26 September 2018
Mortgage-backed securities (MBS) make up almost a quarter of the US fixed income market; they offer a less volatile source of returns and are seeing increased levels of issuance.
While many investors will already be familiar with mortgage-backed securities (MBS), there are some particular aspects of the US market which could make it an asset class with appeal to non-US investors seeking to establish a truly diversified global fixed income portfolio.
An MBS is an instrument which is backed by a large pool of mortgages whereby the investor is entitled to the cash flows associated with those underlying mortgages; each pool can include individual mortgages on either residential or commercial properties.
There are two main groups of MBS: ‘agency’ and ‘non-agency’. The former are guaranteed or insured by a government agency, and are therefore more secure but offer lower rates of return. The latter are issued by private institutions, are privately insured or not insured at all, and are therefore subject to credit risk, but may potentially deliver significantly greater rewards.
While the MBS market played a central role in the global financial crisis (GFC), the asset class has evolved considerably during the decade or so since, which has seen the issuance of a range of different instruments. Non-qualifying mortgages is an area in which the number of opportunities has increased; the developed market definition is loans made to borrowers whose financial and / or property profiles fall outside conventional guidelines in regards to characteristics such as loan size, and debt to income ratio or loan to value ratio. In addition, a whole specialist area in troubled loans has emerged, such as re-performing loans, where the borrower has been delinquent by at least 90 days but has resumed making payments.
It may be surprising to find that MBS is actually the second largest segment of the US bond market after treasuries, accounting for almost a quarter of the US fixed income market. In our view, there are a number of reasons why an investor may wish to buy US MBS. With mortgages accounting for such a sizeable part of the US bond market it is difficult to have a representative exposure to this market without including mortgages. MBS can offer significantly higher yields than treasuries with similar maturities; this includes higher-quality agency, as well as non-agency, issuance. One reason for this enhanced yield is the risk of prepayment and the associated reinvestment risk that comes with MBS. In the case of Ginnie Mae, and arguably both Freddie Mac and Fannie Mae, this enhanced yield comes with little or no additional credit risk. The combination of high credit quality, large size and a diverse range of investors mean the US MBS market is generally highly liquid.
Chart 1: US mortgage-related securities outstanding
in USD billions
CMBS = Commercial MBS, RMBS = Residential MBS.
Past performance is not an indicator of future performance and current or future trends
Before the boom in sub-prime lending in the early stages of the new millennium, we were comfortable with the concept of judiciously absorbing credit risk in return for the higher yields associated with it. However, sub-prime proliferated incredibly quickly because so many parties had vested interests in its expansion. Government officials used policy tools to gain popularity by promoting home ownership, mortgage originators and investment banks collected large fees, investors overlooked credit standards in exchange for yields that could be levered into high returns on equity, and so on.
As it became clear to us that credit risk was becoming increasingly mispriced, we changed our focus to the agency side of the market which offered a different set of opportunities, by taking mortgage prepayment risk and interest rate risk, but not credit risk. After the subprime bubble burst in 2008, and all appetite for credit risk diminished sharply, we were able to benefit from investing where the fundamental dislocations were greatest.
While we felt bad about the unfortunate losses suffered by others, we did what any judicious and specialist investor would have done in the circumstances. With the MBS arena in total disarray, this proved a very auspicious time to re-engage in the non-agency segment of the market.
Almost inevitably, the subprime crisis ultimately served as the harshest form of quality control. Since then, only those individuals with the highest credit ratings are able to obtain mortgages. Additionally, the number of new houses being built is still below the long-term average, meaning that both house prices and mortgage collateral are increasing in value and credit quality is very high.
With the mortgage and housing markets well supported, this is an ideal time to take on mortgage credit risk. As we demonstrated in 2007, our investment approach is naturally conservative. Consequently, we tend to invest in securities that are high in the capital structure where we typically harvest robust and stable returns with low volatility and a sound risk / reward trade off.
The MBS market offers the flexibility to take advantage of opportunities in both agency and non-agency MBS as conditions change. Consequently, investors do not have to figure out whether there are better risk-adjusted rewards to be garnered from taking on credit (non-agency) or prepayment (agency) risk – those decisions can be made for them.
The size of the market of legacy non-agency MBS issued prior to the GFC is still shrinking, and is now less than USD 500 billion. New issues have not quite reached enough size to compensate for paydowns of legacy non-agency assets, so at the moment the non-agency market overall is still shrinking. However we believe the long-term outlook is a positive one overall.
Spreads on the good quality instruments we typically look at are tighter than they were a year ago, but remain attractive relative to other parts of the fixed income market, such as high yield corporate bonds where spreads have tightened substantially.
We favour floating rate, or otherwise short duration, issuance so as not to be subject to changes in long-term rates. The MBS index, however, is comprised primarily of fixed rate securities, which have longer duration and which do fluctuate in value as long rates change. This is one of the ways we differentiate our strategy from others.
The majority of our non-agency exposure is on the residential side as the fundamentals for the US housing market keep getting stronger. In our view, their credit worthiness is strong – there is a shortage of inventory in many markets, causing house prices to rise above the rate of inflation. The home ownership rate in the US has fallen from 69% to 64% since the GFC, but people are now finding the down payments they need in order to buy housing once more. Even so, the housing market is generally more affordable today than it was before 2000 based on the ratio of income to the cost of servicing a mortgage.
That said, housing markets in some US cities have become relatively expensive, in particular areas such as Manhattan and San Francisco. We expect they will cool off; indeed this is something they need to do. Meanwhile, for much of the country, inventories and house prices are in line with the long-term trend.
Chart 2: Roles of different types of securities in an MBS portfolio
Allocations and holdings are subject to change. For illustrative purposes only.
New regulations and tighter lending standards have improved mortgage credit quality in the wake of Fannie Mae and Freddie Mac’s well publicised travails in the lead up to and during the GFC, which stemmed primarily from their holding of lower quality mortgages. Consequently, the underwriting criteria for US agency residential mortgages remain fairly tight, although they have been loosened to some extent to help first-time buyers. Non-agency underwriting criteria are also tight, and the amount of capital required by banks to hold them is significantly more than for agency. As a result, defaults on mortgages originated since 2008 are low, which is a positive for investors such as ourselves.
From the standpoint of both lenders and investors, we believe the market is as good as it has been for some time. We still see good value in the MBS market and our holdings are relatively small compared to the overall size of our investable universe. We will continue to monitor new issuance with great interest, and the primary market has some promising opportunities.
Therefore, relative to the rest of the fixed income market, MBS continues to look appealing, particularly given the lower volatility than many of the other fixed income markets.
Important legal information
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 not an indicator of future performance and current or future trends.
Investments in the product mentioned in this material are speculative and involve a high degree of risk. An investor should not make an investment unless the investor is prepared to lose all or a substantial portion of the investment. The fees and expenses charged in connection with this product may be higher than the fees and expenses of other investment alternatives and may offset profits. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, their value may fluctuate in response to the market’s perception of issuer creditworthiness; while generally supported by some form of government or private guarantee there is no assurance that private guarantors will meet their obligations. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested.