Non-Agency Residential Mortgage-Backed Securities: Select Opportunities in RMBS Despite Cooling Housing Market

This Non-Agency RMBS sector report is excerpted from the Fourth Quarter 2022 Fixed-Income Sector Views.

Non-Agency RMBS spreads widened in the third quarter to post-COVID wides due to market volatility, despite light dealer positioning and modest trading volumes. RMBS 1.0 and RMBS 2.0 subsectors—RMBS issued pre- or post-GFC—posted third quarter returns of -0.5 percent and -6.4 percent, respectively, according to Citi Research. Returns for the sector are likely to follow broader risk markets and remain volatile in the near term.

New issuance slowed by 45 percent in the third quarter relative to the third quarter of 2021, and year-to-date issuance is 25 percent below the same period last year. With mortgage rates rising from 3.3 percent to 7 percent year to date and an average mortgage rate of 3.5 percent on the outstanding stock of loans, housing purchase and refinancing activity fell to historical lows and suppressed creation of new loans that would be pooled into new MBS. Additionally, rising rates and spread widening curtailed economic benefits of securitization. Therefore, we expect new issuance will be challenged in the near term.

The strength of the housing market in recent years has created meaningful differences in home equity levels across subsectors. Properties securing older loans have experienced greater price appreciation than those securing younger loans. Consequently, older loans have de-levered more, and have lower loan-to-value ratios and lower risk of loss. Thus far, these differences in credit risk have been reflected in an orderly way in market pricing. The chart shows how closely single-family rental securities’ pricing tracks the implied leverage of the underlying pool of homes. Similar linear credit curves exist in RMBS backed by non-qualified mortgages and reperforming loans. Despite a cooling housing market, the strength of this relationship demonstrates that current bond pricing reflects limited expectations for material distress.

Conservative mortgage underwriting, favorable consumer and labor market conditions, and an excess demand for shelter in the United States underpin our constructive view on RMBS despite softening prospects for home prices. We favor non-qualified mortgage RMBS 2.0 mezzanine and senior tranches with stable weighted average life profiles, reperforming loan deals, and RMBS 1.0 backed by loans with significant home equity.

—By Karthik Narayanan and Roy Park

Important Notices and Disclosures

This material is distributed or presented for informational or educational purposes only and should not be considered a recommendation of any particular security, strategy or investment product, or as investing advice of any kind. This material is not provided in a fiduciary capacity, may not be relied upon for or in connection with the making of investment decisions, and does not constitute a solicitation of an offer to buy or sell securities. The content contained herein is not intended to be and should not be construed as legal or tax advice and/or a legal opinion. Always consult a financial, tax and/or legal professional regarding your specific situation.

This material contains opinions of the authors, but not necessarily those of Guggenheim Partners, LLC or its subsidiaries. The opinions contained herein are subject to change without notice. Forward-looking statements, estimates, and certain information contained herein are based upon proprietary and non-proprietary research and other sources. Information contained herein has been obtained from sources believed to be reliable but are not assured as to accuracy. Past performance is not indicative of future results. There is neither representation nor warranty as to the current accuracy of, nor liability for, decisions based on such information.

Investing involves risk, including the possible loss of principal. Investments in fixed-income instruments are subject to the possibility that interest rates could rise, causing their values to decline. High yield and unrated debt securities are at a greater risk of default than investment grade bonds and may be less liquid, which may increase volatility. Investors in asset-backed securities, including mortgage-backed securities and collateralized loan obligations (“CLOs”), generally receive payments that are part interest and part return of principal. These payments may vary based on the rate loans are repaid. Some asset-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 and valuation risk. CLOs bear similar risks to investing in loans directly, such as credit, interest rate, counterparty, prepayment, liquidity, and valuation risks. Loans are often below investment grade, may be unrated, and typically offer a fixed or floating interest rate.

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