Securitized Sudoku: An Investor’s Trilemma

By: Jake Remley
July 14, 2021

In the depths of winter, cooped up from quarantine and bleary-eyed from video screens, I took up Sudoku as an evening pastime.   The basic gist is to populate a 9 x 9 grid such that each row, column, and sub-square has exactly one of each digit from 1-9.  No math is necessary, but one must pay meticulous attention to each number’s placement.  The same applies in today’s securitized markets.  With more and more variations than ever, investors must understand what’s in their securitized allocation because it may not behave the way they expect.

Other ABS (Asset-Backed Securities) and CMBS (Commercial Mortgage-Backed Securities)

The days of ABS being synonymous with liquid, high-quality credit cards and auto trusts are long gone.  Growth in “Other ABS”— ABS backed by collateral other than auto, student loan, equipment, or credit card receivables — is exciting for relative value hunters in the sector.  New collateral types include franchise royalty receivables, triple-net lease obligations, and pools of specialty warehouse and data center leases.  Other ABS types – railcar, timeshare, and cell towers – are expanding their market footprint.   Year-to-date, Other ABS has topped 25% of total ABS issuance, outpacing all other traditional ABS sectors combined (save auto ABS at 50% of issuance).

It’s no wonder Other ABS has grown.  Deals backed by new collateral types often require attractive pricing concessions to attract buyers.  In today’s tight spread environment, that means spreads of 100+ basis points (bps).  However, there’s a catch – Other ABS collateral typically does not amortize, so it is often placed into bankruptcy-remote master trust structures, which require periodic replenishment of collateral.  Principal payment of existing ABS notes occurs when issuers refinance the outstanding notes back into the ABS market.  However, issuers can afford themselves flexibility on the refinancing date by attaching call options to their ABS, which allow for principal repayment years ahead of the effective maturity date.  But these calls can eat into bond holders’ returns, especially when interest rates undulate.  Furthermore, they require more sophisticated relative value techniques (i.e. models to analyze the optionality underlying the cashflows), which can hurt transparency and liquidity in volatile markets.

CMBS has also seen growth in non-conventional collateral types.  Pools of single-family rental homes and single-borrower portfolios of commercial properties financed through securitized trusts often give issuers the right to extend deals past maturity.  These issuer options are economically valuable, especially if refinancing at maturity does not lower interest expenses.  Yet, as with Other ABS, advertised spreads, while attractive, hide this structural fine print.  As a result, holders must be wary of the potential for spread and liquidity volatility through the market cycle.

Lastly, collateralized loan obligations (CLOs) are another type of Other ABS that may provide good value relative in today’s securitized markets. CLO issuance has picked-up in 2021 and the sector is fast approaching $1trn in market value. While spreads on floating-rate senior tranches remain attractive (approximately 3-month Libor + 100bps fixed margin at issue), out-sized mark-to-market risk can come from an issuer’s refinance option, often only 1-2 years after issuance. While this refinance option is not directly subject to interest rate volatility, it is sensitive to the spread environment. If a deal is trading at a spread tighter than where it was issued, the CLO manager is incented to refinance to lower the fixed margin. Conversely, if a deal is trading at a spread wider than it was issued, the manager is incented to leave the deal outstanding. The latter lengthens the market’s estimate of the expected maturity date and increases the deal’s price volatility. Overall, investors should weigh a variety of factors in CLO security selection — the deal manager, the loan collateral, and the structure are all key considerations in a decision to purchase at a given spread.

Traditional ABS and CMBS

Investors who favor cash flow and liquidity stability can still rely on traditional ABS and CMBS.  These pillars of the securitized indices remain the dominant portions of each market.  Conduit CMBS (where the loans are underwritten with the intention of securitization) has over $500bn in float and traditional ABS over $80bn.  Both are issued mainly via static trusts, so issuer optionality on the return of principal is not the norm.  Tranches backed by automobile, equipment loans/leases, or, in the case of conduit CMBS, diversified pools of multi-family, office, and retail properties have predictable monthly cashflows and transparent trust mechanics.  But today’s market pricing is tight, with spreads only 25-50bps above Treasuries.

Residential Mortgage-Backed Securities (RMBS)

RMBS is the third and largest leg of the securitized universe.  Liquidity in the $7+trn Agency MBS market is currently supported by the Federal Reserve’s QE (Quantitative Easing) program.  This provides a powerful liquidity backstop during times of market stress.  Take March 2020, for example.  Within two weeks of the WHO’s declaration of a global pandemic, the Federal Reserve announced unlimited buying in U.S. Treasuries and Agency MBS.   So, while markets around the globe melted down, Agency MBS investors obtained a bid-side lifeline for redemptions and/or sector rotations.

Non-agency RMBS has also seen tremendous growth.  Yields are attractive – currently 25-50bps over Agency MBS.  The rebirth of the sector five years ago has resulted in a sector with issuance of $100+bn/year now.  Non-Agencies offer attractive yield and security selection opportunities.  While today’s non-agencies have robust credit fundamentals (see: Non-Agency RMBS: Expect Bumps But Not 2008 – Income Research + Management), liquidity is not on par with Agency MBS.

But RMBS has a significant drawback – the stated yield is a mere estimate of projected income.  If prepayments rise (e.g., when interest rates fall) or fall (e.g., when interest rates rise), yields can be eroded by shifting cashflows.  For example, on 1/1/2020, the Agency MBS Index had a duration of 3.19yrs and a yield of 2.54%.  It ended the year at 2.42yrs, 1.28% yield, and a total return of 3.83%.  However, had the index’s cashflows not shortened, the total return would’ve been approximately 5.5%.  So, while Agency MBS has tremendous liquidity and Non-Agency MBS has attractive spreads, the yields in both are prone to erosion from shifting cashflows.


Securitized markets have a lot going on these days.  The plus is that investors have choices.  The drawback is that no one sector is a panacea.  Investors must understand the trade-offs amongst liquidity, yield, and stability of cashflows when constructing a securitized strategy.  Just as every digit has a unique spot on the Sudoku board, every securitized sector has a specific role in today’s diversified bond portfolios.


Sources: Bloomberg Barclays. Data as of 07/12/21. The above examples are for illustrative purposes only.  Actual results may differ. The securities mentioned are for illustrative purposes only. This is not a recommendation to purchase or sell the securities listed. Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith. The views contained in this report are those of IR+M and are based on information obtained by IR+M from sources that are believed to be reliable.  This report is for informational purposes only and is not intended to provide specific advice, recommendations for, or projected returns of any particular IR+M product.  No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Income Research & Management.