Structured Financial Instruments

Structured financial instruments are collections of assets backed by collateral. Collateral ensures that if a borrower defaults on loans, their assets can be seized and sold to recover part or all of the issuer's losses.

These instruments offer various tranches, each with distinct risk and return levels. Senior tranches suit risk-averse investors who want priority repayment in bankruptcy, though at a lower yield. Less senior, higher-yielding tranches appeal to risk-tolerant investors.

Pooling loans enhances diversification and provides exposure to specific asset classes and industries, benefiting investors.

Mortgage-Backed Securities (“MBS”)

An MBS is a collection of home loans bundled together. The basic idea is that a pool of loans should perform better than any single loan. In a default on one mortgage, the income from the other loans can offset the loss. Compared to investing solely in corporate bonds, MBS investment can offer the following advantages:

• Enhanced Liquidity: Agency RMBS, backed by US government agencies such as Ginnie Mae, Fannie Mae, or Freddie Mac, provides a liquid option. The US agency mortgage market boasts high liquidity, surpassing the corporate bond credit market in size.
• Real Estate Exposure: Investors gain exposure to real estate through a collection of mortgages.
• Opportunity for Interest Rate Volatility: Agency RMBS has prepayment and extension risks tied to interest rate expectations. When rates increase, cash flows might be delayed (extension risk). When rates decrease, borrowers might repay mortgages early and refinance at lower rates (prepayment risk). Investing in agency MBS allows an investor to express a view on decreasing market expectations of interest rate volatility.

Asset Back Securities (“ABS”)

Much like MBS, ABS enables investment in multiple loans at once, including:

• Auto loans.
• Auto lease receivables.
• Credit card receivables.
• Student (or other personal) loans.
• Bank loans.
• Accounts receivable.

For portfolio managers wanting to express views on consumer credit, ABS can provide a more liquid option than creating their loan portfolios. This makes ready-made portfolios an appealing alternative.

Collateralized Debt Obligations (“CDOs”)

A CDO is a bond composed of a diversified pool of other bonds. CDOs typically have different classes known as tranches, including ‘senior’ bond classes, ‘mezzanine’ bond classes, and ‘subordinated’ bond classes. Lower tranches have a lower priority in receiving cash flows in case of default.

The collateral for a CDO usually consists of corporate loans or bonds. While CDOs lack significant diversification compared to corporate bonds, they offer exposure to default correlations and potential benefits:

Relative Value: During the global financial crisis, CDOs often traded below their expected valuation based on underlying bonds due to differences in aggregate and individual default probabilities.

Exposure to Default Correlations: The correlation of expected defaults within a CDO impacts the relative value between senior and subordinated tranches. Higher correlations reduce the advantage of owning higher credit quality bonds, impacting returns.

Negative Default Correlation: Investors can profit by selling the subordinated tranche and buying the senior tranche if they expect a negative default correlation.

High Default Correlation: If default correlation is high, both loans either default or don't. Senior and subordinated tranches have similar chances of receiving principal, and a higher interest rate in the junior tranche may make it more valuable.

CDO Market Prices: CDO market prices reflect investors’ expectations of credit default correlations, providing a way to express views on correlations.

Leveraged Exposure to Credit: Mezzanine and equity tranches of CDOs offer additional return potential if underlying collateral performs well. Even then, they face a higher risk of losses in adverse credit environments. This trade-off provides leveraged exposure to the underlying collateral.

Collateralized Loan Obligations (CLOs)

CLOs are unique fixed-income securities backed by a diverse pool of leveraged loan obligations with floating interest rates. Investors can use CLOs to spread their investment exposure across a wide range of credit ratings, obtaining different levels of credit risk through a single investment. This feature has made CLOs popular, particularly among institutional investors such as insurance companies with the financial capacity for such investments.

Covered Bonds

Like CDOs, covered bonds are issued by financial entities, often banks. They are backed by specific assets of the issuer as well as the general obligations of the issuer. Covered bonds are considered lower risk due to their dual collateralization, providing extra security for investors. 

Question

An investor with expectations for increasing interest rate volatility would most appropriately:

1. Short agency MBS.
2. Buy agency MBS.
3. Buy callable corporate bonds.

Solution

The correct answer is A.

If investors believe that market expectations of interest rate volatility will rise, shorting agency MBS in their portfolio would align with this prediction.

B is incorrect. On the other hand, buying agency MBS would be suitable if the expectation were for a decrease in interest rate volatility.

C is incorrect. Regarding callable bonds: The value of a callable bond equals the straight bond value minus the call option’s value. Purchasing callable bonds could result in losses if the anticipation were for increased interest rate volatility. This is due to the positive relationship between volatility and option values. A higher call option value leads to a decrease in the value of the callable bond.

Reading 22: Fixed Income Active Management: Credit Strategies

Los 22 (j) Describe the use of structured financial instruments as an alternative to corporate bonds in credit portfolios