Non-Agency Residential Mortgage-Backed Securities (RMBS): Solid Ground
Favorable credit trends and market technicals allowed the sector to shrug off slowing housing activity and higher interest rates.
This Non-Agency Residential Mortgage-Backed Securities sector report is excerpted from the Fourth Quarter 2018 Fixed-Income Outlook.
Non-Agency RMBS prices remained stable in the third quarter as steady demand from investors and dealers allowed the market to shrug off higher mortgage rates and mixed housing data. We remain constructive on the performance prospects for the sector as borrower credit curing and negative net supply should continue to support the market. Higher rates have created a headwind for housing affordability—mortgage rates have increased by 100 basis points in the last 12 months, equating to a 12 percent borrower payment increase on a typical 30-year fixed rate, level pay, fully amortizing mortgage. Although this has caused housing demand to soften recently, longer-term trends of favorable demographics, and limited near-term supply should continue to support housing valuations. The U.S. homeownership rate, has been rising in response to improved economic conditions and increased household formations since bottoming out in 2016. With nationwide affordability near historical averages and supply choked by a decade of depressed new construction, the housing market still appears to be on solid ground.
Household Formations Are Driving Up Homeownership
The U.S. homeownership rate has been rising in response to improved economic conditions and an increase in household formations, particularly among homeowners since bottoming out in 2016.
Source: U.S. Census Bureau, Guggenheim Investments. Data as of 6.30.2018.
The non-Agency RMBS sector outperformed the Bloomberg Barclays Aggregate index, posting a 1.4 percent total return for the third quarter and 5 percent year to date. Third-quarter new issuance totaled $18 billion, with year-to-date issuance tracking significantly higher than experienced through the third quarter of 2017. New issue in the third quarter comprised $8 billion of recently originated prime and nonprime RMBS, $7 billion of non- and re-performing loan-backed deals, and $3.5 billion in credit risk transfer. Rising short-term interest rates have syphoned issuance away from non-performing loans (NPL) RMBS and toward prime RMBS. Rising bank deposit costs increase the attractiveness of private-label execution for prime loans relative to balance sheet execution. Conversely, higher short-term interest rates pressured financing costs for sponsors of short tenor NPL-backed deals.
Rising Rates Have Shifted Issuance to Prime RMBS from NPL Deals
Rising bank deposit costs increase the attractiveness of private-label execution for prime loans relative to balance sheet execution. Conversely, higher short-term interest rates pressured financing costs for sponsors of short tenor NPL-backed deals.
Source: Bloomberg, Guggenheim Investments. Data as of 9.30.2018.
Despite our constructive sector view, finding relative value within RMBS remains challenging. Spreads remain near post-crisis tights and the market offers little compensation for bearing increased spread duration, subordination, or idiosyncratic risk. We continue to favor shorter maturity and structurally senior tranches for their lower potential price volatility as well as passthroughs backed by seasoned credit-sensitive collateral types that should benefit from improving credit fundamentals.
—Karthik Narayanan, CFA, Managing Director; Roy Park, Director; Alex Zhang, Vice President
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