Careful Search for Value
Tight spreads necessitate caution, but improving credit fundamentals beget opportunities.
This Non-Agency Residential Mortgage-Backed Securities sector report is excerpted from the First Quarter 2017 Fixed-Income Outlook.
Non-Agency RMBS investors shrugged off the negative effects of higher interest rates on home price appreciation and prepayments and discounted the potential for pro-growth fiscal policies to extend the current economic expansion. Non-Agency RMBS spreads in higher-risk subsectors converged toward lower-risk subsectors throughout the year. Spreads in many subsectors are now near post-crisis tights.
All Non-Agency RMBS Spreads Compressed in 2016
Spreads on all non-Agency RMBS sectors have compressed over the course of 2016. Tight spreads necessitate a cautious outlook, but opportunities exist to benefit from improving credit fundamentals.
Source: Wells Fargo, Guggenheim Investments. Data as of 12.31.2016. Note: CRT=credit risk transfer securities; SSNR=super-senior tranche; ARM=adjustable-rate mortgage.
Most fixed-income instruments promise stable contractual principal and interest cash flows. For RMBS, borrower behavior (voluntary prepayments and involuntary defaults) is the primary driver of bond cash flows; contractual cash flows play a secondary role. In today’s environment of improving borrower equity, increasing prepayments, and falling default rates, this variability can tilt returns in investors’ favor by increasing a bond’s cash flows above what the market expects. For example, consider the performance of a floating-rate option ARM RMBS purchased in January 2015 and held until December 2016. Spreads over Libor started and ended the period at approximately 230 basis points. Basic bond math suggests the total return during the two-year holding period would be approximately 5.5 percent (two years of 230 basis points plus two years of one-month Libor, which averaged 35 basis points). Due to better-than-expected credit and prepayment performance, however, the actual return would have been 8.7 percent, according to JP Morgan research, as investors benefited not only from receiving more cash than expected, but also from increased expectations for future cash flows, which elevated bond prices despite unchanged spreads.
RMBS tracked the broader rally in credit risk markets in the fourth quarter 2016, posting a 2.4 percent total return, and bringing full-year 2016 total return to 8.4 percent. More credit-sensitive, longer maturity, and subordinated tranches performed the best.
With spreads so low, we look to upgrade to shorter maturity and more senior tranches for a relatively small spread concession. However, we believe opportunities exist to earn returns in excess of quoted spreads due to the nature of discount-priced RMBS in today’s favorable credit environment. Our outlook favors short maturity subprime RMBS, nonperforming loan/reperforming loan (NPL/RPL) senior tranches, and senior re-securitizations, as well as option ARM and subprime floaters with potential upside from ongoing credit improvements. We would look for a widening of spreads on longer maturity and more deeply subordinated securities to deploy capital to those subsectors.
Uniquely Variable RMBS Cash Flows Represents an Opportunity for RMBS Investors
RMBS presents a special case of fixed income where borrower behavior is the primary driver of bond cash flows and contractual payments play a secondary role. This variability is a source of positive optionality in today’s improving mortgage credit climate.
Source: Guggenheim Investments. Data as of 12.31.2016.
—Eric Marcus, Director; Karthik Narayanan, CFA, Director
Important Notices and Disclosures
This article is distributed for informational purposes only and should not be considered as investing advice or a recommendation of any particular security, strategy or investment product. It contains opinions of the authors but not necessarily those of Guggenheim Partners or its subsidiaries. The authors’ opinions are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but are not assured as to accuracy. Past performance is no guarantee of future results.
Investing involves risk. In general, the value of fixed-income securities fall when interest rates rise. High-yield securities present more liquidity and credit risk than investment grade bonds and may be subject to greater volatility. Asset-backed securities, including mortgage-backed securities, may have structures that make their reaction to interest rates and other factors difficult to predict, making their prices volatile and they are subject to liquidity risk. Investments in floating rate senior secured syndicated bank loans and other floating rate securities involve special types of risks, including credit risk, interest rate risk, liquidity risk and prepayment risk. Guggenheim Investments represents the following affiliated investment management businesses of Guggenheim Partners, LLC: Guggenheim Partners Investment Management, LLC, Security Investors, LLC, Guggenheim Funds Investment Advisors, LLC, Guggenheim Funds Distributors, LLC, Guggenheim Real Estate, LLC, GS GAMMA Advisors, LLC, Guggenheim Partners Europe Limited and Guggenheim Partners India Management. ©2017, Guggenheim Partners, LLC. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Guggenheim Partners, LLC.
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