Securitised Credit: Its Role in Portfolios
Securitised credit can play a distinctive role in fixed income portfolios, offering diversified sources of return and income that are not always available through traditional sovereign or corporate bonds.
By providing exposure to pools of consumer, housing, and commercial loans, securitised assets allow investors to access broad segments of realeconomy lending through publicly traded securities. Several characteristics drive investor interest:
- Diversification: Securitised products are backed by large, diversified pools of loans, spreading exposure across thousands of borrowers. Over time, regulatory and structural reforms, particularly following the global financial crisis, have strengthened underwriting standards and improved overall credit quality in many parts of the market.
- Low correlation: Securitised credit has historically exhibited relatively low correlation with traditional fixed income and other asset classes, reflecting its distinct risk drivers, structural features, and amortising cash flow profiles. This differentiation can help reduce overall portfolio volatility, especially during periods of market stress.
- Income generation: The amortising nature of securitised assets means that both interest and principal are repaid over time rather than at maturity. This feature can be appealing to income-oriented investors, such as retirees, who seek a stable and predictable income stream.
- High quality exposure: Compared with individual corporate bonds, securitised assets can reduce exposure to idiosyncratic default risk, as cash flows are supported by pools of well-underwritten loans secured by tangible underlying assets.
- Customisation: Securitised products can be tailored to meet specific investor needs, including preferences around cash-flow profiles, structural features, and levels of credit enhancement.
Risks associated with securitisation
As with all investments, securitised credit carries specific risks that vary by structure, tranche, and collateral type. These include:
- Credit risk is the risk that underlying borrowers fail to meet their payment obligations. Losses are first absorbed by junior tranches and migrate upward only if defaults accumulate, meaning subordinated tranches carry higher credit risk than senior tranches. Securitisations backed by lower-quality collateral are also more vulnerable to credit deterioration.
- Interest rate risk reflects the sensitivity of a fixed income security’s price to changes in interest rates. Many securitised products have floating-rate coupons, which can limit duration risk as coupons reset with prevailing market rates, reducing price volatility relative to fixed-rate bonds.
- Prepayment risk arises when borrowers repay loans earlier than expected. For example, homeowners tend to refinance when interest rates fall, switching from higher-rate to lower-rate mortgages. Investors receive principal back sooner and may need to reinvest in a lower-yield environment. This dynamic is often referred to as negative convexity.
- Liquidity risk refers to the risk that investors may not be able to sell their assets quickly or efficiently. Securitised markets are generally less liquid than government or corporate bond markets, which can result in wider bid-ask spreads and higher transaction costs. The primary exception is the agency mortgage-backed securities (MBS) market, which typically exhibits strong liquidity.
Behaviour of securitised credit across market environments
Performance across securitised sectors can vary meaningfully depending on collateral type, deal structure, and prevailing economic conditions. The table below highlights how different securitised credit sectors generate returns and where risks typically emerge across market cycles.
How securitised credit sectors perform across market cycles
Source: PIMCO. For illustrative purposes only.
Mortgage-backed securities (MBS)
Commonly issued as 30-year fixed-rate securities, agency MBS are particularly sensitive to interest rate cycles. Falling rates tend to increase refinancing activity and prepayment risk, while rising rates generally slow prepayments.
Non-agency MBS performance is driven primarily by housing market conditions. During housing market downturns, junior and lower quality tranches are most exposed to losses, while senior tranches typically demonstrate greater resilience. In stable housing environments, senior tranches tend to offer lower but more predictable returns.
Commercial mortgage-backed securities (CMBS)
CMBS performance is influenced by commercial real estate cycles. Economic slowdowns can lead to higher vacancy rates and weaker cash flows, affecting junior tranches first. Senior tranches are generally well protected, except during severe and prolonged market dislocations. Prepayment risk is often lower for CMBS than for RMBS due to contractual prepayment penalties.
Asset-backed securities (ABS)
ABS performance is closely linked to consumer credit cycles. During recessions, rising unemployment and income stress can increase default rates, while stable economic conditions typically support steady cash flows and low default rates.
Collateralised loan obligations (CLOs)
CLO performance is driven primarily by corporate credit conditions. Periods of credit stress can increase loan defaults, with equity and mezzanine tranches absorbing losses first. Given the floating‑rate nature of the underlying loans, interest rate risk is generally limited, making credit quality the dominant risk factor.
Securitised credit as a portfolio building block
Securitised credit can play a strategic role in portfolios, providing diversified sources of income and differentiated risk exposures that complement traditional fixed income.
By understanding risk exposures, structural features, collateral quality, and market drivers, investors can use securitised assets to help build more resilient portfolios and navigate changing market environments with greater confidence.
