Non-Agency Residential Mortgage-Backed Securities: Limited Compensation for Risk
We favor a defensive approach that emphasizes shorter-maturity senior tranches.
This Non-Agency Residential Mortgage-Backed Securities sector report is excerpted from the Third Quarter 2017 Fixed-Income Outlook.
Non-Agency RMBS spreads have now rallied to post-crisis lows as improving credit fundamentals, particularly the prepayment and default behavior of re-performing loans, have emboldened investors. In addition, the shortage of new supply continues to provide a tailwind.
New Supply Shortage Creates Technical Tailwind
Improving credit fundamentals, particularly the prepayment and default behavior of re-performing loans, have emboldened non-Agency investors. In addition, the shortage of new supply continues to provide a tailwind. Net new supply was essentially zero in the first half of 2017.
Source: SIFMA, Guggenheim Investments. Data as of 6.30.2017.
Non-Agency RMBS spreads have now rallied to post-crisis lows as improving credit fundamentals, particularly the prepayment and default behavior of re-performing loans, have emboldened investors. In addition, the shortage of new supply continues to provide a tailwind. New issuance totaled $18 billion for the quarter, distributed across credit risk transfer ($5.5 billion), new issue prime and nonprime ($3 billion), and non-and re-performing loan-backed deals ($9.5 billion). This compares to $25 billion of pay-downs experienced across pre-crisis deals. Spread differentials between lower-risk and higher-risk RMBS tranches remain historically narrow, and reflect broader complacency in fixed-income markets.
Non-Agency RMBS Spreads Narrow Across the Credit Spectrum
Spread differentials between lower-risk and higher-risk RMBS tranches remain historically narrow, with year-ago and latest spreads essentially setting the 52-week range.
Source: Wells Fargo, Guggenheim Investments. Data as 6.30.2017. Note: CRT=credit risk transfer securities; SSNR=super-senior tranche; ARM=adjustable-rate mortgage.
With many segments of the RMBS market priced for smooth sailing, the market offers little incremental spread for taking on increased systemic market risk or idiosyncratic security-level risk, and therefore warrants cautious positioning. For example, a number of RMBS deals recently experienced unexpected losses at optional redemption when the deal trustee withheld funds to reserve for hypothetical future legal expenses. This unprecedented situation, which is concentrated in prime and Alt-A deals originated in or before 2005, represents a new dimension of risk that was not previously priced into the market. Other such idiosyncratic risks exist in deeply subordinated bonds and small collateral pools, neither of which offer attractive spreads relative to their investment risk.
Non-Agency RMBS recorded strong performance in the second quarter of 2017, posting a 3.2 percent total return and outperforming the Bloomberg Barclays Aggregate Index. Trading volumes tapered off over the quarter with the approach of the traditionally slow summer months. We witnessed the strongest performance in the more credit-sensitive option ARM and subprime-backed subsectors, where a combination of tighter spreads and an improving outlook for future cash flows propelled returns.
We currently favor a defensive approach that emphasizes shorter maturity senior tranches backed by pre-crisis subprime, and non- and re-performing loans that benefit from monthly amortization, lower prospective price volatility, and improving credit fundamentals while carrying low interest-rate sensitivity. We continue to avoid deeply subordinated or long maturity tranches with their limited yield pickup and potential for heightened price volatility and idiosyncratic performance.
—Karthik Narayanan, CFA, Managing Director; Eric Marcus, 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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