Finding Value in Structured Assets
The portfolio managers of Calvert Short Duration Income Fund and Calvert Ultra-Short Income Fund look for total return potential in CMBS and ABS.
By Eric Elg, Portfolio Manager, Calvert Investment Management, Inc. and Vishal Khanduja, CFA, Portfolio Manager, Calvert Investment Management, Inc.
The portfolio management team of Calvert Short Duration Income Fund and Calvert Ultra-Short Income Fund continually seeks relative value opportunities across fixed-income asset classes with the goal of including the securities that offer better potential for total return with similar or lower risk relative to the Funds' passive benchmark indices. This asset class scrutiny includes certain types of bonds, such as commercial mortgage-backed securities (CMBS) and asset-backed securities (ABS), that are not included in the Funds' passive benchmarks. After making relative value judgments by asset class, the portfolio managers then collaborate closely with Calvert's team of taxable fixed-income credit analysts to examine the structure and collateral of individual CMBS and ABS issues and select bonds to add to the portfolios.
At times since 2008, the Funds' portfolio managers have periodically maintained allocations to CMBS and ABS. These asset classes sometimes can offer more risk-adjusted relative value than other types of bonds, such as corporate debt or Treasury securities, or can help add yield without significantly increasing the credit risk or interest rate risk of the Funds.
General CMBS Structure
In a typical CMBS structure, many individual commercial mortgage loans of varying size, property type, and location are pooled and transferred to a trust. The trust issues a series of bonds that may vary in yield, duration,1 and payment priority, with "senior" bonds receiving priority over "subordinate." Each month the interest received from all of the pooled loans is paid to the bondholders, starting with those investors holding the highest-rated bonds, until all accrued interest on those bonds is paid. Then interest is paid to the holders of the next-highest-rated bonds, and so on. The same occurs with principal as payments are received. The most senior bond in a CMBS transaction will get the first priority on the monthly interest and principal that the mortgage pool generates, and it will be the last to take any losses.
ABS and Other Structured Products
ABS represent a broader class of securities that actually encompass CMBS. In an ABS deal, the cash flows come from any one of a wide range of forms of underlying collateral—credit card receivables, auto loans, student loans, or mortgages, for example—which are the source for the interest and principal payments to bondholders. As in the CMBS structure, an ABS issuer forms a trust and issues bonds with cash flows allocated so that senior tranches (or levels of payment priority) receive interest or principal payments before the subordinated tranches. If there is a shortfall in cash flows, the subordinated tranches are the first to take losses. ABS can have either fixed or floating interest rates.
In an even broader sense, fixed-income market participants consider ABS and CMBS to be "structured assets" or "structured products." Securities in this asset class, which also includes residential mortgage-backed securities, feature principal and interest cash flows that reach different tranches according to a predetermined priority structure.
CMBS Attractive After Financial Crisis
Calvert Investment Management, Inc. was among the early fixed-income fund managers to add short-maturity CMBS to its short-term bond funds following the credit crisis of 2008 to 2009. As investors rushed to shed relatively risky assets during the financial crisis, many CMBS were being priced to reflect a probability of default that was unrealistically high. Our portfolio managers believed that this was an opportunity to apply their rigorous security selection process to add fundamentally sound assets at attractive yield spreads.2 The portfolio managers collaborated closely with the credit analysts to select and purchase CMBS that were well-structured and backed by well-underwritten collateral. These bonds offered an opportunity to add attractive risk-adjusted yield and total return potential to Calvert Ultra-Short Income Fund and Calvert Short Duration Income Fund without taking on significant additional credit risk.
By mid-2012, many fixed-income investors had moved into CMBS, pushing their yield spreads down to levels that the Funds' portfolio managers thought were generally unattractive relative to other asset classes such as corporate bonds with similar maturities and risk profiles. The portfolio managers also currently see significant prepayment risk (the risk that the borrowers on the underlying collateral will repay the principal on the loans more quickly than anticipated, which causes bondholders to lose future interest payments) in CMBS issues. As a result, our portfolio managers tactically reduced the size of the CMBS allocations in both Funds in the second half of 2012, although both portfolios still hold some CMBS.
As of December 31, 2012, structured assets (including ABS, CMBS, and some residential mortgage-backed securities) accounted for 8.3% of the net assets of Calvert Short Duration Income Fund and 13.8% of Calvert Ultra-Short Income Fund.
Structured Assets Start 2013 Strong
Looking forward, 2013 has started off strongly for structured products—yield spreads for the CMBS and broad ABS sectors have compressed even with healthy new and secondary supply in the market. At the current level of dollar prices and yield spreads, the Funds' portfolio managers do not think that short-term CMBS in general are particularly attractive investments for the funds. Given the current market levels, the portfolio managers have become extremely selective in maintaining or adding to the Funds' allocations to structured assets in general. However, they are finding relative value in some more-esoteric ABS and CMBS sectors. In ABS, the portfolio managers and credit analysts are evaluating securities backed by vacation timeshare financing, car dealer inventory loans, and rental car financing, for example. In CMBS, they are finding relative value opportunities in single-asset securitizations.
Single-asset (or single-borrower) CMBS are backed by more concentrated commercial mortgages than in the typical CMBS structure. The collateral for single-asset CMBS can be the cash flows from a mortgage on only one large commercial property or mortgages on a specific hotel or restaurant chain's properties.
Many single-asset CMBS issues offer yields comparable to corporate bonds but have higher credit quality and significant price appreciation potential. Most single-borrower CMBS stand to perform well as the economy improves. As a result of their less diversified collateral, single-asset CMBS tend to have more concentrated credit risk than typical CMBS issues backed by a wider range of commercial mortgages. However, our credit analysts have the expertise and tools needed to analyze the credit quality of single-asset CMBS collateral and structures.
1. Duration measures a portfolio's sensitivity to changes in interest rates. Generally, the longer the duration, the greater the change in value in response to a given change in interest rates.
2. Yield spreads measure the difference in yield between a non-Treasury bond and a Treasury security with a comparable maturity.
Investment in mutual funds involves risk, including possible loss of principal invested. Though each Fund strives to limit interest rate risk, changes in interest rates can adversely affect the value of an investor's securities. When interest rates rise, the value of fixed-income securities will generally fall. To the extent that a Fund holds corporate bonds and/or bank loans, it is subject to credit risk, including credit downgrades and issuer default risk. Mortgage-backed securities are also subject to the risk that issuers will prepay the principal more quickly or more slowly than expected, which could cause a Fund to invest the proceeds in less attractive investments or increase the volatility of their prices. To the extent mortgage-backed securities held by a Fund are subordinated to other interests in the same mortgage or asset pool, the likelihood of the Fund receiving payments of principal or interest may be substantially limited. Because a significant portion of securities held by Calvert Ultra-Short Income Fund may have variable or floating interest rates, the amount of the Fund's monthly distributions to shareholders are expected to vary with fluctuations in market interest rates. Generally, when market interest rates fall, the amount of the distributions to shareholders will likewise decrease. Each Fund is non-diversified and may be more volatile than a diversified fund. There is also a risk that the Funds' portfolio management practices may not achieve the desired result.