The Securitized Market

Securitization traces its roots to the late 18th century when railroads securitized farms to fund expansion. However, the modern mortgage-backed securities market began in 1970 when HUD created the first residential mortgage-backed security through the Government National Mortgage Association.

This innovation allowed banks to transfer risk and homebuyers to purchase with smaller down payments, significantly expanding homeownership. It extended the American dream to those previously unable to raise substantial down payments.

By 1985, securitization evolved to include non-mortgage assets, starting with automobiles. This marked the beginning of the asset-backed securities (ABS) market, which quickly expanded to include diverse collateral types such as credit cards, equipment, aircraft, private student loans, and cell phone contracts.

This evolution transformed the financial landscape, creating new investment opportunities and funding mechanisms across various economic sectors.

Securitization begins when a lender and borrower agree on loan terms, including amount, interest rate, collateral and maturity. The loan is then sold or pledged to a trust with similar loans, creating a securitized product. Bankers analyze expected cash flows, including interest, principal, prepayments, expected delinquencies and defaults, and recoveries. These cash flows are structured into securities that are broken down into tranches (e.g., Classes A, B, C) and sold to investors.

Historical data on credit trends are readily available for established markets like credit cards and automobiles. Deals may be submitted to rating agencies for review and preliminary rating, considering credit enhancements.

The non-rated securitized deal market has recently grown as issuers avoid rating agency fees, and some securities, like non-performing loans, are challenging to rate. More deals are issued under Rule 144A, which allows private placement without SEC registration. These securities often offer yield compensation due to potentially lower liquidity and may not meet specific institutional or private investor guidelines.

In the securitized market, issues are divided into tranches with varying degrees of subordination. Each tranche has a different level of credit protection or risk exposure. Typically, a senior class (A tranche) is supported by junior or subordinated tranches (B, C, etc.), with the subordinated tranches absorbing losses first to protect the senior classes.

Senior classes have the first claim on cash flows, while junior classes receive principal payments only after senior classes are fully repaid. This cascading cash flow arrangement is known as a cash flow waterfall. If the underlying asset pool can't cover payments due to defaults, losses are absorbed by subordinated tranches first, protecting the senior tranches until losses exceed the subordinated amounts.

Senior securities, often rated AAA or AA, carry lower risk, whereas subordinated classes have lower credit ratings and higher risk. The most junior class often called the equity class, is highly exposed to default risk and may be retained by the originator for potential profit. This equity class receives any remaining cash flow after all other classes are paid but typically does not receive a coupon, which the issuer retains to show its commitment.

Credit enhancements are structural features designed to reduce the risk of loss for investors in securitized products. They provide an added layer of protection by helping ensure that cash flows from the underlying asset pool continue to support bond payments, even if some borrowers default.

Common forms of credit enhancement include:

Excess spread.

After interest from the underlying loans is used to pay expenses and bondholders, any remaining income — known as excess spread — can be set aside to cover future shortfalls.

Reserve accounts.

A portion of the deal’s proceeds may be placed in a reserve fund to serve as a buffer against temporary cash flow disruptions.

Overcollateralization.

Bonds may be issued for less than the total value of the underlying assets, creating a cushion that absorbs potential losses.

Subordination.

Securities are structured into senior and subordinated tranches. Subordinated tranches absorb losses first, protecting senior bondholders unless losses exceed the available support.

Together, these mechanisms help align risk with investor preference and support the stability of securitized structures.

The primary reason for securitization is to lower a company's funding costs. A company rated BB with high-quality assets (AAA or AA) can borrow at lower rates using these assets as collateral rather than issuing unsecured debt.

For instance, Ford Motor Company lends money to consumers to facilitate car sales. By securitizing these loans, Ford receives funds from investors, which it can use to make additional loans and sell more cars. Without securitization, Ford would need to issue unsecured debt, which is more expensive and would deteriorate its credit quality. Thus, securitization allows companies to move transactions off their balance sheet and access cheaper funding while maintaining higher credit quality.

Investing in securitized assets offers several compelling benefits, particularly for fixed income portfolio managers seeking strong risk-adjusted returns. Here are the key advantages:

1. Diversification and Enhanced Returns: Securitized assets provide an opportunity to diversify beyond traditional fixed income investments like Treasuries, investment-grade corporate bonds, high-yield bonds and emerging markets debt, thereby potentially enhancing the portfolio’s overall risk/return profile.
2. Inefficiencies and Opportunities: The securitized market often contains inefficiencies that astute investors can exploit, given that it is less explored than mainstream fixed income sectors and potentially offers higher returns.
3. Credit Enhancements: Many securitized products come with credit enhancements, such as excess spread, reserve accounts, overcollateralization, and subordination. These features reduce credit risk and provide additional security to investors, making these assets more attractive relative to their risk level.
4. Underrepresentation in Benchmarks: Much of the securitized market is not included in traditional fixed income benchmarks like the Bloomberg US Aggregate Bond Index, meaning securitized assets can serve as a differentiator and allow portfolio managers to access unique opportunities not widely held or tracked.
5. Market Size and Scope: The securitized market is substantial, valued at over $1.6 trillion, yet only about 8% is included in major bond indices. This vast and largely untapped market offers ample opportunities for investment and portfolio enhancement.

By incorporating securitized assets into their portfolios, investors can achieve better diversification, exploit market inefficiencies, and potentially secure higher returns, all while benefiting from the added protections of credit enhancements.

Securitized debt has structural features that distinguish it from many traditional corporate bonds.

One key characteristic is the return of principal through regular payments from the underlying loans, such as mortgages, auto loans or credit card receivables. Because borrowers make monthly payments, investors typically receive principal back over time rather than in a single payment at maturity. As the bond pays down, its credit profile may improve, since a smaller outstanding balance remains exposed to loss.

These recurring principal payments also generate steady cash flow. In many cases, investors may receive a meaningful portion of their capital back each month, creating flexibility to reinvest.

That flexibility can be particularly valuable in rising rate or volatile spread environments. Rather than selling holdings to reposition a portfolio, investors can redeploy incoming cash flows as opportunities emerge.

Investing in securitized assets carries inherent risks, primarily due to the market’s smaller and less liquid nature than corporate or Treasury markets, which can pose significant challenges, as seen during extreme market volatility.

A notable example of unprecedented volatility occurred in March and April 2020. This period was marked by a "run on the bank" scenario, where investors rushed to sell high-quality, short-duration assets into a virtually closed market. This situation surpassed the market turmoil witnessed in both 2008 and 2001. Despite this price volatility, the underlying bonds demonstrated strong credit resilience.

Liquidity risk remains a critical consideration for investors, particularly those with a short-term focus or who attempt to time the market. However, these investments can enhance a bond allocation’s risk/return profile for long-term oriented investors who comprehend the liquidity profile of securitized assets. Understanding and managing these risks is essential for leveraging the potential benefits of securitized assets.