Structured Financial Instruments and Analytics

If you want broad exposure to debt, you can always jump into a pooled investment.

__Structured financial instruments__ are securities that represent sliced, diced, and repackaged debt pools. A structured financial instrument is to a bond what sausage is to a pure cut of beef: there's a lot of stuff being represented in each piece, and not all of it is always good. Based on this, structured financial instruments are sure to have what characteristic?

Not necessarily. Many do have impressive returns at times, but that's not a direct result of their design.

Not really. Risks of these instruments shouldn't be classified as counterparty risk.

Exactly. Because structured financial instruments include pieces of many different debt instruments, diversification is a natural result of their design (which is a lot better for debt investing than for meat digesting). They often offer some very decent returns and allow investors to compare directly to bonds for more opportunities in relative value analysis.

__Asset backed securities (ABS)__ are one subset of structured financial instruments, which allow investors to get exposure in consumer credit, including car loans and credit card debt. Within ABS, there are also mortgage-backed securities (MBS), which are quite popular in the United States. Returns on MBS are about the same as corporate bonds, but MBS are much more liquid, which is really nice. Investors get exposure to real estate with MBS, and the mortgage payments are guaranteed by quasi-government entities in the United States. How do you think that affects the securities' investment profile?

No. Returns aren't enhanced by the payment guarantee.

No. They are highly liquid, but the payment guarantee doesn't directly affect that as much as another characteristic.

Absolutely. The risk with MBS isn't default risk; it's prepayment risk. If interest rates drop, homeowners will pay off the mortgage early, which makes MBS sort of like a callable bond. This depends on the tranche, though. MBS are broken up into tranches, with some getting principal payments before others do. And of course, that affects the prices and yields of various MBS securities.

So MBS really allow investors to feel the effects of both the real estate cycle and the credit cycle. This is a different exposure that provides a fair amount of diversification.

On the other hand, a __collateralized debt obligation (CDO)__ offers less diversification, since this security is typically collateralized by corporate bonds. It's a "financial sausage" with a higher content of real meat, so to speak. You still get some potential relative value plays, and you still get multiple tranches to choose from. This goes from senior to mezzanine and down to subordinated tranches. What would you expect from this subordinated tranche as far as defaults and yields?

No. That describes the senior tranche.

Yes. Subordinated tranches will have the highest defaults, mezzanine somewhere in the middle, while senior is best. Makes sense.

No. That wouldn't be fair. No one would buy them.

But now consider that the defaults start to align, in a way. If the correlation among defaults of these tranches starts to increase, then there's less of a difference among them. An investor of which tranche would be most upset by this?

Actually, no. The subordinated tranche will relatively outperform in this case.

Not really. Those mezzanine investors are always in the middle.

That's right! The senior tranche was supposed to be better. So it is priced higher, meaning a lower yield. But if the defaults start to become more highly correlated, that relative value disappears, and the mezzanine tranche will do better than the senior tranche, and so on. Default correlations are an interesting exposure investors can find with CDOs. Also, since the subordinated tranche can move so much more depending on market conditions, it's kind of like having some extra leverage there.

Finally, there are __covered bonds__. Investors can go after the issuer if default occurs, as always. But covered bonds have a "cover pool" of assets sitting there, waiting for investors if it happens. So this added protection will make default rates very low for covered bonds, meaning that what else is low?

Correct. Covered bonds are about as safe as it gets in the structured financial instruments market. You may never look at sausage the same way again.

No. Issue size isn't affected.

No. Trading volume wouldn't be related to this.

To summarize: [[summary]]

High returns

Diversification

Counterparty risk

Better returns

Higher liquidity

Lower default risk

Lower defaults and yields

Higher defaults and yields

Higher defaults and lower yields

Senior

Mezzanine

Subordinated

Yield

Issue size

Trading volume

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