Investing in securitized products

Securitized products represent a complicated sector of the fixed-income market. These products are pools of financial assets that are brought together to make a new security, which is then divided and sold to investors.

Since the value and cash flows of the new asset are based on its underlying securities, these investments can be hard to analyze. Regardless of whether an individual ultimately chooses to invest in securitized products, a better understanding of this dynamic market is critical to the development of a robust, well-rounded investment education.

This article will explain what securitization is, outline its benefits and discuss the investment characteristics of securitized products before concluding with a look at how securitized products might fit into an individual investor's portfolio.

Securitization describes the process of pooling financial assets and turning them into tradable securities. The first products to be securitized were home mortgages. These were followed by commercial mortgages, credit card receivables, auto loans, student loans and many other financial assets.

Bonds backed by home mortgages are commonly referred to as mortgage-backed securities (MBS), and bonds backed by non-mortgage-related financial assets are called asset-backed securities (ABS). Mortgage-backed securities played a central role in the financial crisis that began in 2007, wiping out trillions of dollars and shaking world financial markets.

Although there are important distinctions among the various types of mortgage- and asset-backed products, for the purposes of this article we will simply refer to all of these bonds as "securitized products." They are also grouped into an area known as structured finance in the investment banking community. (To learn more, check out "Profit From Mortgage Debt With MBS.")

The process of creating a securitized bond is straightforward. A financial institution (the "issuer") with assets it wishes to securitize sells the assets to a special-purpose vehicle (SPV). For legal purposes, the SPV is a separate entity from the financial institution, but the SPV exists only to purchase the financial institution's assets. By selling the assets to the SPV, the issuer receives cash and removes the assets from its balance sheet, providing the issuer with greater financial flexibility. The SPV issues bonds to finance the purchase of the assets; these bonds can be traded in the marketplace and are referred to as securitized products.

One key feature of securitized products is that they are usually issued in tranches. This means that the larger deal is broken down into smaller pieces, each of which has different investment characteristics. The existence of different tranches makes securitized products appealing to a wide range of investors, because each investor can choose the tranche that best combines his or her desire for yield, cash flow and safety.

(To learn more, check out "What Is a Tranche?" and "Behind the Scenes of Your Mortgage.")

There are several key benefits that securitization provides to market participants and the broader economy:

• Frees capital for lending: Securitization provides financial institutions with a mechanism for removing assets from their balance sheets, thereby increasing the pool of available capital that can be loaned out.
• Lowers the cost of capital: A corollary to the increased abundance of capital is that the rate required on loans is lower; lower interest rates promote increased economic growth. 
• Makes non-tradable assets tradable: This action increases liquidity in a variety of previously illiquid financial products.
• Spreads the ownership of risk: Pooling and distributing financial assets provides greater ability to diversify risk and provides investors with more choice as to how much risk to hold in their portfolios.
• Provides profits for financial intermediaries. Intermediaries benefit by keeping the profits from the spread, or difference, between the interest rate on the underlying assets and the rate paid on the securities that are issued.
• Creates an attractive asset class for investors. Purchasers of securitized products benefit from the fact that these products are often highly customizable and can offer a wide range of yields. 

(Learn more in "Understanding Structured Products.")

High Yield

Many securitized products offer relatively attractive yields. These high returns don't come for free though; compared to many other types of bonds, the timing of the cash flows from securitized products is relatively uncertain. This uncertainty is why investors demand higher returns.

Diversification

As one of the largest fixed-income security types, securitized products present fixed-income investors with an alternative to government, corporate or municipal bonds.

Safety

There are several methods that financial intermediaries use in order to issue bonds that are safer than the assets that back them. Most securitized products have investment-grade ratings.

Internal credit enhancement refers to safeguards that are built into the structure of the securitized product itself. Common forms of internal credit enhancement include subordination (where highly rated tranches receive cash flow priority over lower-rated tranches) and overcollateralization (where the amount of bonds issued by the SPV is less than the value of the assets backing the deal). The intended effect of any type of internal credit enhancement is that cash flow shortfalls due to losses in the value of the underlying assets do not affect the value of the safest tranches of bonds. This works well, given relatively low levels of losses, but the value of the protection is less certain if losses on the underlying assets are substantial.

External credit enhancement occurs when a third party provides an additional guarantee of payment for bondholders. Common forms of external credit enhancement include third-party bond insurance, letters of credit and corporate guarantees. The main drawback to external credit enhancement is that the additional protection is only as good as the party providing it. If the third-party guarantor experiences financial hardship, the value of its guarantee may be negligible, leaving the safety of the bonds dependent on the bonds' underlying fundamentals.

(Learn more about bond ratings in "What Does Investment Grade Mean?" and "Junk Bonds: Everything You Need to Know.")

As with many other areas of the fixed-income marketplace, the main participants in the securitized products market are institutional investors. There are several reasons for this, including large average transaction sizes, a lack of readily available pricing information and difficulty in properly valuing many securitized products. (Learn the rules that govern bond pricing in "Bond Market Pricing Conventions.")

Despite these challenges, many individuals invest in securitized products. Owners of diversified fixed-income mutual funds or exchange-traded funds often indirectly hold securitized products through their funds' holdings. Some individuals also choose to invest directly in securitized products.

Most brokerage firms offer an inventory of securitized products to select from. The best way to purchase securitized products from an inventory is to begin with an idea of the investment characteristics being sought (size, yield, safety, maturity, etc.). By starting this way, an investor is likely to find an appropriate securitized product that suits his or her needs and helps to build the investor's portfolio.

Because of the size and importance of the securitized products market, a basic understanding of securitized products will benefit even those investors who have no intention of investing directly in securitized products. For individuals intrigued by this sector, significant additional research should be conducted before contemplating an investment in this complicated slice of the fixed-income market.