Non-Agency Residential Mortgage-Backed Securities: Tread Lightly
Wider spreads and inconsistent liquidity belie positive long-run fundamentals.
This Non-Agency Residential Mortgage-Backed Securities sector report is excerpted from the First Quarter 2019 Fixed-Income Outlook.
Late-cycle credit market volatility in the fourth quarter and elevated RMBS dealer inventories weighed on non-Agency RMBS spreads and market liquidity. The credit tailwinds of healing borrower credit performance, favorable demographic trends, and limited housing inventory remain in place, but proved no panacea to higher risk premiums demanded by investors in the face of an aging credit cycle. Looking ahead, the rally in Treasury yields has reduced mortgage borrowing costs by 0.5 percent since November and should improve housing affordability and turnover, providing incremental upside to credit performance.
Despite posting negative -2.2 percent total return in the fourth quarter, non-Agency RMBS completed 2018 with a 3.3 percent total return and outpaced broader credit markets. New issuance tapered over the fourth quarter in response to deteriorating market conditions but completed 2018 at a post crisis high of $100 billion. Post-crisis RMBS subsectors are demanding greater investor focus as new issuance volumes increase and the pre-crisis market continues to roll off.
New Non-Agency RMBS Issuance Sets a Post-Crisis High
New issuance reached $100 billion in 2018 and is garnering greater investor focus as the pre-crisis RMBS subsector continues to roll off.
Source: Guggenheim Investments, Nomura. Data as of 12.31.2018.
While securitizations backed by non- and re-performing loans (NPL/RPL) drove much of the growth since 2013, NPL issuance decreased in 2018. Issuance is expected to decrease further in 2019 as increasing funding costs in the short end of the yield curve as well as strengthening U.S. housing fundamentals diminish distressed supply. Instead, supply of RPLs, prime, and non-prime (also referred to as non-qualified mortgage, or non-QM) RMBS are expected to increase. Recent credit spread widening had an adverse impact on securitization economics. Spreads on RPL AAA as well as on other loss-remote, recently issued tranches have drifted wider by 60 basis points since March 2018—a 133 percent increase—which has meaningfully eroded securitization profitability for sponsors. For securitizations of new loans, particularly in the case of the non-QM market where loans are made in a relatively inelastic market, the higher cost of securitized debt can be transmitted to new loan pricing to preserve profitability. In NPL/RPL markets, in which sponsors aggregate loans over time, widening spreads and inconsistent liquidity create a headwind to issuance.
Spreads on Recent-Issue AAAs Have Underperformed Other Sectors
Spreads on re-performing loan AAAs have widened by 60 basis points—a 133 percent increase—since the tights of March 2018. This change will create headwinds for new issuance.
Source: Guggenheim Investments, Wells Fargo. Data as of 1.12.2019.
Balancing our constructive outlook on non-Agency RMBS fundamentals is our expectation of ongoing market volatility and irregular liquidity, emphasizing shorter maturity and structurally senior tranches for their lower prospective price volatility. We also favor pass-through structures backed by seasoned credit-sensitive collateral that stands to benefit from improving credit fundamentals.
—Karthik Narayanan, CFA, Managing Director; Roy Park, Director; Alex Zhang, Vice President
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