Introduction to Securitized Fixed Income
Securitized products are pools of financial assets that produce cash flows, which are combined to produce a package of securities. The financial assets are often debt instruments like mortgages, auto loans, student loans, and credit card receivables. The cash flows from these debt instruments go into a trust and are then redistributed to produce a new security, or the securitized product.
This process of combining the financial assets to produce debt securities to be resold to investors is called securitization.1 Securitized products can provide fixed income investors with an alternative to corporate, government or municipal bonds with the potential for greater diversification and higher yields.
A common example of a securitized fixed income product is mortgage-backed securities, which are secured by homes or real estate loans. Other securitized products include asset-backed securities, which are bonds created from other types of consumer debt or commercial receivables.
How Securitized Products Work
In the process of securitization, financial assets are packaged together into a single trust with multiple, tradable securities.2 This process is similar to the way mutual funds are a diversified package of assets, such as stocks or bonds or certain funds that are backed by commodities like gold or oil. In the case of securitization, the most common financial assets used are loans or other financial obligations that generate receivables, such as different types of consumer or commercial loans.
Benefits & Risks of Securitized Fixed Income
- Efficient income. Certain securitized strategies may provide a more stable duration and higher yield than traditional fixed income products.
- Diversification. Rather than focusing on one particular debt sector or asset class, securitized products can be diversified across multiple asset types and cash flow strategies with strategic asset allocation.
- Reduced sensitivity. Actively managed portfolios can be structured with shorter-duration, investment-grade securities, which may reduce interest rate sensitivity, or the risk of potential losses associated with a change in interest rates. This can also help protect against the risk of inflation.
- Market acceptance. Securitized fixed income products as an asset class have increased transparency, regulation, and oversight.3 The securitization process and the issuers of these types of instruments have become instrumental to commercial and consumer lending, taking many loans off banks' balance sheets and benefiting investors in the broader fixed income markets.
However, there are some risks of investing in securitized products that investors should also be aware of before investing:
- Default risk. Although securitized products are often backed by consumer and commercial loans, there is still the possibility the debtor will fail to fulfill their payment obligation.
- Interest rate risk. Although an actively managed fixed income portfolio can reduce the risk associated with rising interest rates, investors should be aware that the risk of falling prices remains in certain rising-rate environments.
Why Fort Washington?
Our highly experienced portfolio management team believes the best approach to this asset class is:
- A focus on moderate to higher risk/return opportunities within securitized products.
- Maintaining high spread/short spread duration portfolios to reduce volatility.
- Having longer holding periods to enable realization of yield advantages.
Our Philosophy:
- Securitized products offer an attractive risk/return profile versus competing fixed income assets.
- Securitized products tend to have complex structures and uncertain cash flows, offering potential for inefficient markets and attractive risk-adjusted returns.
- Strong front-end due diligence and back-end surveillance processes are necessary to navigate markets and manage risk.
- Emphasizing the income component of return and focusing on high spread/shorter spread duration securities supports fundamental investing with a longer-term horizon.
