Default-Risk-Adjusted Returns

Fixed income investors interested in achieving enhanced risk-adjusted returns must carefully consider risks, such as prepayment and default, that affect realized yields associated with different types of bonds. In this write-up, we compare the risk-return profiles of Agency and non-Agency securities as well as corporate debt obligations. We find that Agency Interest Only (IO) securities have historically provided investors with higher carry at reduced levels of risk relative to other fixed income products. Non-Agency IOs may also offer good investment opportunities, but this depends on market spreads and the quality of prevailing underwriting standards. In recent years, these standards have greatly improved from those used during the Financial Crisis. When compared to Agency and non-Agency securities, corporate debt obligations offer suboptimal risk-adjusted returns. Corporate bonds also require investors to perform laborious underwriting to understand fully their vulnerability to default. Our analysis indicates that Agency IOs offer a unique risk-return profile for fixed income investors by providing the security of US Government backing at higher yields than US Treasuries. 

Agency Securities

Defaults in Agency IOs are termed involuntary prepayments. These occur when a borrower stops making payments and the Agency (i.e. Fannie Mae, Freddie Mac, Ginnie Mae) must step in to pay back (i.e. prepay) the balance of the principal of the government guaranteed loan. Fannie and Freddie Mac report the default rates on loans underlying selected Agency securities. These involuntary prepayments are measured by the Constant Default Rate (CDR), which is the annualized percentage of principal involuntarily paid off via default. We find that the average annualized CDR from January 2000 through June 2015 (the most recent data) was 0.84% for Fannie Mae and 0.82% for Freddie Mac, as shown in Chart 1. During the height of the Financial Crisis, Fannie and Freddie bonds had annualized CDRs of 3.34% and 3.11%.

Chart 1: Agency CDRs

Non-Agency Securities

Non-Agency deals are issued by banks. They are often constructed with several different tranches, each with its own distinct level of exposure to credit risk. Loan-level detail analysis is often necessary to understand fully a particular security’s exposure to default risk. As observed in Chart 2, default rates vary widely depending on a security’s collateral quality as Prime, Alt A, or Subprime. From 2011 through 2015, average CDRs were 2.89% for Prime, 5.90% for Alt A, and 7.58% for Subprime. 

Chart 2: Non-Agency CDRs

We believe Non-Agency securities may offer attractive risk-adjusted returns, depending on where we are in the credit cycle and the quality of underwriting practices. However, since these conditions vary, we maintain an opportunistic approach to Non-Agency credit. Recently, we have consciously avoided investing in Non-Agency securities as yields are relatively tight, though we are always on the lookout for when the timing may be right for credit exposure. 

Corporate Bonds

When compared to Agency and Non-Agency securities, corporate bonds do not have attractive default-risk-adjusted returns. This is in part due to the difficulty involved in understanding credit exposure in corporate debt, which requires investors to perform laborious underwriting. Moreover, this time-consuming analysis still does not insulate investors from the idiosyncratic risk inherent in bonds issued by a single company. Agency and non-Agency securities benefit from diversification, since each bond is backed by hundreds, if not thousands, of individual loans. In addition, it is important to not be fooled by the purportedly low number of “Investment Grade” (AAA through BBB-) defaults, because these numbers do not include the so-called “fallen angels”, which are companies that were downgraded prior to going bankrupt.

Yield Comparison

Having examined default rates, we now turn to yields in our discussion of risk-adjusted returns across fixed income assets. The yields typically found in Agency IO securities range from 5 to 6%, while non-Agency RMBS usually yields around 5-7% , and High Yield corporate bonds (unadjusted for default) may yield 7-10%. It is important to note that the yields for High Yield bonds assume all cash flows are realized with no defaults, which explains why they are often greater than Agency IO yields. Also, non-Agency securities may typically have higher yields than Agency IOs at the cost of illiquidity, credit exposure, and longer periods until the return of capital. In light of this, the 5-6% yields one can expect from Agency IO strategies represent an outstanding risk-reward profile. 

Another factor in assessing the attractiveness of a fixed income investment is the capital requirement. Corporate bonds require investors to put up a relatively large amount of capital for a semi-annual coupon and a principal amount that is not returned until the bond matures, usually in 10 years or more. In the case of Agency IO securities, investors purchase a stream of monthly interest payments that tend to be front-loaded. As such, capital is returned at a much faster rate, often offering a more attractive yield over a shorter timeframe. Thus, for fixed income investors, Agency IO securities can offer yet another advantage over corporate debt and US Treasuries.

We find there are many sound reasons for investors to have exposure to Agency and non-Agency securities. The Tradex Relative Value Fund primarily invests in Agency securities in a market-neutral portfolio that seeks attractive absolute returns. As previously mentioned, we may, at times, invest opportunistically in non-Agency securities, if the conditions are right for us take on credit exposure. We aim to hedge interest rate risk by maintaining a near-zero duration book along with superior loss-adjusted returns. This market-neutral strategy has delivered enhanced risk-adjusted returns for our investors, offering competitive yields and generous carry with limited downside.

We recommended readers interested in learning more about the Tradex Relative Value Fund’s strategy to contact InvestorRelations@TheTradexGroup.com.