Why the ratings don’t always reflect the risk

Why the ratings don’t always reflect the risk

One of the key strategies that several Putnam fixed-income funds have successfully employed is the use of non-agency residential mortgage-backed securities (RMBS). As the name would imply, these securities are backed by residential mortgages and have been securitized not by a government agency — such as Fannie Mae or Freddie Mac — but by a private institution, such as a brokerage firm or bank.

The RMBS sector was at the center of the financial crisis. Housing prices dropped 30% from their peak, homeowner defaults spiked, and as a result there were significant downgrades of securities within the non-agency residential sector. What was once rated AAA now often garners a CCC rating, well below investment grade.

However, these events have created a tremendous opportunity for firms like Putnam, who have the ability to properly research these securities and are nimble enough to take advantage of them. When many RMBS were originally issued, they typically sold in the marketplace at par, or $100. Today, as a result of the downgrades and the fact that some institutional investors must sell securities once they fall below investment grade, we see these bonds trading in the range of $50 to $60.

When we invest in a non-agency RMBS at $50, our risk is relative to our investment, regardless of the credit rating. The rating may be below investment grade, but it represents the probability of the bond paying off at par. Since we didn’t buy at par — and aren’t investing in these securities with the expectation that they will return to par — we can afford to take an agnostic view of how rating agencies regard the security. In other words, a rating that determines a bond’s probability of returning to par is less relevant to our strategy. Meanwhile, the yield we receive from this kind of situation is exceptionally good because of the tremendous opportunity for security selection in a highly dislocated and inefficient market.

Our outlook on housing is currently negative, and we believe home prices are likely to continue to fall. But even if home prices drop 30% or more from today’s levels, we would still have an expectation of strong performance from our RMBS holdings, which provide very high cash flows relative to the investments we have made.

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