Non-Agency Residential Mortgage-Backed Securities: Watching for Credit Expansion

With fundamentals improving, investors should weigh the benefits and risks of credit expansion.

February 23, 2018

This Non-Agency Residential Mortgage-Backed Securities sector report is excerpted from the First Quarter 2018 Fixed-Income Outlook.

We maintain our long-running constructive view on non-Agency RMBS as healthy housing fundamentals and improving borrower performance support the sector. Strong demand and muted new home construction have pushed inventories to historically low levels, in turn boosting home values. Against this backdrop, ongoing credit curing of legacy MBS borrowers should result in improved prepayments and loss rates on bonds and has already emboldened greater risk-taking by lenders and investors.

Strong Demand and Muted New Supply Push Inventories to Historical Lows

The homeownership rate has risen after 10 years of declines, with gains coming from younger age groups, including first-time buyers. Strong demand and muted new home construction have pushed inventories to historically low levels, in turn boosting home values.

Strong Demand and Muted New Supply Push Inventories to Historical Lows

Source: U.S. Census Bureau, Bloomberg, National Association of Realtors, Guggenheim Investments. Data as of 1.10.2018.

Approximately $50 billion of new issuance is projected for 2018 across a variety of asset types, including non- and re-performing loans, credit risk transfer deals backed by “vanilla” government-sponsored enterprise loans, jumbo prime loans, and most recently, non-qualified mortgage (non-QM) loans. The QM rule was implemented in 2013 under the Dodd-Frank Act and stipulates a number of attributes necessary to provide legal safeguards for the lender. Loans that do not qualify for QM status tend to be investor properties, credit-blemished borrowers, first-time borrowers with higher debt-to-income (DTI) ratios, and self-employed borrowers who use bank statements to demonstrate their monthly cash income. The non-QM market is small—$4 billion outstanding—with issuance concentrated in the last 12 months, but this market is likely to grow with heightened borrower awareness and increased lender comfort around credit performance and securitization execution. Traditional MBS credit metrics of credit score and debt-to-income ratio have remained stable for non-QM to date, but the depth of originator diligence on bank statement-based loans could come under pressure if origination volumes grow significantly.

Non-Agency RMBS recorded strong performance in the fourth quarter, posting a 1.6 percent total return, outperforming the Bloomberg Barclays Aggregate index and bringing year-to-date returns to 10.5 percent. Trading volume tapered off in December while investor appetite and dealer inventory remained stable.

Non-Agency RMBS spreads have now tightened to post-crisis lows and the flat credit curve gives little compensation for bearing increased spread duration, subordination, or idiosyncratic event risks. We continue to favor senior tranches backed by credit-sensitive collateral types, which should benefit from monthly amortization and improving credit fundamentals.

Bank Statement Loans Gain Share of Non-Qualified Mortgage Market

Originator diligence should come under pressure if volumes of non-QM loans grow significantly. Indeed, loans to borrowers who use bank statements to demonstrate their monthly cash income are growing as a percentage of non-QM issues outstanding. FICO scores have not deteriorated as a result of this trend.

Bank Statement Loans Gain Share of Non-Qualified Mortgage Market

Source: Guggenheim Investments. Data as of 1.10.2018.

—Karthik Narayanan, CFA, Managing Director; Eric Marcus, 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. ©2018, 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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