Non-Agency Residential Mortgage-Backed Securities: Rally Fatigue

The long-running rally has emboldened dealers while investors have tempered their risk appetite.

August 23, 2018


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

Non-Agency RMBS spreads have rallied with only short pauses since the first quarter of 2016 and reached post-crisis tights in early second quarter 2018. We remain constructive on the intermediate-term prospects for the sector due to healthy housing fundamentals, improving borrower credit performance, and negative net supply, but we expect future gains to come at a slower and more irregular pace than those realized over the last 24 months. Increased dealer risk appetite aided the last leg of the rally of early 2018 and crowded out fundamentals-based investors. When dealers subsequently looked to normalize their inventory, softer investor demand, along with a flurry of new issuance, acted to widen spreads moderately in the latter half of the second quarter. Unlike all other major fixed-income credit markets, pre-crisis non-Agency RMBS has no new issue pricing, quoted markets, or widespread trade reporting to validate valuations. Market participants instead rely on their cash flow projections and market intelligence aggregated during secondary trading to establish prices. When multiple dealers looking to add risk actively compete with investors, as they did early in the second quarter, the narrow channel for price discovery creates a self-reinforcing feedback loop: aggressive dealers transmit their prices to the market, then other dealers recursively revise their price opinions upward to remain competitive. End investors who instead value bonds based on their intrinsic cash flows (the natural dampers to this positive feedback loop) ultimately provide support to the market at lower price levels.

New issuance totaled approximately $17 billion in the second quarter and represented a meaningful increase from the first quarter’s $11 billion. New issue was comprised of $4.4 billion of nonperforming and reperforming loans (NPL/RPL), $4.6 billion of credit-risk transfer (CRT) securities, and $7.7 billion of recently originated prime and non-prime RMBS. A flurry of non-Agency RMBS issuance in May and June contributed to spread widening late in June. Despite the recent dealer inventory dynamics and new issue headwinds, non-Agency RMBS outperformed the Bloomberg Barclays Aggregate index and posted a 1.8 percent total return in the second quarter. Total return stands at approximately 3.5 percent year to date.

Despite recent incremental spread widening, non-Agency RMBS spreads remain near post-crisis tights. We continue to favor shorter-maturity senior tranches for their lower prospective price volatility as well as pass-throughs backed by credit-sensitive Alt-A and subprime collateral, which should continue to benefit from improving credit fundamentals.

Non-Agency RMBS Spreads Remain Tight

Non-Agency RMBS spreads have rallied with only short pauses since the first quarter of 2016 and reached post-crisis tights in early second quarter 2018. Fundamental trends inform our constructive intermediate-term view for the sector.

Non-Agency RMBS Spreads Remain Tight

Source: Wells Fargo Securities, Guggenheim Investments. Data as of 7.19.2018.

Increased Non-Agency RMBS Issuance in the Second Quarter Weighed on Spreads

New issue was comprised of $4.4 billion of nonperforming and reperforming loans (NPL/RPL), $4.6 billion of credit-risk transfer (CRT) securities, and $7.7 billion of recently originated prime and non-prime RMBS. A flurry of non-Agency RMBS issuance in May and June contributed to spread widening late in June.

Increased Non-Agency RMBS Issuance in the Second Quarter Weighed on Spreads

Source: Bloomberg, Guggenheim Investments. Data as of 6.30.2018.

—Karthik Narayanan, CFA, Managing Director; Alex Zhang, Vice President

 
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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