Non-Agency Residential Mortgage-Backed Securities: Building Blocks for Recovery
Elevated economic risks and credit stress are fully priced and should set the stage for future performance.
This Non-Agency Residential Mortgage-Backed Securities sector report is excerpted from the First Quarter 2021 Fixed-Income Outlook.
Non-Agency RMBS prices increased over the fourth quarter as broader risk markets continued to recover from their pandemic-induced dislocations. RMBS 1.0 and 2.0 returned 1.8 percent and 1.0 percent in the fourth quarter, respectively, putting returns in positive territory for all RMBS subsectors for 2020. Highly rated RMBS 2.0 bonds have fully retraced their second-quarter selloff, while lower-rated RMBS 1.0 and mezzanine classes have retraced approximately 80 percent of their early 2020 slide.
High unemployment strained homeowners’ finances and resulted in elevated mortgage delinquencies, which are now on a slow path to recovery.
Mortgage Delinquencies Are Slowly Declining
High unemployment strained homeowners’ finances and resulted in elevated delinquencies, which are now on a slow path to recovery.
Source: Guggenheim Investments, J.P. Morgan. Data as of 12.31.2020.
Structural changes in loan servicing after the 2008 financial crisis, which strongly favor workouts over foreclosures, and the absence of weakly documented or highly leveraged “affordability mortgages,” have kept collateral losses far below those experienced in 2008–2009 and prevented credit deterioration from transmitting adverse feedback to the housing market.
Looking forward, pre-financial crisis originated RMBS 1.0 is emerging as a rare institutional-scale, investable market that has experienced two credit cycles in its history. These cycles have the effect of creating “credit burnout,” or positive credit selection, where cycles of stress have forced liquidation or modification of weaker loans, thereby leaving a collateral pool of surviving borrowers who are less sensitive to future economic shocks. RMBS 1.0 loans outstanding today have survived the 10 percent unemployment and 30+ percent home price decline of the financial crisis, as well as the 16 percent peak unemployment experienced in the second quarter of 2020. In addition, loan principal amortization and home price gains have reduced RMBS 1.0 loan-to-value ratios to approximately 55 percent, suggesting significant homeowner equity and incentive to perform.
RMBS 1.0 Mortgage Loan LTV Declined to 55 Percent
RMBS 1.0 Mortgage Loan-to-Value Ratios Declined to 55 Percent
Loan principal amortization and home price gains have reduced RMBS 1.0 loan-to-value ratios to approximately 55 percent, suggesting significant homeowner equity and incentive to perform.
Source: Guggenheim Investments, Intex. Data as of 12.28.2020. Chart shows ratio of amortized outstanding mortgage loan balance to estimated updated home price for 2005–2007 vintage and subprime loans.
The combination of a stable housing market, low interest rates, and multi-cycle credit burnout underpin our preference for senior tranches of credit-sensitive RMBS 1.0 deals. For longer investment horizons, RMBS 1.0 has the potential for price appreciation from improving credit performance and bond cash flows. RMBS 2.0 tranches at the senior level offer credit stability and a modest yield pickup to the risk-free benchmarks, while subordinated tranches offer incrementally higher yields supported by the tailwinds of improving credit fundamentals.
—Karthik Narayanan, CFA, Managing Director; Roy Park, Director
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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.
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