Non-Agency Residential Mortgage-Backed Securities: Investor Demand Meets Short Supply

Improving fundamentals and limited supply have insulated the sector from broader market volatility.

May 17, 2018


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

Healthy housing fundamentals, improving borrower credit performance, and negative net supply helped non-Agency RMBS shrug off broader market volatility in the first quarter and supported the uninterrupted trend of credit spread tightening that began in the second quarter of 2016. The non-Agency RMBS market continues to function at an institutional scale with approximately $650 billion outstanding and annual trading volume of 15–20 percent of outstanding balance. New issue in RMBS has picked up to $50 billion to $70 billion per year in recent years, but this supply has merely offset paydowns arising from prepayments, defaults, and amortization, leaving investors with a relatively stable pool of reinvestment opportunities. First-quarter new issuance totaled $12 billion, with an increased number of prime jumbo sponsors lured to the market by established securitization execution and a historically low pricing discount to Agency MBS passthroughs. Relative to 2017, we expect higher issuance of 2.0 prime and nonqualified mortgage RMBS and a reduction in non- and re-performing (NPL/RPL) mortgage-backed issuance.

New Issue and Paydowns Remain Approximately in Balance

New issue in RMBS has picked up to $50 billion to $70 billion per year in recent years, but this supply has merely offset paydowns arising from prepayments, defaults, and amortization. Investors have been left with a relatively stable pool of reinvestment opportunities.

New Issue and Paydowns Remain Approximately in Balance

Source: Wells Fargo, Guggenheim Investments. Data as of 3.31.2018.

Non-Agency RMBS recorded strong performance in the first quarter, posting a 1.7 percent total return, outperforming the Bloomberg Barclays U.S. Aggregate Bond index and most other fixed-income subsectors. Trading volume increased in January and February from the seasonal lows of December 2017 but tapered to below $2 billion per week in March. The more credit-sensitive Option ARM and subprime-backed subsectors posted the strongest performance as investors showed comfort with paying higher prices for improved expected future cashflows.

Non-Agency RMBS spreads reached post-crisis tights in the first quarter, with more credit-sensitive sectors performing the best. The flat credit curve gives little compensation for increased spread duration, subordination, or idiosyncratic event risks. Low supply creates incentives for investors to compromise security selection and credit standards and gravitate toward higherrisk trades. We remain vigilant for such underwriting “creep” and continue to favor shorter-maturity, structurally senior tranches for their lower prospective price volatility, as well as passthroughs backed by credit-sensitive collateral types, which should benefit from improving credit fundamentals.

Spreads Tightened to Post-Crisis Lows

Non-Agency RMBS spreads reached post-crisis tights in the first quarter, with more creditsensitive sectors performing the best. The flat credit curve gives little compensation for increased spread duration, subordination, or idiosyncratic event risks.

Spreads Tightened to Post-Crisis Lows

Source: Wells Fargo, Guggenheim Investments. Data as of 3.31.2018.

—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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