ABS & MBS Investing During Challenging Times
Jim Womack, CFA Brad Buie, CFA Kyle Johns, CFA Portfolio Manager Portfolio Manager Portfolio Manager
April 29, 2020 Asset-Backed Securities
2 Asset-Backed Securities What Are They and How Are They Different From Other Bonds?
Generally Speaking:
• ABS are backed by thousands of borrowers. • Credit worthiness is most often independent of the issuer. • Significant credit support at issuance that builds over time. • Strong credit profile generally not reliant on asset valuations.
3 Asset-Backed Securities How do Asset-Backed Securities Work?
Large Value of Auto AAA Loans Rated Supports Smaller ABS Trust Value of ABS Bonds AA Rated A Rated BBB Rated
4 Asset-Backed Securities Traditional Credit Metrics for Analyzing Auto ABS
Overcollateralization Deal Specific Credit Metrics • Delinquencies (30, 60, 90+ days) Subordination • Cumulative net losses • Changes in credit enhancement Underlying Loan Characteristics • Fico scores (credit profile of borrowers) Economic Fundamentals • Loan terms (length, LTV, etc.) • Collateral values (i.e., used auto prices) • Distribution of loan terms • Economic environment • Geographic distribution • Fleet age
Collateral Characteristics Financial Market Conditions • New vs. used, cars vs. SUVs • ABS spreads • Equity performance (of issuer/servicers) Sponsor/Servicer (e.g., Ford, GM, etc.) • Corporate debt performance • Experience, financial condition
5 Asset-Backed Securities Underlying Loan Terms Can Be Monitored Month-to-Month
Type CLC
NOTE: Bloomberg is not perfect, sometimes you have to go to the servicer reports.
6 Asset-Backed Securities Underlying Credit Performance Can Be Monitored Month-to-Month
Type CLP
NOTE: Bloomberg is not perfect, sometimes you have to go to the servicer reports.
7 Asset-Backed Securities Exhaustive Credit Analysis Protected Assets In The Last Recession
Nearly 1/3 rd of ‘AAA’ ABS Were Downgraded in 2009! 18% Fell to Junk or Defaulted.
‘AAA’ Rated ABS Index By Lowest Rating 1074 constituent securities as of Jan 1, 2008 AA 3% A 2% BBB 8% AAA BB 1% 100% B, CCC, CC, C 7% AAA 69%* DEFAULT 10%
2008 2009
* Includes bonds that were placed on negative credit watch, but not downgraded 8 Source: ICE BofA ML, Bloomberg Asset-Backed Securities Exhaustive Credit Analysis Protected Assets In The Last Recession
Weaker Credits Are Exposed When the Economy Suffers… It Shows Up In Prices Too!
Bond Prices (Weighted Average Bond Price) $105 • The rebound in bond prices was heavily impacted by index $100 rebalancing. The lowest price bonds were downgraded and fell $95 out of the index, thus the average price of the remaining $90 Bloomberg Barclays ‘AAA’ Rated Auto ABS Index bonds moved higher. Bloomberg Barclays ‘AAA’ Rated Credit Card ABS Index Sample (Actual) ABS Portfolio managed by Atlanta Capital $85
Period When Many Bonds Dropped Out of Index
While the ABS Sector Was Resilient, You Couldn’t Rely On Just the Ratings Agencies 9 Asset-Backed Securities Adjusting the Scale: An Unprecedented Pace and Number of Job Losses
2020 COVID-19 Weekly Initial Jobless Claims Claims Peak: 6.9 million 8 Last 5 weeks: 26+ million
6
4 of Jobless Jobless Claims of Millions 2008 Financial Crisis 2 Claims Peak: 665 thousand
0 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 2011 2015 2019
Source: Department of Labor, Bloomberg 10 Asset-Backed Securities An Increased Importance Is Now Placed on Evaluating Credit Support
CARMAX 2019-3 Credit Support Reserve Account: Cash Deposited by Issuer 0.25% Overcollateralization: Amount of Loans in Excess of Outstanding Bonds 0.25% Subordination Class (tranche): Repaid Last and Protect Senior Class (lower payment priority) 6.95%
CARMAX 2019-3 Sequential Pay Structure SPA
Principal and Interest Interest Only Senior Class Weighted Average Life ‘AAA’ Rated Subordinate Class B = ‘AA’ Rated C = ‘A’ Rated D = ‘BBB’ Rated
May 2020 May 2021 May 2022 May 2023 May 2024 11 Asset-Backed Securities An Increased Importance Is Now Placed on Evaluating Credit Support
CARMAX 2019-3 MTCS
Bond Class (tranche) Initial CE Model Assumptions Current & Est. CE
NOTE: Bloomberg does not accurately model credit enhancement for ABS with subvention. This includes issuers like Toyota, GM, Nissan, Ford, Hyundai, etc.
12 Asset-Backed Securities Unique Attributes & Key Terms for Credit Card ABS
JP Morgan Chase Credit Card Trust - CHAIT 2020-A1 A1 YT
The Revolving Pool Structure Results in a Soft Bullet Maturity. Credit Support Does Not Build Over Time Like in Auto ABS
Historical Excess Spread
Excess Spread = Yield less Charge Offs
Avg. 3-Mth Excess Spread Below 0 Results in Early Am. Event
Early Am. Means Outstanding Senior Bonds Will Be Repaid Pro- Rata, Regardless of Soft Bullet Maturity Date
13 Asset-Backed Securities Monitoring Collateral Performance of Credit Card ABS
JP Morgan Chase Credit Card Trust - CHAIT 2020-A1 A1 CLC
Performance Data Is Typically Stale on Bloomberg The Revolving Pool Structure Means All Investors Have Exposure to the Outstanding Pool of Receivables. Risk Exposure Should Be Viewed at the Trust Level, Not Security Level. 90+ Day Delinquency Rate Leads the Charge Off Rate
14 Asset-Backed Securities Exhaustive Credit Analysis Will Protect Assets In This Recession Too
Weaker Credits Are Exposed When the Economy Suffers… It Shows Up In Prices Too!
The longest maturity, least seasoned Total Returns for ‘AAA’ Rated Prime Auto ABS by Class bonds that haven’t yet seen significant (3/1/2020 – 3/23/2020) growth in credit support were the Year of most impacted in the sell off. Origination A2 A3 A4 Shorter, seasoned vintages (where 2018 -0.4% -2.4% -6.4% credit support has grown significantly) performed much better in the worst of 2019 -1.5% -5.1% -9.4% market conditions. For many investors, the key will be 2020 -2.8% -6.2% -10.0% how ratings hold up in the coming weeks and months.
15 Asset-Backed Securities Current Environment – What We Know & How It Impacts Our Thinking
Deferments for Auto Loans & Credit Card Payments • ABS Servicers have the ability and discretion to enact borrower deferments. Most current deferment policies are consentient with existing disaster servicing policies (i.e. hurricanes). • There’s a strong incentive for the Service/Issuer to minimize loan losses & act in the best interests of bondholders. The Recent Economic Shock Is Unprecedented and Impacting All Types of Borrowers • Deferment requests are not contained to borrower with spotty repayment records. FICO’s may not be the best measure of a bond’s creditworthiness going forward. Credit support is more important than ever. Watch lists and Downgrades by the Ratings Agencies Tend to Occur with a Lag • Auto and Credit Card servicer reports released in March and April show muted delinquencies and do not reflect a rapidly changing labor market. • Loss assumptions by Rating Agencies will be adjusted based on incoming data. Downgrade risk is elevated. Ratings Agencies Value Seasoning (loan age) and Structure, Particularly for Auto ABS • Credit Enhancement builds over time for Auto ABS and borrowers have more “skin in the game” with older loans. • Credit analysis is critical. Decisions should be made in the context of minimizing downgrade risk in the future.
16 Mortgage-Backed Securities
17 Mortgage-Backed Securities A Significant Return Premium Without Sacrificing Credit Quality
Cumulative Excess Returns*
20.0%
0-3 Year Agency MBS Index 1-3 Year Agency Index 15.0% (includes notes and callable securities)
10.0%
5.0%
0.0% 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019
*Excess Return is total return of the specified index less the total return of the equivalent duration Treasury note
Source: ICE BofA Merrill Lynch, data through March 2020 18 Inception of ICE BofA ML Excess Return data is 12/31/1996 Mortgage-Backed Securities The Mortgage Market is One of the Deepest and Most Liquid of Spread Sectors
Marketable Debt Outstanding Average Daily Trading Volume 18 700
$16.9 15 600 $650
500 12 400 9 $10.3 $10 $ Billions $ Trillions 300 $320 6 200
3 $1.9 100 $21 $5 0 0 Treasury Mortgage Corporate Agency Treasury Mortgage Corporate Agency
19 Source: The Securities Industry and Financial Markets Association Data as of February 29, 2020 Mortgage-Backed Securities The Traditional Agency Pass-through
Homeowner Bank Trustees
Guaranteed Timely Principal & Interest Government Sponsored Entity (Ginnie Mae, Fannie Mae, Freddie Mac)
Investors receive pro-rata share of interest, principal, and principal prepayments.
Investors 20 Mortgage-Backed Securities Investors Have Uncertainty About When They Get Their Principal Back
Key Characteristics of MBS: Bonds receive principal and interest monthly, because borrowers make monthly mortgage payments Borrowers can repay their loans without penalty and at any time
Homeowners prepay their mortgages for a variety of reasons (Refi, Job Transfer, Death, Divorce, Upsize, Downsize, Etc.)
Understanding the Risks: Because the GSE’s (Fannie Mae, Freddie Mac, and Ginne Mae) guarantee the principal and interest payments, investors are not concerned IF they will get their money back, but WHEN Understanding the drivers of prepayments is an essential first step to analyzing MBS Prepayment expectations and the resulting impact to the bond’s future cash flows determine the duration of a mortgage security (i.e. its price sensitivity to changes in interest rates) Minimizing cash flow variability is key to managing risk
21 Mortgage-Backed Securities Collateralized Mortgage Obligations (CMOs) Increase Cash Flow Certainty
Homeowner Bank Trustees
Government Sponsored Entity Guaranteed Timely Principal & Interest (Ginnie Mae, Fannie Mae, Freddie Mac)
Classes Increase Cash Flow Certainty
Helps investors target maturity profile. $ $ $ Short, intermediate and long-maturity investors $ $ $ $ $ $ can participate in the mortgage-backed Class 1 Class 2 Class 3 securities market. 22 Mortgage-Backed Securities Why So Much Focus on Cash Flow Stability?
Extension & Call Risk:
1 Year ? 5 Year Purchase Date Call Date Maturity Date
Whether it’s a callable bond or a mortgage security with unstable cash flows, extension risk (i.e. duration extending as a result in rising rates) exacerbates price declines
In a declining rate environment, call risk results in the bond’s duration shortening, muting price appreciation and creating the need to reinvest at lower yields.
It’s important to understand the risks with each investment and it will impact the overall portfolio
23 Mortgage-Backed Securities Understanding the Basics of Homeowner Repayment (Prepayment)
30-Year Loans: 30-Year loans spread payments out to reduce the monthly payment. For 30-Year borrowers, most of their initial monthly payments is the interest on the loan. This results in 30-Year borrowers being very sensitive to interest rate changes.
10-Year & 15-Year Loans: 10-Year and 15-Year loans are designed for homeowners who want to payoff their loan quickly. Interest is a much smaller part of the monthly payment. 10-Year and 15-Year borrowers are LESS sensitive to interest rate changes
Other KEY Loan Characteristics That Impact Repayment (Prepayment) Stability Loan Rate vs. Today’s Rate Seasoning (Loan Age) Spread-at-Origination (SATO) Loan Size Loan-to-Value Ratio
24 Mortgage-Backed Securities Understanding the Basics of Homeowner Repayment (Prepayment)
Factor Primary Impact Secondary Impact Overall Impact 30-Year Loan More Rate Sensitive More Default Risk Less Cash Flow Stability 10 & 15-Year Loan Less Rate Sensitive Less Default Risk More Cash Flow Stability Hi Loan Balance More Rate Sensitive More Default Risk Less Cash Flow Stability Low Loan Balance Less Rate Sensitive Less Default Risk More Cash Flow Stability More Seasoned Less Rate Sensitive Less Default Risk More Cash Flow Stability New Loan More Rate Sensitive More Default Risk Less Cash Flow Stability Hi LTV More Rate Sensitive More Default Risk Less Cash Flow Stability Low LTV Less Rate Sensitive Less Default Risk More Cash Flow Stability Hi SATO More Rate Sensitive More Default Risk Less Cash Flow Stability
25 Mortgage-Backed Securities Can Loan Characteristics Impact the Portfolio? Our Experience Says YES!
ICE BofA ML Mortgage Index Duration Variability 6.0 3.0% 5 Year Treasury Yield Treasury - Year 5.0 2.5%
4.0 2.0%
3.0 1.5% Duration 2.0 1.0%
1.0 0.5% 2012 2013 2014 2015 2016 2017 2018 Duration 5-Year Treasury Yield Min Dur: 1.8 Years 3.8 Year Range (left axis) (right axis) Max Dur: 5.6 Years
Sample (Actual) MBS & CMO Portfolio Duration Variability 3.0 3.0%
Note: Increase in 5
Year Treasury Yield Treasury - Year Key Loan Characteristics: 2.5 November came from 2.5% adding 15% to MBS with 2.23 year duration. 2.0 2.0% Loan Loan Term Seasoning Balance 1.5 1.5% 55% 10-Yr 70 Months $96,000 Duration 41% 15-Yr 156 Months $20,000 1.0 1.0% 5% 30-Yr 159 Months $73,000 0.5 0.5% 2012 2013 2014 2015 2016 2017 2018 Duration 5-Year Treasury Yield Min Dur: 1.8 Years 0.5 Year Range (left axis) (right axis) Max Dur: 1.3 Years (0.1 year range attributable to changes in rates) 26 Mortgage-Backed Securities Can Loan Characteristics Impact the Portfolio? Our Experience Says YES!
ICE BofA ML Mortgage Index Duration Variability 6.0 3.0% 5 5.0 2.5% Yield Treasury - Year 2.0% 4.0 1.5% 3.0 duration 1.0% 2.0 0.5% 1.0 0.0% 2019 2020 Duration 5-Year Treasury Yield Min Dur: 2.2 Years 2.7 Year Range (left axis) (right axis) Max Dur: 4.9 Years
Sample (Actual) MBS & CMO Portfolio Duration Variability 3.0 3.0% 5
Year Treasury Yield Treasury - Year Key Loan Characteristics: 2.5 2.5% 2.0% 2.0 Loan 1.5% Loan Term Seasoning Balance 1.5 29% 10-Yr 81 Months $43,000 duration 1.0% 48% 15-Yr 102 Months $76,000 1.0 0.5% 23% 30-Yr 143 Months $07,000 0.5 0.0% 2019 2020 Duration 5-Year Treasury Yield Min Dur: 1.6 Years 0.3 Year Range (left axis) (right axis) Max Dur: 1.9 Years (0.1 year range attributable to changes in rates) 27 Mortgage-Backed Securities Single Family Forbearance, Deferral and Modification (STILL EVOLVING)
Single Family COVID-19 Mortgage Forbearance Program:
Program Requires Borrower to Make a Balloon Payment at the End of Forbearance. IF UNABLE TO PAY BALLOON
Requires Borrower to Repay Missed Payments via Repayment Plan. IF UNABLE TO PAY REPAYMENT PLAN Borrower is Offered Payment Deferral (past due P&I IS due at maturity) Capped At Two Payments IF UNABLE TO CATCH UP TO 60 DAYS DELINQUENT
Borrower Receives a Loan Modification. Goal is to Reduce the Monthly Payment Up To 20% Through Rate Reduction, Term Extension, Etc. LOAN MODIFICATION WILL RESULT IN A MORTGAGE PREPAYMENT FOR BONDHOLDERS
28 Mortgage-Backed Securities The Characteristics Below Also Mitigate Forbearance Risk… Why?
Factor Primary Impact Secondary Impact Overall Impact 10 & 15-Year Loan Less Rate Sensitive Less Default Risk More Cash Flow Stability Low Loan Balance Less Rate Sensitive Less Default Risk More Cash Flow Stability More Seasoned Less Rate Sensitive Less Default Risk More Cash Flow Stability Low LTV Less Rate Sensitive Less Default Risk More Cash Flow Stability
Shorter loan terms are generally used by borrowers intent on reducing debt. Those borrowers generally have less consumer debt and more financial flexibility. Low loan balance and low LTV also provide greater flexibility to the borrower while removing the incentive to refinance based on declining mortgage rates. We saw loans with these characteristics perform significantly better in the wake of the last recession.
29 Mortgage-Backed Securities Understanding the Basics of Homeowner Repayment (Prepayment)
Freddie Mac Monthly Loan Buyouts
30-Year Loan Buyouts 15-Year Loan Buyouts Percentage
30 Source: FHN Financial, CPRCDR Mortgage-Backed Securities Introduction to Bonds Backed by Agency Multi-Family Loans
Loans made for the purchase of multi-family housing units (i.e., apartments, affordable housing, etc.) Generally 10-year balloon loans that include prepayment penalties for the first 9½ years.
Government Sponsored Entity (Example: Freddie Mac) Trust Investors A1 Tranche 6.8 year WAL Freddie Mac 8.5 year Window Multi-Family Guaranteed Loans 10-Year Loans K-Certificates A2 Tranche Deposited That Meet 9.7 year WAL Into Third Freddie Mac 0.5 year Window Party Trust Underwriting Mezzanine Bonds Guidelines Subordinate Bonds 31 Mortgage-Backed Securities Introduction to Bonds Backed by Agency Multi-Family Loans
Fannie Mae Freddie Mac Fannie Mae loans require yield maintenance which is used to Freddie Mac loans include a 24 month lockout feature which discourage the borrower from early repayment. This prepayment prohibits prepayments in the first 24 months. Defeasance is used penalty passed through to bond holders in the event of in later years so that cash flow to bondholders is unaffected by a prepayment in the first 9½ years. prepayment between year 2 and year 9½.
DUS Bond Program Highlights ACE Bond Program Highlights K Bond Program Highlights
Typically backed by one (1) loan Typically backed by 75-125 loans, Typically backed by 75-125 loans, similar to Fannie Mae Ace program structure provides greater Typically small issue sizes that diversification vs. Fannie Mae Large and liquid issue sizes that typically range between $750 million and range between $5 and $50 million. DUS program $1.25 billion
Favored by those requiring CRA Large and liquid issue sizes that Freddie K loan and deal terms offer the most prepayment protection within eligibility typically range between $750 the multi-family programs They yield about the same as a million and $1.25 billion more diversified Fannie ACE or Freddie K Program bond
32 Mortgage-Backed Securities Introduction to Bonds Backed by Agency Multi-Family Loans
FHMS K031 A1 Scenario Analysis LDES
33 Mortgage-Backed Securities Introduction to Bonds Backed by Agency Multi-Family Loans
Foreclosed Loan Default Scenario Largest Loan Loan Default Scenario 50% Severity / 3-month Lag 50% Severity / 8-month Lag
34 Mortgage-Backed Securities Current Environment – What We Know & How It Impacts Our Thinking
For Agency Mortgage Investors, It’s About When You Get Your Money Back • Identifying bonds that will exhibit repayment (pre-payment) stability is the key to managing risk.
The Recent Economic Shock Is Unprecedented and Impacting All Types of Borrowers • Forbearance and loan modifications will occur at unprecedented levels, but history will still be guide in the current recession. • From traditional residential mortgages to mortgages backed by multi-family properties, loan characteristics will continue to be the primary driver of repayment stability. • Loan-term, Seasoning, Remaining Loan Balance and LTV are the most impactful characteristics.
The Recent Market Events Have Pushed Mortgage Spreads Wider • Valuations cheapened across the mortgage spectrum. • Bonds backed by loans with favorable characteristics remain attractive.
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