terms of principal distribution; it is paramount to understand any potential investment’s structure.
Shows a very simple non-agency RMBS structure. In this deal, there is one senior class that makes up 90% of the entire deal, and one subordinate class that comprises the remaining 10%. Here, principal payments flow down from the senior class to the subordinate class, while losses flow the opposite direction. In this example, investors in the senior classes have credit support of 10% which means that losses on the underlying loans would have to exceed 10% of the principal balance before the senior class starts taking losses. Given that the size of the subordinate class is only 10% of the entire deal, it does not take much in terms of defaults for investors in that class to experience losses.
After a thorough understanding of the structure, managers should then analyze the underlying collateral to gain an understanding of how the loans are paying, what portion is defaulting, and how much of those losses are being recovered.
Understanding collateral performance helps guide investors’ stress testing of the bond. When stressing a deal, investors make assumptions regarding three basic variables:
- Voluntary Prepayment Rate (VPR) – the rate/pace predicted for future unexpected principal payments
- Constant Default Rate (CDR) – the rate/pace expected for the underlying collateral to go into default on an annualized basis
- Loss Given Default (LGD) – If the loan defaults, the percentage of the current loan balance expected to be lost during liquidation and how long the property stays in the liquidation pipeline.
Investors in these types of transactions will typically stress bonds by changing one of these variables on the underlying pool of loans. This allows the investors to evaluate their potential deal performance, given a particular stress scenario.
Investment Grade Credit
There are a variety of ways to analyze corporate credit, with one of the more popular methods being the use of a structural model, such as the Kealhofer Merton Vasicek (KMV) model. This approach uses the basic accounting formula (assets = liabilities + equity) and states that a company defaults when its debts exceed its market value. To determine how likely a firm is to default in the future, the model needs to forecast the future path of the firm’s market value. Since the current market value of a firm’s assets cannot be directly observed, it must be derived. One way to do this is to consider the firm’s equity as a call option on the firm’s market value.
If a firm defaults, equity holders lose their stake; if a firm succeeds, shareholders benefit one-for-one in the increasing value. This payoff profile looks like a call option, with the strike price being the book value of the firm’s liabilities. Investors use option pricing models and equity information to derive the market value of a firm’s assets. Given the market value of the firm’s assets and equity volatility, it is possible for investors to project forward market values with the difference between the market value at a given point in time and the book value of liabilities being the distance to default.
Keeping an Eye on Risk
The work doesn’t stop here. Once credit-risky bonds have been added to a portfolio, portfolio managers must be cognizant that these risks are not static and must be frequently measured. Prudent investors stress their credit-risky assets in the same way they did prior to purchase. Periodically running models to test their investments, comparing actual performance with expectations is a best practice.
Non-agency RMBS investors keep track of changes in prepayments, both voluntary and involuntary, as well as changes to the loss severity. Investment grade credit investors track rating and outlook changes to a particular credit to determine if the change is temporary and/or represents something more structural.
Balance sheet and portfolio managers are in the business of managing risks, which includes credit risk. Adding credit risk to a bond portfolio can enhance returns and add diversification benefits. Investors must ultimately understand the risks they are undertaking and conduct thoughtful and thorough analyses when evaluating credit-risky assets.
Director, Investment Management Group
Hafizan Hamzah is a Director at ALM First Financial Advisors, joining the firm in 2010. Mr. Hamzah works in ALM First’s Investment Management Group and assists in developing client-specific portfolio strategies as well as portfolio rebalancing. In addition to portfolio management, Mr. Hamzah is responsible for monitoring and rebalancing hedges associated with the firm’s mortgage pipeline and mortgage servicing rights hedge strategies.
Mr. Hamzah’s areas of expertise include fixed income portfolio management, mortgage pipeline hedging, MSR hedging, as well as asset liability management.
Mr. Hamzah received a bachelor’s degree in business administration from Southern Methodist University in Dallas, Texas.