- The non-agency MBS market has evolved over the past few years with new sectors offering attractive investment opportunities.
- Non-agency MBS have attractive fundamentals as consumers benefit from a stronger dollar and lower energy prices.
- Flexible strategies with disciplined credit selection can help take advantage of the evolving non-agency RMBS investment landscape.
The recent collapse in energy and commodities prices has roiled the investment-grade and high-yield markets; it has also provided a fundamental tailwind for residential mortgage borrowers. The combination of a stronger dollar and lower energy costs benefits the consumer, improving their discretionary income. The residential mortgage market directly benefits from the tailwinds of an improving consumer balance sheet. In aggregate, non-agency residential mortgage-backed securities (RMBS) do not represent a major part of the fixed-income market, but the recent issuance growth offers an attractive investment opportunity. Furthermore, important for portfolio construction, these investments have exhibited a very low correlation to other credit sectors (investment grade/bank loans/high yield) and, therefore, provide attractive risk attributes within a broadly diversified investment portfolio.
Exhibit 1: Correlation of trailing 3-year returns by fixed-income asset class
Source: Bank of America, as of December 31, 2015
Prior to the global financial crisis (GFC), the non-agency MBS market was an integral segment of the mortgage market, efficiently providing homeowners access to capital for the purpose of purchasing a house. Unfortunately, the combination of weak lending standards and excessive leverage, both on behalf of borrowers and investors, led to the downturn in housing which also happened to be the primary cause of the GFC. Following the crisis, mortgage lending standards tightened so dramatically that there was effectively no access to mortgage credit unless it was guaranteed by the government through Fannie Mae, Freddie Mac or Ginnie Mae. The non-agency securitization market no longer existed. Many layers of regulation and reform have since created an environment that has significantly restricted the flow of capital to the residential securitization markets. It has taken a while for the markets to adapt, but thankfully, six years after the GFC, capital markets are finally starting to thaw, and private mortgage credit is once again being provided to the residential mortgage market. This has created attractive opportunities for MBS investors. Specifically, three new sectors have been created to help finance emerging segments of the mortgage market:
Government-Sponsored Enterprises (GSEs) Credit Risk Transfer – Fannie Mae and Freddie Mac offer very competitive mortgage rates because the U.S. government inherently guarantees principal repayment to investors; however, this exposes the U.S. government to potentially large losses as seen in the GFC. At the direction of the FHFA, a housing regulator that oversees the GSEs, Fannie Mae and Freddie Mac were required to reduce their exposure to the underlying mortgage loans they guarantee by selling some of the risk. Credit risk transfer securitizations allow Fannie and Freddie to transfer the risk of those losses to institutional investors by selling a risk profile that mimics a securitization of GSE originated mortgages.
Non-Performing Loans/Re-Performing Loans (NPL/RPL) – These loans consist of mortgages that became delinquent during the GFC. The majority of these loans were held by banks or with the GSEs but have been sold off to investors such as hedge funds, REITs or private equity firms. These investors have looked to the securitization market to provide term financing for their investments. The bonds backed by the NPL/RPL loans have predominately not been rated by rating agencies but offer very attractive yields and a short average life.
Single-Family Rental – Large quantities of homes (foreclosed/delinquent borrowers) were purchased at distressed prices during the crisis by institutional investors for the purpose of renting the individual homes. In total over 100,000 single family properties are currently managed by these institutional investors. The entities that manage these investments have utilized the securitization markets to structure long-term financing for these properties, with bonds rated from AAA down to BB, based on investor risk preference.
Exhibit 2: Non-agency issuance by sector, 2011-2015
Source: Citi, as of December 31, 2015
These new types of securitizations within the non-agency mortgage market offer attractive risk-adjusted return opportunities. They benefit from favorable fundamentals and the lack of correlation to the broader fixed-income market, providing diversification without sacrificing returns. Flexible investment strategies with disciplined credit selection based on strong fundamental analysis will be best suited to take advantage of the evolving non-agency RMBS investment landscape.
© Columbia Threadneedle Investments
© Columbia Threadneedle Investments
