This Non-Agency Residential Mortgage-Backed Securities sector report is excerpted from the Third Quarter 2017 Fixed-Income Outlook.
Non-Agency RMBS spreads have now rallied to post-crisis lows as improving credit fundamentals, particularly the prepayment and default behavior of re-performing loans, have emboldened investors. In addition, the shortage of new supply continues to provide a tailwind.
New Supply Shortage Creates Technical Tailwind
Improving credit fundamentals, particularly the prepayment and default behavior of re-performing loans, have emboldened non-Agency investors. In addition, the shortage of new supply continues to provide a tailwind. Net new supply was essentially zero in the first half of 2017.
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Source: SIFMA, Guggenheim Investments. Data as of 6.30.2017.
Non-Agency RMBS spreads have now rallied to post-crisis lows as improving credit fundamentals, particularly the prepayment and default behavior of re-performing loans, have emboldened investors. In addition, the shortage of new supply continues to provide a tailwind. New issuance totaled $18 billion for the quarter, distributed across credit risk transfer ($5.5 billion), new issue prime and nonprime ($3 billion), and non-and re-performing loan-backed deals ($9.5 billion). This compares to $25 billion of pay-downs experienced across pre-crisis deals. Spread differentials between lower-risk and higher-risk RMBS tranches remain historically narrow, and reflect broader complacency in fixed-income markets.
With many segments of the RMBS market priced for smooth sailing, the market offers little incremental spread for taking on increased systemic market risk or idiosyncratic security-level risk, and therefore warrants cautious positioning. For example, a number of RMBS deals recently experienced unexpected losses at optional redemption when the deal trustee withheld funds to reserve for hypothetical future legal expenses. This unprecedented situation, which is concentrated in prime and Alt-A deals originated in or before 2005, represents a new dimension of risk that was not previously priced into the market. Other such idiosyncratic risks exist in deeply subordinated bonds and small collateral pools, neither of which offer attractive spreads relative to their investment risk.
Non-Agency RMBS recorded strong performance in the second quarter of 2017, posting a 3.2 percent total return and outperforming the Bloomberg Barclays Aggregate Index. Trading volumes tapered off over the quarter with the approach of the traditionally slow summer months. We witnessed the strongest performance in the more credit-sensitive option ARM and subprime-backed subsectors, where a combination of tighter spreads and an improving outlook for future cash flows propelled returns.
We currently favor a defensive approach that emphasizes shorter maturity senior tranches backed by pre-crisis subprime, and non- and re-performing loans that benefit from monthly amortization, lower prospective price volatility, and improving credit fundamentals while carrying low interest-rate sensitivity. We continue to avoid deeply subordinated or long maturity tranches with their limited yield pickup and potential for heightened price volatility and idiosyncratic performance.
—Karthik Narayanan, CFA, Managing Director; Eric Marcus, Director
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