For Jennifer Bridwell, Pimco’s head of alternative products, managing a portfolio of distressed mortgage-backed securities (MBS) is much like protecting family treasures in a storm cellar. The assets are locked up until the weather improves and their potential value can be realised.
With a strong conviction that structured credits will regain their value, her team has been snapping them up even before the onset of the global financial crisis in 2008.
“We believe most mortgage-related assets purchased at distressed levels will outperform equities and other traditional asset classes with less downside risk volatility, and we think they are cheap," states Bridwell.
"While often we might not be permitted to buy many of these assets in traditional client mandates, in a fund we can invest alongside our clients without traditional liquidity and ratings constraints.”
Today her team manages eight distressed and three hedge strategies for Pimco’s alternative business. The Newport Beach-based firm has been growing its alts business aggressively with one eye on potential returns and another on freeing clients from traditional constraints.
Investors in distressed assets have to look beyond credit ratings, since many MBSs have been downgraded to below triple-C from triple-A ratings at issuance, and trust in managers' knowledge of an MBS market that today stands at more than $10 trillion.
“The manager would snap up these assets, lock them away and protect them from liquidity so that months or years later they could earn higher returns when they can be sold in a more orderly market,” states Bridwell.
She notes that her team has been spending more time travelling to Asia to see institutional investors, saying they are becoming more receptive to distressed strategies in an environment where interest rates are close to zero and 10-year US treasuries yield 1.5%.
But interest in MBSs among Asian high-net-worth individuals is low; they have shown greater investment interest in volatility as an asset class, suggests Bridwell.
Aside from agency MBSs, which are backed by the USA's Federal National Mortgage Association (Fannie Mae) and Federal Home Mortgage Corporation (Freddie Mac), Pimco has also invested across the residential MBS market post-crisis.
As much as 99% or more of agency MBSs are trading at a premium, at an average dollar price of over $103, according to a BlackRock US housing report in June. The fact that government-sponsored enterprises such as Fannie Mae and Freddie Mac provide a guarantee on underlying mortgages means investors including pension funds view them as almost as safe as Treasuries.
But in the non-agency MBS market, which is essentially a credit market which is not government backed, debt can trade at a discount of up to 60-70 cents on the dollar.
Bridwell’s team allocates its mortgage assets into hedge and distressed strategies according to their liquidity profile. The more liquid, agency-backed MBS will be in hedge strategies with active trading that could pay between 30 to 90 days; the more illiquid, non-agency MBSs go into distressed.
Of course, one concern among investors is the risk of homeowners being able to refinance existing loans. This would represent a loss of premium for holders of agency MBSs as refinancing means these pools of mortgages would be retired at par, nullifying any secondary market gains.
The market has also become concerned about the prospect of a government-sponsored refinancing programme in this low-rate environment.
Bridwell notes there are structural and credit-related reasons why homeowners are not free to refinance, one being that many borrowers are still suffering negative equity.
But the probability of Freddie Mac and Fannie Mae launching a streamlined refinancing programme remains low, as the agencies that are major holders of mortgage portfolios would themselves also lose out -- the average dollar price of MBSs they own is approximately $111 and refinancing means that borrowers would retire their debt at $100, notes Bridwell.