GAM Investments’ Tom Mansley provides an update on the strength of the US housing market and discusses why certain metrics, such as housing affordability, availability and debt servicing levels, continue to be supportive for investors in the US residential mortgage-backed securities (MBS) market.
The world is in a Covid-19-induced recession, but relative to the recession of 2008 / 2009, there is a crucial difference: the bulk of non-agency bonds in the prior recession had poor credit quality. Since then, non-agency bonds have been backed primarily by higher-quality loans and have been properly structured and priced for the credit exposure. Going into the current recession, therefore, our view was that senior non-agency bonds in the residential MBS market presented the greatest opportunity; as expected, senior bonds performed well from a credit standpoint. However, they did experience volatile price movements due to the liquidity crisis caused by the pandemic.
One consequence of the recent environment has been an increase in demand for single-family housing in the US. This has resulted in an increase in the rate of price appreciation of the assets collateralising MBS, leading to an improvement in their creditworthiness. This has demonstrated to us that bonds high in the capital structure are capable of withstanding recessions.
Household debt servicing
Prudent consumer behavior has also led to a reduction in the amount of household debt compared to income. The ratio of household debt to disposable income has been declining since 2007 and is now at levels last seen prior to 2000. Combining lower debt levels with lower interest rates has resulted in the interest payments that US consumers make as a portion of their income (the household debt service ratio) dropping to the lowest levels seen since the Federal Reserve (Fed) began accumulating the data in 1982, as shown in Chart 1. As a result, on average, it is relatively easy for homeowners to continue paying the interest on their debt.
Chart 1: Debt service ratio and debt to income ratio
The unemployment rate in the US was circa 6% at the end of Q1 2021. While this is higher than the pre-Covid-19 level of 3.5%, that level represented a 50-year low. When examining Chart 2 below, note that 6% is close to the long-term average unemployment rate in the US. Furthermore, the additional unemployment benefits from the Covid-19 relief packages provide a substantial replacement income for the unemployed population. Combined with the low levels of household debt, US consumers, on average, can comfortably make the payments on their mortgages.
Chart 2: US unemployment rate
On top of the strong consumer credit, homes remain affordable. The Housing Affordability Index, which compares the median household income with the cost of a mortgage on a median-priced house, was stable prior to 2005, but in 2006, housing started to become relatively expensive as house prices escalated based on speculative buying. The recession of 2008 / 2009 put a stop to that, causing prices to slump and interest rates to decline, resulting in the index rising to record levels of affordability by 2011. That was needed at the time, since there was an excess of houses on the market that needed to clear. Since then, even though house prices have increased, interest rates have remained low and income has grown, resulting in the affordability of houses remaining significantly higher than the pre-2005 average. Therefore, despite recent price rises, housing remains affordable.
The percentage of owner-occupied homes that are vacant is lower than it has been since 1980. Houses become vacant when people die or move. The current paucity of vacant homes reflects the fact that there is a shortage of homes for people to move into, plus the fact that houses have sold quickly when put on the market. Since 2008, household construction has not kept up with demand. As result, there has been a recent shortage of housing for sale, demonstrated in the low vacancy levels shown in Chart 3.
Chart 3: Homeowner vacancy rates in the US
Owners versus renters
Prior to 2005, more new households purchased homes rather than rented. From 2005 to 2015, that trend reversed with rental growth outpacing purchases as millennials delayed buying homes; the trend shifted again in 2015 and home purchases have again been growing at a faster pace. By looking at the change in home ownership since 2005 by age group, it becomes clear that the largest increase is coming from people under 35 years of age. The millennials are indeed purchasing homes, which is a source of strong demand.
Inventory of houses for sale
Historically, the housing market is balanced when there is a four to five-month supply of houses for sale. Immediately prior to the recession of 2008 / 2009, the supply of houses for sale rose to a record high of 12 months of supply. Thereafter, with the reduced construction of new homes, the supply of houses for sale dropped, reaching a ‘normal’ level by 2016. Subsequently, the level has continued to fall and is now at a record low of about only two months of supply. While millennials had already started buying homes approximately five years ago, the Covid-19 pandemic accelerated the trend of younger families moving to suburban housing. This coincides with a change in working habits for many people from being primarily office to more home-based working. While we expect the housing market to eventually return to a more normal balance of supply and demand, the high demand and low supply should support home prices for a long time.
Outlook for MBS
With the recent accommodative monetary policy and massive government stimulus spending, markets are currently concerned about potential inflation. Should an inflationary market environment take hold, we expect rising interest rates and rising real asset prices will be one of the results. From an MBS perspective, though, we have little concern over the impact of inflation. When real asset prices and house prices increase, the value of MBS collateral increases, thereby improving credit positions from a lender’s perspective. Additionally, the large government stimulus only makes it easier for homeowners to make their mortgage payments, further increasing the creditworthiness of MBS.
Notably, there has been no specific programme from the Fed to backstop the residential MBS market. Spreads in these sectors have been slower to recover than backstopped sectors, such as corporate bonds. Spreads on non-agency mortgages are still significantly wider than they were pre-Covid-19, which is in direct contrast to other sectors that are trading at higher levels today than they were pre-Covid-19. This means that there is still an opportunity to buy assets that are continuing to recover and could have additional capital gains, as well as attractive yields.
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 current or future trends. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice. The securities listed were selected from the universe of securities covered by the portfolio managers to assist the reader in better understanding the themes presented. The securities included are not necessarily held by any portfolio or represent any recommendations by the portfolio managers. There is no guarantee that forecasts will be realized.