Investors in whole mortgage notes are, in effect, the creditors for each note. Creditors are almost always made whole—no matter what happens to the debtor.

In contrast, when a corporation defaults on its bonds, the question becomes: “What am I left with if this security defaults?” With residential whole mortgage notes, the worst-case scenario is that you are left with the underlying properties.

That’s why, for many investors, asset-backed securities represent a more attractive alternative than investments in corporate debt.

Although a new asset class for investors, there are $2.5 trillion worth of residential whole mortgage notes available and plenty of lenders are willing to sell them at deep discounts—often in the 40% range. Sellers may range from the local credit union to large banks such as J.P. Morgan Chase, Citigroup and Wells Fargo. The largest banks are, of course, the biggest sellers.

Owning Real Assets
During tumultuous times, ownership of real assets becomes ever more important: This financial view is held by many of America’s leading pensions and endowments. Pensions and endowments have up to 50% of their portfolios in asset-backed securities, while the average investor may have as little as 5%.

Asset-backed securities enable depository institutions, finance companies and other corporations to raise cash by borrowing against assets. Assets such as credit cards, automobile loans and home equity loans are packaged as the collateral for intermediate-term securities and sold in public markets or as private placements. Other assets that have been securitized in this way include loans for mobile homes, pleasure boats and recreational vehicles—and residential whole mortgage notes.

Endowment managers and wealthy investors want to know, regardless of what happens in the market, that there is a hard asset behind their investments. This hard asset, whether it is gold, real estate or something else, is an indicator of the investment’s quality. An ABS can be collateralized by loans, leases, credit card debt, a company’s receivables, royalties and other assets.

Investments should also be viewed in the context of today’s economy. For more than five years, the Federal Reserve Board has been buying bonds through its quantitative easing program to keep interest rates low and help the housing market recover.

As the Fed unwinds its easing, interest rates are likely to rise and volatility is likely to increase. As the housing market and the broader economy improve, strategies for governments to exit these stimulus programs may renew short-term volatility.

To protect portfolios, it will become even more important for financial advisors and investors to diversify portfolios to withstand the potential shocks.

Financial advisor Gary Sherwold of G.W. Sherwold Associates says investments like residential whole mortgage notes could play the diversification role short-term U.S. government bonds occupied when interest rates were higher.

“The traditional non-correlation strategy of rebalancing a portfolio toward bonds during a cyclical equity downturn is not attractive with rates close to 0.0% in what many analysts say is the beginning of a rising rate environment,” he says. “[Asset-backed] strategies like whole mortgage note investments, on the other hand, give a portfolio a better chance at avoiding increased exposure to rising interest rates.”

Brian Gendreau, author of Cetera Financial Group’s 2013 Market Outlook, also sees residential whole mortgage notes as an alternative to bonds—especially given the improving housing market.

“If you can get a mortgage, then you can buy an appreciating asset,” he says. “Housing is going to continue to be a source of strength for the economy as a whole. … It’s a buyer’s market.  Residential whole mortgage notes are an attractive alternative to traditional bonds for today’s diversified portfolios.”

Given their non-correlation with stocks and bonds, income potential and other characteristics, whole mortgage residential notes can provide income and total return potential, regardless of how volatile the stock and bond markets become.

Gus Altuzarra is CEO and treasurer and Christopher Chase is president and secretary of the Vertical Fund Group (www.verticalus.com), which invests in whole mortgage notes. Altuzarra can be reached at [email protected]. Chase can be reached at [email protected].

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