Structured Fixed Income vs. Derivatives: The Key Differences
To provide clarity on what can be an alphabet soup of names (CMBS? VIX?), this blog post provides an overview of how Callan categorizes two types of investment vehicles: structured fixed income products and derivatives.
(Estimated reading time: 2 min 54 sec)
Structured fixed income products are created through a process called securitization. Typically established by the originator of the assets being securitized, a special purpose vehicle (SPV) is used to purchase a pool of cash flow-generating assets, such as residential or commercial mortgages, credit card receivables, bank loans, or equipment leases. The SPV finances these purchases by selling debt or equity interests in the pool, which are collateralized by the underlying assets.
The SPV is a separate legal entity established to insulate investors from the risk of bankruptcy of the originator. Securitization can create multiple layers of customized securities, ranging from the most senior, higher-rated, investment-grade tranches to the higher-risk, unrated equity, or accrual tranches. This segmentation attracts a broad scope of investors with varying levels of risk tolerance.
Given the complex nature of these securities, an investment manager should be well versed in reviewing the structure and servicer, as well as the underlying assets as part of its due diligence process.
These are the three most common classes of structured fixed income products:
- Residential mortgage-backed securities (RMBS) are pools of mortgages that provide investors with interest cash flows and returned principal from the underlying collateral.
- Commercial mortgage-backed securities (CMBS) consist of pools of commercial mortgage loans on income-producing properties, which include multifamily residences, office buildings, industrial properties, shopping centers, hotels, and health care facilities.
- Asset-backed securities (ABS) comprise pools of collateralized assets that are not mortgage loans, such as consumer debt like credit card receivables, auto loans, or student loans.
Conversely, derivatives are financial contracts that synthetically derive their notional value based on other proxies, such as the volatility of the S&P 500 Index (the famous VIX or “fear” index) or the yield on the 10-year Treasury note. Derivatives contracts are traded mainly on exchanges such as the Chicago Mercantile Exchange (CME), or over the counter (OTC) between dealers and participants. For exchange-traded contracts, profits or losses may be settled at the end of each trading day. For OTC trades, profits and losses may be reconciled on a schedule established at the contract’s initiation.
Unlike structured fixed income products, derivatives are not backed by underlying pools of assets, requiring a different skill-set when evaluating these instruments. The financial markets provide an array of contract types that introduce varying risks and mechanics to monitor, such as counter-party risk, liquidity risk, basis risk, and trade settlement. The skill-set, experience, and technology required to monitor a derivatives trade varies depending on the contract.
With derivatives, it is important to understand the difference between notional value (or notional exposure) and contract value. A notional value is calculated based on the specifics of each contract. For example, if an investor pays $10 for an options contract to buy a security for $100, the contract value is $10 and the notional value is $100.
Remember the old saying: “If it walks like a duck…”? Despite the similarity of its name to some of the structured fixed income investments, stripped mortgage-backed securities (SMBS) are considered derivative instruments and are available as interest-only and principal-only securities. SMBS are highly sensitive to changes in interest rate and prepayment speeds, allowing investors to establish synthetic positions on these types of risks. These derivative instruments can be used to hedge interest rate and prepayment risk exposures as well as speculate on the direction of these factors.