Collateral dominates structure.
That’s an investor’s way of saying that you can’t make a silk purse out of a sow’s ear, or that you can’t turn lead into gold. It’s been an investment theme of mine for as long as I’ve been managing money.
I got my start trading bonds in the mid-‘80s. Mortgage-Backed Securities were a little less than a decade old. Investors were just beginning to learn about prepayment risk, as interest rates fell and everyone started refinancing their double-digit mortgages. All those full-faith-and-credit Ginnie Maes were paying off early, and investors who paid premiums for fat coupons found that prepays could sometimes give them a negative yield, if enough of the pool paid off at once.
So some Wall Street types created Collateralized Mortgage Obligations—CMOs. By bundling a bunch of securities together, then sequencing the payments, investors could get a mortgage bond that behaved more like a traditional bond—paying just interest, and then paying off all its principal quickly. By structuring the principal payments, CMOs were supposed to reduce or eliminate prepayment risk. Only they didn’t. Collateral dominates structure. When 30-year mortgage rates fell to 5% in 1993, those CMOs paid off as quickly as anything else.
Fannie Mae 10% Mortgage Prepayments. Source: Bloomberg
Fast-forward 20 years. Mutual funds offer daily liquidity in all kinds of assets: emerging market stocks, foreign government bonds, currencies, non-investment grade bonds. But daily liquidity wasn’t all that easy—investors still needed to wait for the market’s close. Exchange Traded Funds offered exchange-based liquidity—trading every minute, or even more frequently. It made it seem that investments that were difficult to trade could be bought or sold at a moment’s notice.
And while the exchange-traded funds are liquid, the underlying instruments haven’t changed. Illiquidity is still illiquidity. Whether it’s high-yield bonds or micro-cap stocks or “jump-z” CMO tranches or private real-estate trusts, a collective instrument must carry the risk-characteristics of its underlying constituents, even if it has a blue-chip financial architecture designed by a top Wall Street legal firm and approved by the SEC. Collateral dominates structure—kind of like the mathematical law of identity: A equals A.
That’s why junk-bond ETFs usually trade at a modest premium or discount to their net asset value—although sometimes they’re way off. These bonds are hard to buy or sell, and when a significant amount of money flows into or out of the fund, its price has to reflect the expected transaction costs. It’s not that the index value is bogus, it’s just its decimal-point precision doesn’t allow for the nuances of a bid/ask spread in the bond market. And when big news or fund-flows hit an illiquid market, the bid/ask spread gets wider.
Junk Bond ETF discount/premium to Net Asset Value. Source: Bloomberg
Structure can’t take risk out of a market. Over the years, Wall Street has tried to repackage risk into different types of vehicles. But prepayment risk and interest rate risk and credit risk and illiquidity risk weren’t removed, they were just hidden for a while, waiting for the right circumstances to bring them back out into the open. If investors think the underlying risks have been eliminated, can be hazardous to their financial health.
It isn’t just what we don’t know that gets us into trouble. It’s what we think we know that turns out to be wrong. That’s where the real danger is.
Douglas R. Tengdin, CFA
Chief Investment Officer