Advisers should tread carefully in subprime market

Arecent rally in subprime-mortgage-backed bonds, which were widely reviled as being among the root causes of the financial crisis, should definitely be considered in a larger context.

One thing that the latest news shouldn’t do is drive financial advisers to run out and try to load up on subprime debt.

For starters, the 17% rally so far this year by one proxy of triple-A subprime loans says more about liquidity within this particular market than anything else.

“We’re of the opinion that a lot of these subprime bonds are cheap, but in terms of price action right now, liquidity is dominating the fundamentals,” said Peter Freitag, a principal at Prudential Fixed Income, which manages $270 billion in fixed-income assets.

The subprime market was similarly liquid at the start of last year, but the liquidity largely dried up during the second half, driving the benchmark performance down, he said.

The performance of a broad category of the highest-rated subprime debt reached a post-crisis high in mid-February 2011, but then gradually declined by 38% over the next eight months, according to a tracking index developed by Markit Group Ltd.

HIGHER YIELDS

“The first thing driving the performance now is that investors are taking on more credit and liquidity risk,” Mr. Freitag said.

That risk is translating to yields averaging around 8%, which compares with 2% for the 10-year Treasury.

In most respects, the $1.1 trillion subprime-debt market remains an institutional space. Morningstar Inc. doesn’t specifically track subprime bonds as part of its fixed-income mutual fund analysis.

But even within the institutional community, the subprime market isn’t for everyone.

Some investors are prohibited from investing in subprime by mandate and, as Mr. Freitag pointed out, others simply are not going to touch anything associated with the word subprime.

“They might not have the right kind of analysts, or they might avoid it just because it is called subprime,” he said.

Even considering the impressive yields, the subprime-debt market still is an area in which most advisers and retail-class investors should tread lightly, if at all.

“These are the types of investments that lure investors seeking yield, but this is not where grandma should put her safe money,” said J. Brent Burns, president of Asset Dedication LLC, which builds fixed-income separate accounts.

“Sure, nominal yields look pretty good, and if nothing happens in the markets to send these things spinning, the investor may whistle past the graveyard,” he said. “But when the markets deteriorate, investors will look back and realize they were not paid for the risk.”

Adviser Steve Lugar, managing director at Beaird Harris Wealth Management Inc., has a similar perspective with regard to fixed-income risk.

“We believe that at various times, people have been led astray by chasing yield,” he said. “That’s why we prefer to take the risk on the equity side of the portfolio.”

Of course, this doesn’t mean we can’t glean something worthwhile from the latest subprime-bond rally.

“A lot of the interest in these bonds suggests people feel the economy is improving and the worst troubles are behind us,” said David Sherman, manager of the RiverPark Short Term High Yield Fund (RPHIX).

“You’re still taking on individual consumer credit risk, but the general view seems to be that those people still paying their mortgage will continue to pay,” he said.

The “seasoned portfolio” theory also works for Mr. Freitag, who said that even under the worst-case-scenario calculations, subprime bonds still look attractive.

“We think the space is somewhat unique right now,” he said. “Even in scenarios that are worse than what you think will happen, the yields are attractive, and that’s unusual in the fixed-income space.”

Questions, observations, stock tips? E-mail Jeff Benjamin at [email protected]

Related Topics: Mortgage Backed Bonds