Morningstar - Q3 2024 - 31

4
2
12/1999
EXHIBIT 1
tools to push risk off their books in recent years,
including credit risk transfer securities, which offer
more-generous yields in exchange for exposure
to some of the first losses on pools of the agencies'
mortgages. And several years ago, Fannie
Mae decided to securitize and resell so-called
reperforming mortgage loans, whose borrowers
had become delinquent but got back on track
when the agencies made loan modifications.
A little bit like scratch-and-dent appliance sales,
they've been a big hit with investors.
Other housing subsectors have become popular
with investors, including nonperforming
loans, rental payment securitizations, and jumbo
and nonqualified mortgages. They've had
more than $1 trillion in gross issuance over the
past 10 years, though refinancings, amortizations,
payoffs, and defaults have shrunk outstanding
supply, according to J.P. Morgan. To date,
there are no widely available indexes or passive
options for any of them.
They're Not Oranges, They're Apples
Bonds have characteristics that make indexing
them a different proposition than equities.
Some are rooted in the very nature of a bond
as a loan, and in its placement in a company's
capital structure determining who gets
what if the company goes bankrupt. Absent
complicating factors, equity owners have
rights to all the company's profits and are on
the hook for all its losses.
Those rights to profits are the bedrock of stock
investing. When you own a business, its
upside is theoretically unlimited if it's well run and
conditions are right. A key tenet of indexing
is that the market's efficiency means information
about the fortunes of public companies is
baked into their prices. So, buy them all and hang
on, since doing so is effectively a call option
on the success of American business.
There is no such ethos when it comes to the
bond market. For starters, there's always a chance
that the kind of economic growth that can help
stock prices can also drive inflation, the nemesis of
fixed income. Most bonds carry fixed rates whose
levels the market sets based on the embedded
costs or risks of key components, including the risk
No Index Here Nonagency residential mortgage securities and other housing
subsectors are popular with investors, but no indexes exist for them.
Postfinancial Crisis-Nonagency Mortgage Sectors
$150B
Reperforming Loan
111.86
120
Nonqualified Mortgage
110.05
90
Jumbo 2.0
82.70
Credit Risk Transfer
64.39
60
Rental
53.81
30
2012
2015
Source: J.P. Morgan. Data as of Dec. 31, 2023.
2018
2021
2023
Agency Investor
36.71
Nonperforming Loan
16.74
12/2006
12/2013
02/2024
that inflation will erode the purchasing power of
its interest and principal payments.
That's one way of many that the interests of stock
and bond investors in the same company can be
sharply opposed-and management teams
typically pledge their first allegiance to stockholders.
That can mean corporate managers are motivated
to do things that have a high probability of
benefiting their equity owners, even if it weakens
the position of their bondholders. In fact, every
company is incentivized to raise its stock price and
pay as little as possible to its bondholders.
All else equal, if you have the highest conviction in
a borrower, you most likely would prefer to own
them, not lend to them.
When it comes to the amount of debt that
companies take on, meanwhile, more debt often
means investor demand for higher yields and
even credit rating downgrades, which themselves
can trigger the former. Governments and
issuers of securitized debt don't have shareholders
per se, but they still have interests that are
different from those of their lenders.
Where the Rubber Meets the Road
When borrowers get heavily leveraged, indexed
bond investors are forced to maintain that
growing exposure and take on more risk. That's
what happened when automobile sector
debt ballooned in the early 2000s, dominating the
investment-grade corporate bond market. It
constituted 17% of the Morningstar US Corporate
Bond Index at the end of 2001, with the debt
of Ford and General Motors and their subsidiaries
holding top spots. The spread between their
bond yields and those of Treasuries ran 200-300
basis points higher. (Higher spreads signify
more risk and vice versa.)
By the end of April 2005, right before bond rating
agencies downgraded both automakers'
debt to junk status, their spreads had blown out
morningstar.com/products/magazine
31
Years
http://www.morningstar.com/products/magazine
Morningstar - Q3 2024

Table of Contents for the Digital Edition of Morningstar - Q3 2024
