If bonds and 1993 don’t mean anything to you, think of what happened when the music finally stopped: Orange County, derivatives, and bankruptcy. Or perhaps you will recall Piper Jaffray’s ill-fated government fund that had advertised itself as safe from Uncle Sam.
Wall Street was naturally behind the scenes of the carnage, slicing and dicing plain-vanilla mortgage pools into exotic mortgage derivatives and selling them at tidy profits. A scant few investors understood them–or their risks–and the damage soured a whole generation on the very word “derivatives.”
They’re Baaack …
But while the most complex mortgage derivatives have largely been verboten in the halls of mutual fund companies since then, some have made a comeback, particularly after the 2008 crisis. A combination of rock-bottom short-term interest rates and unusually low levels of mortgage refinancing has been the perfect setting for so-called interest-only and inverse interest-only mortgage securities.
There are different ways to structure IOs and inverse-IOs, and depending on their traits and market conditions, both can be lucrative–but volatile. Inverse-IOs, for example, are designed with inherent leverage in their structures and are extremely sensitive both to changes in short-term rates (usually LIBOR) and shifts in the speed at which homeowners are prepaying their mortgages. When things are going just right, as they were for most of the past year, those securities can pay extremely generous yields and generate massive total returns, even if the market simply remains stable.
Prepayments can be an especially nasty problem, though, because a mortgage that is refinanced (or bought out by government agencies targeting delinquent loans) essentially eliminates some of the principal upon which an IO or inverse-IO security’s interest payments are made. The net effect is a permanent loss. And inverse-IOs court an additional set of risks, given that their payments fall if short-term interest rates rise.
Both securities usually trade at very low dollar prices relative to the total amount of mortgage market exposure they provide, and they became even cheaper thanks to the financial crisis. During a recent conversation, for example, Fidelity manager Bill Irving noted that, broadly speaking, the inverse-IO market was priced such that roughly $12 in market value represented $100 in exposure to the mortgage market. Put another way, the market values of inverse-IOs are highly leveraged to even modest price shifts in the mortgage market, so a small change in the aforementioned $100 exposure could represent a big change to the $12 of an investor’s market value.
When Fannie Mae and Freddie Mac both announced in early 2010 that they would be buying out delinquent loans (of 120 days or more) from mortgage pools that each has guaranteed, the market reacted strongly to the news, given that the action would be indistinguishable from a rise in prepayments to most investors. According to Mitch Flack of Metropolitan West Asset Management and TCW, that translated to price losses of roughly 10% to 20% for most inverse-IO securities.
Are Dangers Lurking?
What does that mean for your bond fund? Unfortunately, it’s difficult to generalize too much, because it’s possible that a manager holding these structures may be hedging his risks with other tools or may have even scraped together a handful of ones that, for one reason or another, have become inherently less risky than they once were.
Meanwhile, given the way that most fund companies denote these exposures in their reports, sniffing them out can be difficult. They’re not always grouped together, for example, and even if they are, it’s usually impossible to tell just how much risk is being taken, either in individual holdings or across positions. The only good way to know whether a particular fund is taking on a lot of mortgage derivative risk is to ask the fund company directly.
Small Package, Big Bang
They’ve definitely been showing up in funds, however, and were extremely popular with some managers in 2009. Fidelity’s Irving told Morningstar that he regretted not getting into inverse-IOs a bit earlier, for example, but has profited from modest exposures and has since become less sanguine about their risks and return potential going forward. He notes that even with a pretty modest 0.5% market value weighting in Fidelity GNMA Fund (FGMNX), the stake in inverse-IOs translates to a notional market exposure equivalent to roughly 5% of the fund’s net assets. Even though Oppenheimer U.S. Government (OUSGX) was badly chastened by trouble across Oppenheimer’s bond lineup in 2008, newly installed manager Krishna Memani has been willing to stash roughly 3.5% in inverse-IOs, which he notes also act as a natural hedge against some of the more plain-vanilla mortgages in his portfolio. Other exposures to nonagency and commercial mortgages have helped, too, but Memani’s inverse-IO holdings have contributed to the fund’s top-quartile trailing 12-month returns.
Anecdotally we know that more than a handful of other managers have dabbled in this space, but it’s unlikely that any have been more bold than Putnam’s fixed-income chief, Rob Bloemker. Although several Putnam bond funds were badly stung during the financial meltdown in 2008, Bloemker and his colleagues are adamant that much of the pain was a function of the market’s liquidity crisis and that their investment decisions have otherwise been spot on. Their latest results certainly support the point, and much of their 2009 success, especially in the firm’s Putnam Income (PINCX), Putnam U.S. Government Income (PGSIX) and Putnam American Government Income (PAGVX) funds, has been driven by bold allocations to IO and inverse-IO securities.
Bloemker believes that there is still value in the sector, that the rewards of holding IOs right now still strongly outweigh their risks, and that most of the raw risk of rising short-term rates among his funds’ inverse-IO positions is reliably hedged away. While some believe that the market is now fairly valued, he and other managers argue that prices remain so compelling that even higher levels of prepayments will leave them with healthy returns. The Putnam team recently reported having between 23% and 27% of each fund’s market value invested in IOs and inverse-IOs that were hedged to make them act much like IOs.
The funds’ fat returns alone argue strongly that those are aggressive positions, but the proof of Putnam’s skill will be in whether Bloemker and his crew are able to transition out of their trades before a shift in the mortgage markets takes a bite out of them. Even if that were to happen, it might not spell major fund-level losses, but it would likely put them well behind most competitors. If Bloemker and his team do pull it off, they will look like shrewd heroes. If they don’t, well, that’s another story.
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