Morningstar - Q2 2020 - 54

Strategies

research, noted that discounts disappeared
on some higher-quality bond ETFs after the Federal
Reserve announced it would purchase ETFs.
And trading conditions appear to be improving in
the agency mortgage, investment-grade corporate,
and muni bond sectors.
The Bad News

Unfortunately, some bond funds are more
vulnerable than others in a liquidity crunch. As
yields on high-quality bonds were near
historic lows for years after the global financial
crisis, some fund managers reached for yield
in less liquid segments of the market.
One area where they found it was niche
structured credit sectors, particularly subordinated
tranches of securitized bonds that rank below
those that have a senior claim on underlying
assets' cash flows. These much riskier securities
are difficult to identify-and distinguish
from their higher-quality brethren-in public
portfolio disclosures, and unlike corporate bonds
and high-quality asset-backed sectors, their
performance isn't tracked by widely followed
indexes. Although these sectors rewarded
investors with generous payouts in recent years,
they've suffered spiraling price declines.
Among the more popular of these higher-yielding
structured sectors have been agency credit
risk transfer securities, or CRTs, a sector created
in 2013 to transfer mortgage credit risk from
government mortgage agency balance sheets to
private investors. While these bonds differ
in the degree of credit risk they take on, they
hadn't as a group had to endure extreme
market illiquidity or an economic slowdown-
until now.
Concerns about the impact of mortgage
payment holidays-which would provide relief
to struggling homeowners grappling with
coronavirus-related hardship-on CRT
fundamentals, in addition to forced selling from
leveraged investors and funds, have caused
prices on the sector to plunge. Some of these
bonds were reportedly trading at prices 40
percentage points lower than their highs as of late
March, with yield spreads widening to
previously unseen levels of more than 2,000 basis

54

Morningstar Q2 2020

points. As we saw during the financial crisis, even
some bonds that ultimately made good on
their principal and interest payments-as some of
these still may-suffered dramatic price declines
from which it took years to recover.

portfolio was roughly 95% invested in nonagency
residential mortgage credit, it's unlikely the
managers were able to raise cash without locking
in losses. The fund lost more than 40% of its value
from the beginning of March through March 24.

While subordinated tranches in other structured
credit sectors-such as collateralized loan
obligations, nonagency residential and commercial
mortgages, and other asset-backed
securitizations-are similarly vulnerable in this
environment, it's rare to see open-end mutual
funds invest in lower-rated, subordinated tranches
given that their inordinate credit and liquidity
risk make for a potentially combustible package
inside a daily liquidity vehicle.

But the fund was already an outlier. Its portfolio
chock-full of subordinated mortgage credit avoided
by other funds, indeterminate credit-quality profile
(most of its holdings were nonrated), and absence
of high-quality holdings to provide liquidity
should have raised concerns. The fund's outsize
returns in recent years should have also raised
questions about the risks its managers were taking.

CRTs have more commonly appeared in mutual
fund portfolios but usually only in small sizes
of 10% or less. Some large, active, diversified bond
managers, such as Dodge & Cox, Fidelity,
Pimco, and TCW, have steered clear entirely.
Outside of those with modest CRT stakes,
Morningstar analysts have been reluctant to award
ratings of Gold, Silver, or Bronze to diversified
bond funds that invest in these riskier corners of
the structured credit market.

That's especially true for funds we've rated
in the ultrashort and short-term bond categories,
where investors who are enticed by funds
that offer a little bit of extra yield in the good years
are also quick to run when those funds fail to meet
their expectations for safety. Those hit hardest
in the current crisis tend to have larger exposures
to various flavors of structured credit. For instance,
Neutral-rated Invesco Variable Rate Investment
Grade ETF VRIG, the ultrashort category's
second-worst performer in March as of March 24
with an 11.5% loss, has held more than 20%
in CRTs for the past few years. As of December,
the fund's liquidity buffer in the form of a U.S.
Treasury stake was only 10% of assets.
The most vulnerable strategies in the current
environment started flashing red well in
advance. For example, AlphaCentric Income
Opportunities IOFIX, a multisector bond
fund that has invested the majority of its assets
in mezzanine subprime MBS, experienced
heavy redemptions in recent weeks. Given that the

Planting the Seeds of Recovery

The moral of the story isn't much different than it's
ever been. When a yield- and return-chasing
strategy that digs deep into sectors with lots of
credit and liquidity risk meets investors who
crave that income so much that they're willing to
ignore its risks, we wind up with an inherently
unstable pairing. As we've just seen, many
of those same investors are easily spooked enough
to ask for their money back the minute trouble
hits, forcing managers to dump riskier holdings at
the worst possible time.
On the other hand, the historic bargains currently
available in investment-grade bond sectors
give investors who own well-diversified
intermediate core and core-plus bond funds plenty
of reason to hold on to their investments. When
regulators and lawmakers step in to repair markets,
they look to first protect sectors that are being
hurt for technical rather than fundamental reasons,
all but ensuring that high-quality securities will be
money-good when all is said and done.
Meanwhile, diversified bond funds that earn Gold,
Silver, or Bronze ratings almost all have ample
liquidity in the form of U.S. Treasury and agency
MBS holdings to be able to meet redemptions and
reposition their portfolios to take advantage
of bargains in other sectors. In fact, many have
already started. K
Miriam Sjoblom, CFA, is director, fixed-income strategies,
with Morningstar Research Services.
Eric Jacobson is a senior analyst, fixed-income strategies,
with Morningstar Research Services.



Morningstar - Q2 2020

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