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In addition to these primary benefits, MBS offer other potential benefits as well. MBS are among the most liquid fixed income securities in the world, and are attractive risk-based capital assets under Basel 1 and 2.1
MBS also have been among the world’s most attractive opportunities for alpha in broader fixed income portfolios due to the fact that trading is usually dominated by accounting and regulatory-constrained investors. These constraints can create attractive opportunities for total return investors. Because of the many potential benefits MBS may offer, financial institutions continue to make substantial allocations to MBS.
In a market as deep and liquid as MBS, finding value requires a thorough understanding of the sector’s unique risk factors and opportunities. PIMCO analyzes MBS using proprietary models developed by our financial engineers and refined by our portfolio managers over many years. We believe the experience of our mortgage team and the level of sophistication of our proprietary analytic platform are critical factors in the successful management of MBS portfolios.
PIMCO’s goal in managing mortgage-backed securities is to generate consistent, long-term outperformance. In our efforts to achieve that goal, we employ a unique approach to the MBS market that emphasizes actively managed exposure to Agency pass-throughs, which we believe offer the greatest potential for risk-adjusted excess returns in a mortgage portfolio.
While we focus primarily on Agency pass-throughs, we also look for value and attractive risk-adjusted return opportunities in all segments of the larger MBS market. However, we believe the Agency pass-through market can offer the greatest potential for alpha due to its liquidity and credit quality. For Non-Agency MBS, Commercial MBS, and mortgage derivatives, we frequently demand more yield in compensation for the probability of principal loss and liquidity risk than the market typically provides. As a result, PIMCO’s dedicated mortgage portfolios will be primarily concentrated in Agency MBS holdings.
We believe Agency MBS can offer the best opportunity for excess return in a mortgage portfolio. Our goal in managing MBS portfolios is consistent, repeatable, high-quality alpha.
PIMCO does not rely on any single model in its investment process. Rather, we take a multi-faceted approach to MBS valuation, with three major components:
We believe using this multi-faceted approach is the most effective and robust method for evaluating the return potential of MBS and the risks they entail.
In the current environment of sharp home price decline where borrower home equity has been reduced, non-Agency mortgage securities carry historically high levels of default risk. PIMCO’s primary goal is to determine ultimate loss on a security or loan. We determine loss expectations by employing a proprietary loan level quantitative model in addition to an analysis of qualitative factors such as servicer practice and government housing policy impacts. The primary objective of this loan level analysis is to project the cumulative losses on a pool basis, as well as the prepayment and delinquency trajectories.
In addition to understanding the risks embedded in the pool of loans as well as the structure of the securities, PIMCO analyzes the macro effects of trends in the non-Agency MBS market. We monitor the effects of mortgage credit on national and regional home price appreciation, the availability of mortgage financing, origination trends affecting Agency MBS prepayments, and the balance sheet effects on holders of non-Agency MBS. Given the recent volatility of the sector and its far reaching impact outside of securitization markets, a robust mortgage credit research capability is key to understanding its linkages to other sectors as well as to the broader economy.
PIMCO’s term structure models are tailored for LIBOR and swap rates, which are most consistent with the mechanics of the MBS market and the risk/valuation of securities in the sector. Our prepayment model incorporates historical behavior, stressing recent prepayment speeds, and is also sensitive to home price levels, which are a key driver of housing turnover. In addition, we compare our internally created term structure and prepayment model against publicly available Wall Street models daily. This side-by-side analysis is extremely useful in identifying securities with high model risk and also helps us to understand the possible range of outcomes for a security or a portfolio.
We also employ proprietary analytics to evaluate individual MBS with respect to their underlying characteristics, such as: rate, type, servicer, loan balance, origination date, borrower quality, housing prices, and spread to traditional loans at origination.
Our substantial analytics capabilities provide portfolio managers with what we feel is the best possible platform for the complexities of MBS risk management.
1 Basel 1 and 2 are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. Their purpose is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face.
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market’s perception of issuer creditworthiness; while generally supported by some form of government or private guarantee there is no assurance that private guarantors will meet their obligations. PIMCO strategies utilize derivatives which may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. The credit quality of a particular security or group of securities does not ensure the stability or safety of the overall portfolio. There is no guarantee that these investment strategies will work under all market conditions and each investor should evaluate their ability to invest for a long-term especially during periods of downturn in the market. Diversification does not ensure against loss.
This material contains the current opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2014, PIMCO.
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