Non-Agency Residential Mortgage-Backed Securities: Upside in Re-Performing Loans

Fundamental improvements should support credit-blemished loans, but tight valuations favor capital structure seniority.

November 14, 2017


This Non-Agency Residential Mortgage-Backed Securities sector report is excerpted from the Fourth Quarter 2017 Fixed-Income Outlook.

Positive credit trends in non-Agency RMBS are no secret: The long-running progress in housing and labor markets have improved borrowers’ home equity positions and lowered default rates. In contrast to the late-stage credit cycle concerns expressed in other fixed-income sectors, improvements in credit performance, particularly in the credit-blemished re-performing loans (RPL) sector, are likely to drive positive non-Agency RMBS performance. Part of this improvement in RPL is that loan servicers’ modification practices have evolved over time, and consequently default rates on modified loans continue to fall. More effective modifications and the passage of time have allowed borrowers to improve their credit scores and personal finances. A notable result of this curing is the 120 percent increase in RPL prepayments since 2014. Although the balance of pre-crisis loans has fallen, the RPL segment has become a larger part of the overall market. The combination of low payment and blemished credit history cap the long-term propensity for RPL borrowers to prepay, but in the intermediate term we expect improving RPL performance to provide upside to the more credit-blemished loans in the non-Agency RMBS market.

Default Rates on Modified Loans Have Improved

Improvements in credit performance of RPL is likely to drive positive non-Agency RMBS performance. Loan servicers’ modification practices have evolved over time, and consequently default rates on modified loans continue to fall.

Default Rates on Modified Loans Have Improved

Source: Amherst-Pierpont, JP Morgan, Guggenheim Investments. Data as of October 2017.

Non-Agency RMBS recorded strong performance in the third quarter, posting a 3.2 percent total return, outperforming the Bloomberg Barclays Aggregate index, and bringing year-to-date returns to 8.7 percent. Trading volume increased from the seasonal lows of the summer, and was met with heightened investor and dealer demand. The strongest performance was posted by the more credit-sensitive option adjustable-rate mortgage and subprime-backed subsectors. The impact of hurricanes Harvey and Irma was concentrated in the most subordinated tranches of credit risk transfer (CRT) deals, which initially widened by 75–100 basis points before partially recovering.

Non-Agency RMBS spreads have now rallied to post-crisis tights, and the sector offers investors little compensation for adding to spread duration, subordination, or idiosyncratic event risks. We continue to favor shorter-maturity senior tranches backed by credit-blemished collateral types, which should benefit from monthly amortization, lower prospective price volatility, and the improving credit fundamentals described above.

Prepayments Improve as RPL Gains Market Share of Pre-Crisis RMBS

More effective modifications and the passage of time have allowed borrowers to improve their credit scores and personal finances. A notable result of this curing is the 120 percent increase in RPL prepayments since 2014. Although the balance of pre-crisis loans has fallen, the RPL segment has become a larger part of the overall market.

Prepayments Improve as RPL Gains Market Share of Pre-Crisis RMBS

Source: Amherst-Pierpont, JP Morgan, Guggenheim Investments. Data as of October 2017. Three-month CRR = three-month average conditional repayment rate, a measure of voluntary principal repayments.

—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. ©2017, 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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