Searching for Returns in Fixed Income Markets- A Discussion of Asians Bonds Development and Opportunities in Structured Securities
Stephen Chang
Head of Fixed Income, Pacific Regional Group
December 2004
• Investment Outlook
• A Case for Asian Bonds– Asian bonds outlook– Alpha potential– Status of Asian bond market development– Benchmark selection– JPMF Asian bond presence
• Opportunities in Structured Securities– Introduction to Mortgage Backed Securities (MBS)– Introduction to Asset Backed Securities (ABS)– Risk Implication for portfolio management
• Prepayment and structure risk• Pricing and relative value
Agenda
Investment Outlook
• Range trading in US Treasuries has persisted with no real trends
• US economic data has been strong but sustainability is questionable
• Asia has been experiencing strong economic growth, outpacing those in US and in Europe
• Asian currencies are arguably undervalued with central bank FX reserves building up rapidly from trade surplus and foreign investment
• Twin Deficits in the US are a structural problem where a correction should lead to USD declining further
• Liquidity is aplenty in US and Asian countries with capital inflow, and lack of lending growth
Investment Outlook: Key Themes
US Treasuries: Range Bound Environment
Source:BloombergSource:Bloomberg
US Economy: Payroll Growth Sustainability
Source:BloombergSource:Bloomberg
US Economy: Borrowing for Consumption
Source:BloombergSource:Bloomberg
US Budget: Deficits Financing Growth
Source:BloombergSource:Bloomberg
• Structural bearish USD environment:
Exposure to Asian fixed income securities
• Range-bound yield environment:
Considerations for Structured Securities
Investment Outlook Implications
A Case for Asian Bonds
Asian Bond Outlook: Changing Dynamics
How would the current situation evolve? Our central scenario:
Situation/Development Investment Implication
Current status High growth, inflation rising Long Asian FX
Pegged currency/intervention Long Asian Equities
Low real interest rates Long Asian Credits
Central banks following fed action Long local short end bonds
1-2y horizon Asia moves to floating regime Long Asian Credit
Central banks raise rates Long Asian FX
Growth rate begins to moderate Neutral Bonds
Longer term outlook High rates reining in inflation Neutral FX
Interest rate peaks/growth slows Long Asian local bonds
• Asian increasing need for moderate risk assets– Changing demographics– Barbelling portfolio between cash and equities
• Liability matching– Too much US dollar as reserves?– Increasing integrated in trade activities
• Active management opportunities– Uneven growth and inflation trends– Central Banks’ dilemma and varying response– Lack of cross-border investor
Growing Demand for Asian Bonds
• Range of Instruments – 11 Asian countries with local currency debt market– US Dollar, Japanese Yen and Euro issuance from Asian Sovereigns
and Corporations– Credit play from AAA rated governments to high yield issuers
• Currency Exposure– Appreciation against USD and other major currencies– Protection against inflation risk
• Upgrade potential– Strength of Asian economies from strong growth and exports– Reduction of country/sovereign risk– Positive ratings outlook
Alpha Potential in Asian Bonds
Alpha Potential: FX volatility and Yield Correlation
Status of Asian Bond Market: USD Issuance Statistics
• USD bonds has been the issuance of choice for Asian Issuers
• Sovereign and Corporate names
• Issuance share are dominated by a few names (Hutch, Korea and Philippines sovereigns)
0
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30
40
'85 '86 '87 '88 '89 '90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03
0
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30
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'85 '86 '87 '88 '89 '90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03
US Dollar Bonds issued by Asian borrowers, 1985-2003 (US$ bn)
01020304050
Singapore HongKong
China Korea Malaysia Thailand India Philippines Indonesia
1980-1992 1993-1997 1998-2003
01020304050
Singapore HongKong
China Korea Malaysia Thailand India Philippines Indonesia
1980-1992 1993-1997 1998-2003
US Dollar Bonds issued by Asian borrowers, 1980-2003 (US$ bn)
Source: Bondware, Citigroup
Status of Asian Bond Market: JPY Issuance Statistics• Very limited JPY issuance post 1998
• High profile downgrade has deterred Japanese Investors
• Korea high grade are the lone exception
• Credit enhancement required for lower credit ratings issuers
0
2000
4000
6000
8000
'84 '85 '86 '87 '88 '89 '90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03
0
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6000
8000
'84 '85 '86 '87 '88 '89 '90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03
Yen denominated Bond issuance by Asian issuers (US$ mil)
0500
1000150020002500
China Indonesia Korea Philippines Thailand
1980-1992 1993-1997 1998-2003
0500
1000150020002500
China Indonesia Korea Philippines Thailand
1980-1992 1993-1997 1998-2003
Yen Bond issuance by nationality of issuer (Yen bn)
Source: Bondware, Citigroup
• Non-Japan Asia Local currency bond market has doubled from 1997 to 2002
• Account of GDP 47% at end of 2003 (vs. 20% in 1995)
• Bond share of total financing raised to 19% (vs. 11% in 1995)
• EMEAP (Executives’ Meeting of East Asia and Pacific Central Banks) initiative:
– Bilateral swap agreement totally >36B on foreign currency reserves to pool mutual support
– Asian bond fund: 1st series launched with 1B USD invested in USD debt on EMEAP countries
– Asian bond fund: 2nd series will be launched in early 2005• Expected to increase turnover in Asian bond markets• Increase public awareness of bonds as alternative instruments
Status of Asian Bond Market: Local Currency Bonds Development
Status of Asian Bond Market: Local Currency Bond Issuance Statistics
0100200300400500600
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Private Quasi-Govt Govt
0100200300400500600
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USD Return of local bondsOutperformance
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USD Return of local bondsOutperformance
Asia’s local currency Bond marketAsia’s local currency Bond market
Return comparison of local Bonds vs US Treasury (Jan 01 – Mar 04)Return comparison of local Bonds vs US Treasury (Jan 01 – Mar 04)
Source: HSBC, BIS
• Makeup of local bond issuers varies quite widely
• Local currency bonds provide diversification against US Treasury
• Capital Control Issues– Differing rates between onshore and offshore rates– Convertibility
• Withholding tax issues
• Asian Corporations issuing in USD to achieve wider investor base
• Relatively low transparency in price quotations, wide bid-ask spreads
• Turnover remains generally low
Status of Asian Bond Market: Local Currency Bonds Impediments
• USD credit index: HSBC ADBI, JPM JACI, iTraxx Asian series
• Local currency index: HSBC ALBI, JPM ELMI+
• iTraxx Asian Series– Merger of TRAC-X and iBoxx in June 2004
– Equal weight basket of credit default swaps (CDS)
– Highly liquid
• HSBC ALBI– Historical data since 2001
– Country weights based on HSBC Impediment Index
– Varying selection criteria for country indices
– Duration instability across different countries
• JPM ELMI+ – Inception since 1997
– Basket of tradable local money market bonds or non-deliverable forwards
Benchmarking Selection: Available Indices
• Bond inclusion difficulty:– Size of issuance small– Credit rating limit varies
• Country weights– Driven by country budget situation, e.g. Japan– Market capitalization can change quickly between countries– Duration between countries indices vary significantly
• Replicability:– Bid-ask spreads generally wide– Certain issues see small turnover from buy and hold investor
• Total return approach, focus on alpha generation
Benchmarking Selection: Dilemma
• One of the world’s leading asset management companies with over US$730B* under management
• 167* fixed income investment professionals manage over US$380B* fixed income mandates globally, with over US$12B* in Asian fixed income and balanced portfolios
• Dedication to Asia with over 90* investment professionals and over US$56B* under management
• Regional product offering and market coverage includes:– Pacific and Global Balanced Funds– China Balanced Fund**
– Bond and money market funds in HKD, TWD, THB***
– Asian Credit Research– Asian Convertible Bonds– Plus customized institutional mandates
JPMF Asian Bond Presence: Our Capabilities
* As of 30 September, 2004** via JV China International Fund Management*** via JV Ayudhya JF Asset Management
Opportunities in Structured Securities
MBS and ABS securities offer attractive return enhancement
Source: J P Morgan
Corp and MBS data 1990 -2004. ABS data 1992 - 2004
Excess return of market sectors over Gov’t 1-3yr index, Excess return of market sectors over Gov’t 1-3yr index,
unadjusted for durationunadjusted for duration
0.66%
0.29%
0.54%
0.00%
0.10%
0.20%
0.30%
0.40%
0.50%
0.60%
0.70%
0.80%
BBB Corp 1-3 Fixed ABS 0-3 MBS 0-3 WAL
YTD 2004 in the Lehman Aggregate MBS and ABS securities offer attractive return enhancement
Source: Lehman Brothers
YTD Excess Returns to Treasuries (Duration Neutral)
0.62%
0.88% 0.84%
1.22%
0.78%
-0.10%
0.10%
0.30%
0.50%
0.70%
0.90%
1.10%
1.30%
1.50%
Aggregate Index MBS Credit ABS CMBS (ERISA Eligible)
Introduction to Mortgage Backed Securities
Mortgage fromMortgage from local bank local bank
American American HomeownerHomeowner
6%
Investor buys Investor buys AAA MBS AAA MBS
securitysecurity
5.50%
Agencies Agencies combine combine
mortgagesmortgages
Mortgage fromMortgage from local bank local bank
Mortgage fromMortgage from local bank local bank
5.75%
American American Homeowner 2Homeowner 2
American American Homeowner 3Homeowner 3
How does a US mortgage work?
• Key features:– Usually fixed rate– Prepayable with low costs– Redeemed if mortgage holder moves to a new home
GNMAGNMA
FNMAFNMA
&&
FHLMCFHLMC
Agencies are considered ‘AAA+' credit quality with actual or implied U.S. Government guarantees
• Backed by the full faith and credit of the U.S. Government
• Government-sponsored entities which, given their position in the marketplace and their explicit mandates for housing finance, carry an implicit U.S. Government guarantee
• Both entities have a direct line of credit to the U.S. Treasury
Corporate20.5%
Non-corpcredit4.1%
Treasury24.6%
Agencies11.2%
AssetBacked1.4%
CMBS3.0%
Mortgages35.3%
• Mortgage-backed securities make up 35% of the Lehman Aggregate Index
• 60% of the US mortgage market is securitized
• The market has a diverse lending base
• The market has a diverse investor base, with diverse motivations
The US residential mortgage sector is the largest component of the US fixed income market
As of October 31, 2004
Lehman Aggregate: Percent by par amount outstanding
Benefits of MBS for asset allocation
• Highly liquid Low transaction costs
• Minimal credit risk
• Yield advantage versus U.S. Treasuries
• Diversification
Market Conditions Mortgage spreads ranged from 138 to 150 bps versus 5/10s
treasury blend during the quarter. In September mortgage spreads widened by 8 bps as the yield curve flattened and rates rallied.
Gross fixed rate supply was moderate, as 50% of gross issuance was comprised of Adjustable Rate Mortgages, and net supply of fixed rate mortgages was close to zero. Mortgage rates steadily declined during the quarter from 6% to 5.5% and as a result refinancing activity and supply increased.
Implied volatility was at the lowest levels of the year during July and August. As rates rallied, however, volatility increased as convexity needs of mortgage investors rose.
Current Coupon 30-Year Mortgages
Prepayment Sensitive (Residential) Mortgages
As of September 30, 2004
Outlook Convexity needs of mortgage players will increase in a
market rally of 25bps or more as refinancing activity and fixed rate mortgage supply pick up. Implied volatility should increase further and mortgage valuations should appear less attractive.
Sponsorship from banks will continue, but to a much lesser extent than in the past as Fed Funds are at 2% and the yield curve has flattened by 90 basis points in 2/10s.
Mortgage spreads are at the tighter end of the range for the last year. Given current spread levels, uncertainty regarding future GSE portfolio activity, the flatter yield curve, and increased refinancing risk mortgage spreads are vulnerable to widening.
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Introduction to Asset Backed Securities
What are asset-backed securities?
• ABS derive cash flow and credit characteristics from a pool of underlying assets
• The goal is to isolate the asset pool from the originator
– pool is independent of the originator in the event of bankruptcy
• ABS contain credit enhancements
– allows the securities to attain a higher rating higher than the originator
Issuer motivations
• True sale of assets– free up equity and regulatory capital– liquefy assets– asset liability management
• Access to capital– attractive funding at “AAA” levels– diversify funding sources
Aircraft and computer leases
Agricultural and equipment loans
Unsecured consumer loans
Trade receivables
Student loans
Marine receivables
Truck loans
Emerging markets asset classes
Entertainment royalties
ABS collateral is many and varied...
• Auto loans and leases
• Credit card receivables
• Home equity loans
• Manufactured housing contracts
• Recreational vehicles
• Utility stranded costs
• Dealer floor plan receivables
• Commercial loans
Market Conditions
• AAA par-priced spreads to swaps/LIBOR tightened in the third quarter on strong demand for short duration assets and limited fixed rate supply.
• Two-year and five-year swap spreads tightened 5-8 bps to Treasuries.
• Subordinates and off-the-run names tightened as well.• AAA Home Equity floaters were the one area of softness due
to heavy supply as interest rates remain low and originations high.
31
44 4549
89
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90
100
AAA 3-yr.Corp. BondAgency 3-yr. Debt AAA 3-yr. Credit Card AAA 3-yr. Auto AAA 3-yr. HEL
Note: Spreads are nominal spreads to U.S. Treasuries
Asset Backed Securities S
prea
d to
U.S
. T
reas
ury
(bps
)
Asset Backed Securities are an attractive short duration asset
As of September 30, 2004
Outlook
• Year-to-date issuance volume is up 30% from 2003, led by subprime home equity. Supply may moderate as the Fed lifts rates but will remain robust.
• AAA spreads to swaps are still relatively tight and may experience widening at the margin as market participants take a defensive stance in the fourth quarter.
• Subordinate spreads are backstopped by strong fundamentals in the competing corporate debt market and by CDO demand.
Sources: Various
$ bi
llion
Annual new issuance 1985 — 2004
ABS outstanding exceeds $1.5 trillion
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Other
Student
Equipment
MHC
Home equity
Credit cards
Auto
Benefits of ABS for asset allocation
• High credit quality: Over 90% issued securities are rated “AAA”
• Diversification
• Attractive yields
• Minimal event risk
• Stable average life
• Diverse maturities and structures
• Liquid secondary market:– over $1.3 trillion of public ABS outstanding– average duration of slightly over 2 years– average deal size of over $500 mm
Risk Implications for Portfolio Management
Risk implications for investing in MBS and ABS
• The primary risk to investing in MBS is prepayment risk
• Operationally complex back office headache!
• Collateral and structure risk must be monitored for ABS securities
Prepayment risk in MBS
• A borrower may prepay all or part of the outstanding principal of his mortgage at his discretion
• Prepayment motivations– relocation– access home equity– cheaper finance
• Interest rates drive prepayments
Interest rate Prepayment MBS Duration
• The duration of the mortgage index fluctuates with interest rates
• MBS returns are volatile
Mortgage index duration is volatile
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Dur
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Mortgage index duration fluctuation with time
MBS 45 Degree Line Poly. (45 Degree Line) Poly. (MBS)
US Government Bond excess
return
Sector excess returns
Excess returns of MBS to US Treasuries
Increasing USinterest rates Falling US interest rates
Underperformancein disaster years
-5.00
-4.00
-3.00
-2.00
-1.00
0.00
1.00
2.00
3.00
4.00
5.00
6.00
-3.00 -2.00 -1.00 0.00 1.00 2.00 3.00 4.00 5.00
Source: Lehman Brothers US MBS Index from February 1989 to April 2003 and JP Morgan US Government Bond Index from February 1989 to April 2003Note: All figures are expressed as monthly excess returns over US 3 month Treasury Bill and normalised to a 5 year duration
Return profile for MBS
• MBS underperform in major market moves
• MBS outperform during stable periods
OAS Curves for FNMA Mortgages of Different Vintages
0
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60
70
80
4 4.5 5 5.5 6 6.5 7 7.5 8Coupon
OA
S
276 WAM 312 WAM 342 WAM 348 WAM
OAS Curves for FNMA Mortgages of Different Vintages
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20
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40
50
60
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4 4.5 5 5.5 6 6.5 7 7.5 8Coupon
OA
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276 WAM 312 WAM 342 WAM 348 WAM
Extra dimensions of risk management required for MBS
• Option adjusted Analytics
• Historical based valuations
• Gross and Net Mortgage Issuance
• Activity of major investment classes
• Recent performance vs. other sectors
• Dollar Roll
• Level of liquidity
• CMO Arbitrage
A multitude of resources are critical to mortgage investment strategy
• Evaluate current conditions and valuations
• Forecast changes in the mortgage market trends
• Position portfolios to benefit from changing markets
In evaluating current mortgage market conditions, the following aspects are considered:
Sponsor/ServicerSponsor/Servicer
Master TrustMaster Trust
InvestorInvestor InvestorInvestor InvestorInvestor
Class AClass A
Class BClass B
Class CClass C
Class AClass A
Class BClass B
Class CClass C
Class AClass A
Class BClass B
Class CClass C
(Each C Class has a Reserve Fund)
Certs.
“A”
“BBB”
$ and Seller Interest
“AAA”
Certs. Certs.$ $ $
Reserve Fund - Trap excess spread
Receivables
Traditional credit card ABS structure
• Initial transfer
• Bankruptcy remoteness
• Trust owns receivables
• Security interest in receivables
Legal Structure
• Ongoing cash flow structure
• Payment priority
• Available liquidity
• Credit enhancement
Cash flow characteristics
• Macro and micro economic analysis
• Originator underwriting practices
• Servicing expertise
• Pool characteristics
• Historical credit performance
Collateral analysis
• Originator
• Servicer
• Credit support provider
• Trustee
• Swap counterparties
Main participants
Structured finance investing requires a disciplined credit approach
Analytical framework for investing in ABS
Fixed 5 Year AAA spread to Treasuries
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Credit Cards Fixed AAA - 5 Year Spread Home Equities Fixed AAA - 5 Year Spread
CMBS Fixed AAA 5yr Spread 5 Years Swap Spread
Home EquitiesHome Equities
CMBSCMBS
Credit CardsCredit Cards
Swap SpreadsSwap Spreads
Quantitative and market analytics
• Average life– Cash flow timing may be uncertain– Tranching controls cash flow timing
• Prepayments– ABS prepayments are less interest rate sensitive than MBS– Home loan ABS must be monitored to predict prepayment trends
• Embedded options– Most transactions have servicer call options (i.e., 5 - 10% of original balance)– Pool credit performance triggers may alter cash flows
ABS credit enhancement
• Unique to the originator and the asset type
• Sized to withstand a multiple of future expected losses
• Available in several forms:– excess servicing– over-collateralization– subordination– cash reserve– third-party guarantee
• Financial models evaluate default frequency, loss severity, prepayments, and interest rates.
Ongoing monitoring of transaction credit and prepayment performance creates opportunities
Transaction monitoring
Ongoing review sessions
• Assess the economy/key subsectors/market technicals/regulatory initiatives/relative value
Periodic security analysis
• Actual security credit performance versus the expected case
• Sufficiency of security credit enhancement
• Financial condition of key transaction participants
Develop a watch list
• Key variables/economic data for selected securities/sectors
• Make trade recommendations
Conclusions
• Given the current investment climate, Asian bonds and structured securities will provide good opportunities for investors
• Asian bond market development has picked up and will provide excellent alpha potential
• MBS and ABS are also attractive to fixed income investors given:– Safety– Return – Liquidity – Diversification
• Active management will be required given the range of markets in Asian bonds and the complex risks involved in structured securities
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