28 May 2020
As the world enters a Covid-19 induced recession, GAM Investments’ Tom Mansley believes senior, residential non-agency mortgage-backed securities (MBS) continue to offer investors a potential long-term opportunity.
The massive fiscal and monetary response in the US to fight the economic impacts of Covid-19 has propped up many fixed income markets, such as corporate bonds and agency MBS – securities guaranteed by governmental agencies such as Ginnie Mae, Fannie Mae or Freddie Mac. No such relief, however, has appeared for the non-agency MBS market, causing the asset class’s recovery to lag relative to other fixed income sectors to date. That said, our long standing preference for senior bonds in the non-agency residential MBS market was based on preparation for an economic slowdown or recession and, now that the economy has entered that state, our preference for senior bonds is as strong as ever.
Why senior matters
Cash flows from the underlying mortgages in a pool are used to pay security holders from the top (senior bonds) to the bottom (subordinate bonds). In the event of default, subordinated bond holders will absorb losses first, meaning senior bondholders are more likely to receive the majority of their investment back, and may not suffer any losses. Although we expect the US housing market to perform relatively well for the foreseeable future, unemployment rates are headed for multi-decade highs. Consequently, we expect mortgage defaults and losses on underlying loans to increase from current very low levels. As a result, in the residential mortgage market, we continue to favour senior non-agency residential MBS issued prior to the 2008 crisis. In this sector, home prices have increased and the underlying mortgages have amortised, resulting in low home price adjusted loan-to-values that leave a significant credit cushion in a recession scenario.
Residential versus commercial
Prior to the pandemic, global growth was slowing in many major economies. However, at the same time the housing and mortgage markets in the US were relatively solid. Mortgages are a long-term financing of a long-term asset and credit quality is very high. Regarding the short-term effects, the experiences of the 2008 housing crisis mean we now have very well tested procedures in the US for dealing with temporary delinquencies for borrowers, such as loan modifications, forbearance and the recapitalisation of delinquent interest payments. Meanwhile, since 2008, homeowners have de-levered and rolled back the clock 20 years in terms of debt-to-income ratios, see Chart 1. Payments (as shown by debt service ratios) are also at record lows, meaning the consumer is going into a recession scenario with a very strong balance sheet.
Chart 1: Debt Service Ratio and Debt to Income Ratio
Unlike homeowners, the corporate world has levered up with many businesses increasing debt for share buybacks, for example. Prices of commercial mortgage-backed securities (CMBS), typically backed by large retail shopping malls, hotels and office buildings continue to lag due to a lack of clarity regarding the timing of the lifting of lockdowns and major changes in consumer behaviour that are likely to persist. We therefore believe the fundamentals of the US consumer credit and real estate sectors are generally stronger than those of the corporate sectors and expect consumer credit to outperform corporate credit.
The outlook for markets remains extremely uncertain at present. The world is experiencing its worst recession in decades. However, it is important to note that the current situation is different from the global financial crisis (GFC). In 2008, the credit in the consumer and housing sectors was poor and large actual credit losses were taken. We believe this situation is different because, while there will be some losses due to the current crisis, the very large magnitude of the market price swings are primarily driven by liquidity rather than the impact of deteriorating consumer credit. In 2008, the crisis was caused by bad credit. We feel that this crisis is primarily caused by illiquidity that the Federal Reserve, Treasury and Congress are all trying to fix. Ultimately we believe senior bonds in the non-agency residential MBS market look set to weather the recession and, at current prices, may offer significant value.
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice.