The risks that are inherent in one type of lending, may not be applicable to others.
In terms of duration, MICs are not very sensitive to rates because
they generally invest in 6-24 month mortgages. Additionally, most
MICs are made up of non-traditional debt with rates that far exceed
the banks’ posted mortgage rates. For this reason, they are less
sensitive to change in market levels of rates.
Most MICs are heavily exposed to credit. To call it subprime is a
bit too simplistic, but their borrowers need flexibility for many
reasons, including that they have bad credit, and do not conform to
the standard CMHC insured loan in Canada (where it applies to
residential mortgages). With many different credit profiles, varying
income qualities, debt obligations, high leverage, immediate closing time required, or lack of income or asset verification, MICs can
be particularly susceptible to a weakening economy or property
market, as well as potentially fraudulent applicants.
Perhaps the most important consideration for MIC investors is
liquidity. Aside from the few publicly traded MICs, where liquidity
is found from other investors in secondary trades, MICs differ in
their redemption policies, from daily to annually. Because MICs
are required to pay out all of their income, an investor’s demand
for liquidity must be met with one of: a) cash on hand, b) new
investor money, c) a temporary debt facility, or d) portfolio maturities. Defaults may complicate the liquidity situation for a MIC. If
one mortgage goes into default, and the MIC ends up owning the
secured asset, it could take months or years to sell the property,
tying up the capital unproductively in the meantime. Any losses
would need to be absorbed by cash flows on the rest of the portfolio – reducing the available income to distribute to investors. Our
primary concern is that this reduction would cause investors to want
to redeem – which would not be possible without worsening the
situation. Should the defaults become systemic as happens in bear
markets, this could be problematic.
Finally, we would note that the fee structure of MICs vary widely.
Virtually all have a fee on assets, some have performance bonuses
for meeting/exceeding benchmark returns. Also, given the variety
of income sources, one must pay attention to what income the
investor is entitled. Some pay out only interest to investors, keeping other fees such as closing, early payment, NSF, or renewal fees
for the managers.
• MICs offer high current income, but their liquidity profile is
worrisome. Given the current situation of high property prices
and high household leverage ratios in Canada, we see them as
being particularly risky.
• Only look for MICs with the highest levels of underwriting
diligence, geographic diversification, and a high proportion of
first mortgages. Quality workout teams are a must.
• Being a new offering, (and in a bull market), fee structures vary
• Combining structural and liquidity characteristics, even a
minor “rush to the exits” could prove damaging in the MIC
• We have little history to go on in terms of portfolio diversifi-
cation, since MICs are a relatively new asset class and have
largely not been tested through a cycle.
• MICs are not a good replacement for classic fixed income, and
especially poor as a place to “park cash”
• There are many varieties of structured notes, with returns that
are linked to various underlying, including bonds, equities and
• Only Principal Protected notes should be considered true fixed
• When built correctly, structured notes can be a useful part of a
Structured notes come in all shapes and sizes, but the only one
considered as a true alternative to fixed income is the principal
protected note (PPN). A PPN is a debt obligation with a promise
to repay 100% of capital at maturity along with an agreed upon
payoff profile. PPNs are effectively created when a strip bond is
purchased at present value and the difference between the present
value and maturity value (par) is used to buy call options on a
specific underlying, or in some cases generate a fixed coupon. The
primary factors in determining the initial price of a PPN is the level
of interest rates at which the strip bond is sold, and the volatility of
the options being purchased.
As with any debt obligation or bond, there is interest rate sensitivity as it relates to the present value and term of the note. As such,
any interest rate movements can temporarily affect the market price
of the note on a daily basis, with the range of volatility primarily
attributable to the term of the note.
Structured notes are effectively a debt obligation of the issuing
bank. Therefore, as with traditional plain vanilla bonds, the credit
quality of the issuer will determine the likelihood of principal
repayment at maturity. The guarantee of principal repayment is
only as good as the bank providing the guarantee.
Although PPNs are designed to be held until maturity, clients may
want to sell their notes before then. While a daily secondary market
usually exists, there can be times when the credit and complexity
of structured notes can cause the liquidity to dry up. Investors won’t
be given notification of this. There is little secondary trading as