The Five Categories of Collateral

Published on Feb. 14, 2013

Given the complexity of investment vehicles today, it can be difficult for investors to know what actually backs their investments and what their rights to the collateral are. We composed this article to help our clients understand the types of collateral that ultimately stand behind their investments and how we leverage this knowledge to achieve broader diversification, better risk mitigation, and greater potential upside with their investments.

We believe that, despite the typical complexity that characterizes many types of investment structures, there are only five major categories of collateral that ultimately back just about every investment available: Real Estate, Commodities, Equipment, Companies (including intellectual property), and Government. We developed the chart below to help our clients understand these basic collateral types and how each type responds to major economic factors (such as inflation, deflation, interest rates, recessions, etc.). Though the collateral categories are supposed to be all-encompassing in their scope, the investments listed in the sections below are not intended to be comprehensive but rather representative of many of the major investments with which most investors would be familiar.

Tangible Favorable to Inflation / Finite Supply			Intangible Infinite Supply / Easily Traded
Real Estate Illiquid Reacts to Inflation/Interest Rates	Commodities Mostly Liquid Reacts to Inflation	Equipment Liquid	Companies Very Liquid	Government Very Liquid Highly Reactive to Interest Rates
Residential Commercial MBS CMBS REITs Funds	Oil and Gas Agriculture Precious Metals Industrial Metals Rare Earths Water	Construction Industrial Transportation Warehouse Office Military	Stocks ETFs Bonds ETNs Preferred Equity Annuities Leases Domains	Currencies Municipal Bonds T-Bonds TIPS Fannie/Freddie Ginnie Mae

Figure 1

The first three categories in Figure 1 generally contain tangible assets (that is, they describe physical objects that take up space in the world—e.g., property, oil and gas, tractors, etc.), and the latter two categories contain intangible assets, since they exist based only on the societal acceptance of, and reliance on, legal structure and contract law.

For example, a company is not physical—it does not take up any space (notwithstanding the paper on which it is declared to exist). It is regarded as an entity only in the minds of managers, employees, consumers, courts, government, etc. If you were to point to the headquarters of a company to suggest otherwise, you would be pointing back to real estate owned by that company—not the company itself.

The existence of the company is rooted in its legal standing as supported by the government and societal acceptance. The same goes for governments at all levels (sovereign, state, and municipal). Therefore, these last two categories contain intangible assets because they describe mental or legal constructs, not physical objects that occupy space.

So why does tangibility vs. intangibility matter?

The Impact of Macroeconomics on Collateral Types

Our investment philosophy compels us to consider the impact of macroeconomics on various investment categories (the forest) in addition to analyzing the particular investment itself (the trees) before making a specific investment recommendation. This distinction between tangible vs. intangible assets illustrates just one way in which our macroeconomic perspective can impact our investment decisions.

The effects that inflation or deflation exert on a particular investment are generally determined by the investment's "tangibility."  Tangibility, in an investment sense, refers not only to the physical nature of an investment but also to its finiteness. The finite nature of tangible assets can provide a store of value and can anchor buying power, especially in relation to the theoretical infinite nature of money (a.k.a. its susceptibility to inflation and devaluation since it is created by government fiat).

Thus, in an inflationary environment, tangible assets can hold their "buying power" by increasing in price in relation to a devalued currency. The opposite, of course, is also true in a deflationary environment. If we can surmise the general direction of the economy with regard to inflation vs. deflation (and sometimes, stagflation), and if we understand the distinction between categories of collateral and how they react to the various "flations," we will be able to position our investments to take advantage of the direction of markets accordingly.

The same case could be made with respect to the outsized effects interest rate fluctuations can have on the economy and primary collateral types (such as real estate, government bonds, corporate bonds, etc.). Reasonable positioning in front of a rising interest rate environment could be very profitable if one understands how the various collateral types will generally respond to such activity.

These are merely a couple of ways in which macroeconomic factors play a part in the valuation of particular collateral categories, and which clearly illustrate the benefit of understanding the impact of macroeconomic shifts on collateral types. Applied appropriately, this knowledge keeps us out of trouble and in position to benefit from potentially appreciating assets.

Becoming Truly Diversified

One of the greatest benefits of understanding the primary types of collateral is to help you seek true diversification across the categories. Portfolio diversification across the spectrum of collateral types provides investors with greater downside protection, multiple investment timelines (due to differing liquidity and cycles), and longer-term upside potential.

Many investors think that they are truly diversified because they have a portfolio of stocks, preferred equity, corporate bonds, and annuities. The reality, however, is that an investor with this investment profile is essentially overconcentrated in only one type of collateral. As illustrated by Figure 1 above, stocks, preferred equities, corporate bonds, and annuities are each ultimately backed by the collateral of companies. The different types of investment structure may seem to add a layer of diversification, but if the ultimate collateral is all the same, an investor has greatly limited his total potential diversification and increased downside risk considerably (since investments within the same collateral type tend to move together).

In addition to company collateral (stocks, corporate bonds, preferred equity, and annuities), many investors have a large concentration of cash, CDs, money market funds, or government bonds. While this may be a slight improvement from a collateral diversification standpoint (from just companies, to companies and government collateral), this still leaves an investor underserved by concentrating the investment portfolio in only two out of five available categories, and exclusively into intangible investments. This is especially troubling in an environment that may eventually create much higher inflation.

Value Investing and Collateral Cycles

Each category of collateral tends to move in long-term ("secular") cycles. Though, in rare cases, several categories move in tandem (Companies, Real Estate, and Equipment in the recent Great Recession), separate collateral types are generally not directly correlated in their valuation cycles. Thus, a robust value-investment approach will move capital, not only from investments and investment types within collateral types, but also from one type of collateral to another as various investments and collateral types move throughout their valuation cycles.

Collateral Overlap

Please note that these collateral categories are intended to provide a general guideline for which types of collateral are likely backing your various investments. There can obviously be a significant amount of overlap among categories of collateral. For example, certain stocks might be backed by companies that are ultimately backed by real estate (e.g., Real Estate Investment Trusts—a.k.a. "REITs" ). A structure like this can provide investors with some of the benefits of stock ownership (greater potential liquidity) while at the same time providing the income and value of investment real estate.

Alternatively, an investment in real estate can ultimately be backed or valued by the credit of a company that is operating and leasing the real estate on a long-term basis. The strength (or lack thereof) of an investment grade credit tenant with a long-term lease could stabilize the value of a particular property despite an otherwise-poor real estate market. Net-leased real estate most typically carries this dual collateralization between real estate and companies, offering a combination of benefits between the two collateral types.

These are just a couple of examples of the cross-collateralization that can exist between the primary categories. The possibilities of collateral overlap can be fairly extensive and rather complex. However, with diligent research and an understanding of the legal investment structure of most investments, you can typically get to the bottom of what ultimately backs your investment.

Practical Application

Take the time to thoroughly review your entire investment portfolio. Categorize each individual investment or related group of investments by the respective collateral types that back the investment(s). Total each category to gain insight on how diversified your portfolio is by collateral type. From this point, you can total your tangible vs. intangible assets to get a sense of how your overall portfolio might react to inflation or deflation. Group all of the investments together that pay interest or that employ leverage or financing of some sort to see how interest rate fluctuations might impact your portfolio. You can also organize your investments by where they fit in the "capital stack" to see how much cushion you have against recessions and other major economic shocks. These are just a few of the primary methods we employ when reviewing clients' investment portfolios.

Knowing the actual collateral types backing your investments will promote diversification by helping you avoid overconcentration in any one category. Collateral diversification will facilitate strategic positioning to take advantage of or protect your investments from macroeconomic shifts such as inflation, rising interest rates, recessions, etc. Finally, since separate collateral types tend to move through unique cycles, you will be able to implement a value investing approach to benefit from the cycle lows, which decreases your downside risk and increases your long-term upside potential.