Non-Agency Residential Mortgage-Backed Securities: Credit Tailwinds Remain in Place
Favorable fundamentals should improve cash flows in select subsectors.
This Non-Agency Residential Mortgage-Backed Securities sector report is excerpted from the Third Quarter 2019 Fixed-Income Outlook.
Non-Agency RMBS generated positive performance so far in 2019, returning 2.3 percent in the second quarter and 5.0 percent year to date. Although performance was directionally positive, the sector’s moderate interest rate sensitivity and spread volatility resulted in weaker performance than the Bloomberg Barclays U.S. Aggregate index and other credit sectors.
Dealer inventories remained historically low in the second quarter, and investor participation and overall secondary trading volumes were light. New issuance has trended above 2018 with year-to-date issuance of $35 billion and second quarter issuance of $18 billion. After 10 years of negative net issuance, 2019 issuance is expected to exceed paydowns from the outstanding securities in the market, resulting in positive net supply. Newly issued securities have received steady demand from investors in the second quarter. Notably, sponsorship for deeply subordinated tranches increased over the quarter as risk-seeking investors repositioned into high beta and higher yielding RMBS tranches in response to expectations of a more accommodative Fed and an extended economic cycle.
The high default rates and depressed home prices experienced in 2009–2012 are a distant memory, as home prices have recovered and significant credit curing has occurred among pre-crisis loans in the non-Agency RMBS market. At present, pre-crisis Alt-A and subprime deals comprise a $375 billion market. The confluence of loan amortization, defaults of weaker borrowers, and home price appreciation (HPA) has decreased the average ratio of mortgage loan balance to property value (LTV) and, correspondingly, reduced borrowers’ propensity to default. The LTV of these sectors is now less than 60 percent, and delinquencies have fallen. The average age since modification for Alt-A and subprime loans has trended above 60 months, which increases the likelihood of prepayments as borrowers may more easily qualify for traditional mortgages. As expectations for future losses decline, recoveries on previous forbearance modifications, which are not well-researched or priced consistently in the market, begin to contribute materially to future bond cash flows on selected deals.
Credit Curing of Pre-Crisis RMBS Has Resulted in Lower Delinquencies
% of Mortgage Issuance by Borrower Attribute
The confluence of loan amortization, defaults of weaker borrowers, and HPA has decreased the average LTV and, correspondingly, reduced borrowers’ propensity to default. The LTV of pre-crisis Alt-A and subprime sectors is now less than 60 percent, and delinquencies have fallen.
Source: Guggenheim Investments, JP Morgan, Credit Suisse. Data as of 6.30.2019.
Age of Loan Modification Rises, Increasing the Likelihood of Future Prepayment
The average age since modification for Alt-A and subprime loans has trended above 60 months, which increases the likelihood of prepayments as borrowers may more easily qualify for traditional mortgages.
Source: Guggenheim Investments, Intex, CoreLogic, Citi Research. Data as of 6.30.2019.
We remain constructive on the performance prospects for non-Agency RMBS as borrowers continue to benefit from the favorable consumer-credit and housing fundamentals, which should translate to improvements in bond cashflows over time. We continue to favor senior, shorter maturity classes for their lower price volatility as well as selected credit-sensitive, pre-crisis passthroughs that should benefit from the credit improvements described above.
—Karthik Narayanan, CFA, Managing Director; Roy Park, 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. ©2018, 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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Guggenheim Investments represents the following affiliated investment management businesses of Guggenheim Partners, LLC: Guggenheim Partners Investment Management, LLC, Security Investors, LLC, Guggenheim Funds Distributors, LLC, Guggenheim Funds Investment Advisors, LLC, Guggenheim Corporate Funding, LLC, Guggenheim Partners Europe Limited, GS GAMMA Advisors, LLC, and Guggenheim Partners India Management.