Defensive Driving

Despite constructive fundamentals, challenging relative value warrants risk control.

December 15, 2016

This sector report is excerpted from the Fourth Quarter 2016 Fixed-Income Outlook.

Improving mortgage credit fundamentals and rallying credit markets have compressed non-Agency RMBS spreads and decreased spread differentials between lower- and higher-risk tranches. The market currently gives little consideration to adverse call features, increasing tranche maturity, or reduced seniority. We view this as a rare opportunity to upgrade investment quality at low cost. We expect improving prepayments to support intermediate-term non-Agency RMBS returns. The nearby chart shows that mortgage credit availability has shown only minimal expansion. As a result, performing borrowers in legacy RMBS deals have relied on their own slowly improving financial situations, with little help from lenders, to qualify for refinancing. Loan-to-value (LTV) ratios have trended below the important 80 percent threshold, and prepayments have shown corresponding increases. Looking forward, borrower’s equity build from amortization alone should have the same beneficial effect on prepayments as an additional 2–3 percent annual home price appreciation. In contrast to the effect on premium MBS pools discussed by our Agency MBS team on page 24, discount priced non-Agency RMBS stands to benefit from these increasing prepayments.

Mortgage Lending Standards Remain Restrictive

Tepid expansion of mortgage credit availability, as demonstrated by the MBA Mortgage Credit Availability index, has required borrowers to cure into current underwriting standards without help from lenders. The index is a barometer on the availability of mortgage credit. A higher index reading signifies more credit is available and a lower index reading signifies less credit is available.

Mortgage Lending Standards Remain Restrictive

Source: Mortgage Bankers Association, Haver Analytics, Guggenheim Investments. Data as of 9.30.2016. Data prior to 3.31.2011 is quarterly only. * Represents typical values that may not represent an investable opportunity.

Non-Agency RMBS tracked the broader rally in credit risk markets in the third quarter and posted a 3.4 percent total return, outperforming the Barclays Agg and bringing year-to-date total return to approximately 5.9 percent. All non-Agency subsectors experienced positive performance on the quarter, and spreads on most subsectors stand at post-crisis tights.

We currently favor short maturity subprime RMBS and re-securitizations, as well as non- and re-performing-backed deals. These subsectors show stable prospective performance across a variety of credit and interest-rate stresses, and yield 2.0–2.8 percent above their corresponding benchmark rates. Selected discount dollar-priced floaters also appear attractive due to expected improvements in prepayments. We would look for a widening of spreads on longer maturity, deeply subordinated, and higher risk securities to deploy capital to those subsectors.

Increasing Prepayments Favor Discount Price RMBS

Prepayments, measured by the conditional prepayment rate, or CPR, increased markedly as LTV fell below 80 percent. This trend is expected to continue in the near term.

Increasing Prepayments Favor Discount Price RMBS

Source: J.P. Morgan, Guggenheim Investments. Data as of 8.30.2016.

—Eric Marcus, Director; Karthik Narayanan, CFA, Director

Important Notices and Disclosures

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.

Investing involves risk. In general, the value of fixed-income securities fall when interest rates rise. High-yield securities present more liquidity and credit risk than investment grade bonds and may be subject to greater volatility. Asset-backed securities, including mortgage-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 risk. Investments in floating rate senior secured syndicated bank loans and other floating rate securities involve special types of risks, including credit risk, interest rate risk, liquidity risk and prepayment risk. Guggenheim Investments represents the following affiliated investment management businesses of Guggenheim Partners, LLC: Guggenheim Partners Investment Management, LLC, Security Investors, LLC, Guggenheim Funds Investment Advisors, LLC, Guggenheim Funds Distributors, LLC, Guggenheim Real Estate, LLC, GS GAMMA Advisors, LLC, Guggenheim Partners Europe Limited and Guggenheim Partners India Management. ©2016, Guggenheim Partners, LLC. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Guggenheim Partners, LLC.


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