It’s no secret that the financial crisis is now more than a decade old and the sub-prime market meltdown was the was the epicenter of that crisis. Today in a low interest rate environment that has persisted since the crisis however, investors have been searching for yield. That said there’s a growing interest in the non-agency RMBS space. In this blog, I would like to address what is driving that interest and discuss some of the opportunities the asset class can offer investors.
Now that a lot of time has gone by after the craze and a lot of performance data has been compiled the asset class turns out to be one of the less risky highest yielding investment opportunities in all of fixed income.
Nevertheless, some investors are still spooked by the asset class. One of the main challenges has been what do you say to advisors that might have some doubts and are looking for something like this with lower volatility. I believe that very question is what actually is creating some of that opportunity here. In fact, subprime mortgages are a fantastic investment with very low volatility and risk for most parts of the capital structure that exists out there.
There obviously are some riskier components but for a 40 Act mutual fund I think there are certain investments and places in the capital structure where managers can look to invest that are both liquid, very low risk, and still offer a relatively very high return given where we are in the overall world of rates. That very idea that people are still a little bit scared of it – that’s what in essence creates some of the opportunity. The fact that this is an institutional only market and retail gets easily spooked by some scary words like subprime is what is actually driving some of the return because it is not overly invested by retail.
Finding Opportunities in the Capital Structure
In order to find the best investments in the asset class, I look to invest in the capital structure in the following order:
- Senior debt on top;
- Subordinated debt; and
- Then preferred and common stock equities at the bottom.
The riskiest investments are at the bottom and everything at the top of the capital structure is generally thought to be the least risky. Our space structured credit non-agency RMBS is a form of structured credit which includes thousands of mortgage loans the mortgage borrowers pay monthly. That money is then taken and given to the by the servicer to a trustee who then issues payments or takes that money and pays it down the waterfall according to the pooling and Servicing Agreement for each one of these respective deals. These deals are tranches at the top of the capital structure which get paid first in the event of any loans being liquidated. Securities on the bottom of the capital structure take losses first in the event of any loans being liquidated.
An Active Trading Approach is Best
The best way to invest in the asset class is to take an active trading approach because it is rather unique. The genesis of the marketplace pre-crisis was just a levered funding arbitrage based on credit ratings, and it was based on how much leverage you’ve got for a respective rating. However, post crisis many investors still don’t really take advantage of some of the illiquidity opacity. So, while these securities are still quite liquid, the difference today is that this market is an over-the-counter market, whereby trades are negotiated and there’s no pricing on a “wall,” which makes typical investors feel very happy.
I actually make money by taking advantage of some of those inefficiencies, illiquidity, and opacity. If I can buy assets that yield 3%-5% to maturity, in turn I can make 2%-10% on these securities in short order. By repeating this over and over again that’s how you start creating compounded returns, which far exceed the actual yield of the underlying assets.
The Trade’s Not Over!
The more investors say the trades over the happier I am because I feel there is a lot more fruit to pick. Let’s face it, this is a multi-billion sector and investors that say the trade is over really don’t know the space. Looking back pre-financial crisis, that might be relevant to the multi-billion-dollar macro fund managers who bought on the cheap, made some big returns, and got out of the market. So now you’re left with professionals who know the space. In fact, we have a marketplace that’s still over $300 billion in size with pre-crisis loans and deals. Those deals typically have a 40-year maturity and the bulk of what was bought originating in the 2005-2007 timeframe. Since this period, the space has been shrinking, but it’s still massive and there are plenty of opportunities abound.
Today, there is approximately about one to two billion trades a day. That said I think there are still plenty of opportunities in the RMBS space that will continue to pop up. Structured credit has evolved over the years to the point where I feel RMBS is very seasoned and rather a safe investment. There will certainly be opportunities down the road and the only way you’re going to benefit from the asset class is if you’re in the game.