RMBS: Back to the future

For investors hunting yield as an alternative to private debt vehicles, the US residential mortgage-backed securities (RMBS) market has been a lucrative – if volatile – destination. With yields that can beat high-yield corporate bonds, RMBS promises to continue attracting investor interest in 2017.

“There seems to be a lot of capital that wants to go to work in the RMBS space,” says Brian Grow, managing director of RMBS for Morningstar Credit Ratings. “It is a matter of finding the right yield and risk to match the appetite.”

One measure of investor interest is how well newly issued mortgage bonds sell. While relatively few new ones are being issued these days, those that do tend to be oversubscribed, Grow says. A hybrid type of residential mortgage bond based on the income stream from rental homes has also been well received, he adds.

Not surprisingly, managers of RMBS funds are bullish on prospects for the segment. “From our perspective, there is a tremendous amount of relative value in the RMBS space,” says Sam Dunlap, senior portfolio manager at Angel Oak Capital Advisors, an asset manager with mutual funds, hedge funds and other vehicles. “It gives you high current yield with less rate sensitivity.”

Angel Oak has affiliated mortgage lenders that make loans to homebuyers, a securitisation team that packages those loans into bonds and strategies that hold those and other mortgage bonds.

The current popularity of RMBS represents a revival for an investment that was at the heart of the economic crisis. RMBS was once a gigantic and high-flying sector, but when the housing bubble burst, RMBS collapsed, taking down the US and ultimately the global economy.

The catalysts for the collapse were dicey subprime loans, which were packaged as non-agency bonds (bonds containing loans not guaranteed by an agency like Fannie Mae or Freddie Mac). Before the financial crisis, non-agency RMBS was a trillion-dollar market accounting for more than half of all RMBS. Today it is estimated at about $80 billion.

But non-agency RMBS has been in the spotlight lately as managers try to craft ways of making new non-agency loans and packaging new non-agency bonds. Several factors point to a potential revival of non-agency RMBS, particularly private capital.

Some analysts of, and participants in, RMBS see indications that non-agency mortgages and the bonds that hold them could benefit from the new administration. Treasury Secretary, Steven Mnuchin, has reiterated President Donald Trump’s pledge to reform Fannie Mae and Freddie Mac, which could reduce the role they play in the mortgage market and encourage more private investors to enter.

Redwood Trust, a residential mortgage REIT, has been particularly outspoken about its view that the Trump administration will be good for private investment in the mortgage market. In a letter to investors, two Redwood executives wrote that they stand ready to capitalise on Trump reforms.

“We believe the change in regulatory focus will remove barriers that have kept large segments of private capital from re-entering the mortgage market, and will actively begin to shrink the government’s role in the mortgage market,” the letter signed by Redwood CEO Marty Hughes and chief financial officer Christopher Abate states.

“While no one knows for sure how policies will play out, our view is that federal regulation will trend in a direction that favours private capital and away from government dominance in the mortgage market. We see private capital investors continuing to advance and becoming the leading holders of credit risk in the mortgage markets.”

One way private investors are already gaining exposure is through a government programme to sell existing agency mortgage bonds. The federal Credit Risk Transfer programme is an effort designed to reduce Fannie Mae and Freddie Mac mortgage holdings by selling some to the private market, where they are converted to non-agency status. Fund managers and other investors have been snapping up these bonds at discount prices since 2013.
“I do think the CRT trade is attractive,” says Tracy Chen, portfolio manager and head of structured credit at Brandywine Global Investment Management.

The CRT trade is just one part of the bigger agency RMBS market. Most RMBS REITs and mutual funds still focus on trading agency bonds. But lately these REITs have begun shifting toward non-agency bonds, perhaps helped by the CRT trade. For example, the Two Harbors Investment Trust REIT had 73.1 percent of its assets in agency bonds as of 30 September, 2016; that declined to 71.6 percent by 31 December. At the same time, its holdings of non-agency paper rose from 10.9 percent to 12.2 percent.

Managers that specialise in agency RMBS strategies say these securities continue to offer the opportunity for strong yield and can hold their value over time. They point to several factors that indicate the securities are on a sound footing, including reports of falling delinquency rates by borrowers.

In addition, levered REITs stand to do well if spreads remain favourable with rising interest rates, because of the way they borrow to finance RMBS holdings. Chen says the trend in spreads bodes well.

Shift to non-agency

Not all observers are as optimistic, however. Keith Jurow, an independent real estate consultant, contends that non-performing loans dating from before the collapse are still hidden in legacy mortgage bonds.

In states like New York, where the foreclosure process can drag on for years, there are thousands of homes owned by people who have not made their mortgage payments in five years or more, Jurow says. At some point these bad loans will have to be reconciled. “Something will crack eventually,” Jurow warns. “If I am right, whoever holds these things when it happens will get killed.”

But others scratch their heads at these conclusions. One analyst noted that Jurow is right about New York having a significant backlog of troubled mortgage loans, but the problem is not large enough to upend the rest of the mortgage bond market.

At Angel Oak Capital Advisors, Dunlap is aware of the problem with New York, but says it is not enough to damage the portfolio of mortgage bonds held in Angel Oak Capital’s RMBS-focused mutual fund, which has about 7.5 percent of its RMBS geographic exposure in the state. “Our delinquency rate across our portfolio is in the mid-teens,” Dunlap says.
What worries Chen more than the legacy delinquency problem is a trend towards looser underwriting standards. Lowering acceptable credit scores for borrowers, for example, would allow more people to qualify for loans, but at the same time it could result in higher delinquency rates.

For the moment, MBS remains a desirable alternative for private investors. If the economy moves in a positive direction and credit is available, mortgage lending could expand, and the mortgage bond market along with it – particularly the private, non-agency market.