Strong Credit Performance, Favorable Supply Dynamics

Credit fundamentals and market supply dynamics provide a tailwind for non-Agency RMBS.

March 17, 2016

This sector report is excerpted from the First Quarter 2016 Fixed-Income Outlook.

Improving housing market conditions, strong borrower credit performance, and favorable market supply dynamics helped the non-Agency RMBS market return 3.5 percent in 2015, according to Citigroup. Although not immune to bouts of market volatility, the sector should continue to benefit from these fundamental and technical trends in the intermediate term. Non-Agency RMBS credit fundamentals have improved since 2008 due to positive survivorship bias—the weakest residential borrowers have long since defaulted, leaving more resilient borrowers with improving credit metrics. Although home price appreciation has tempered as the market’s recovery has matured, approximately 65 percent of performing RMBS borrowers now have greater than 20 percent equity in their homes—an important hurdle for credit performance and refinanceability. The passage of time and the improving employment picture has allowed previously delinquent borrowers to “cure” their credit scores and qualify for conventional mortgages; corroboration comes from the investor-friendly 30 percent increase in Alt-A loan prepayments from a year ago. According to the work of our Macroeconomic Research Team, these fundamental economic trends should persist in the intermediate term.

Non-Agency RMBS Credit Performance Has Improved Significantly

Non-Agency RMBS delinquency rates have declined significantly from crisis highs, owing to the recovery in home prices and historically low rates. Though home price appreciation has tempered, improvement in the labor market—particularly stronger wage growth—would continue to support collateral performance and further mitigate credit risk in non-Agency RMBS.

Non-Agency RMBS Credit Performance Has Improved Significantly

Source: Amherst Pierpont Securities. Data as of 1.30.2016.

The non-Agency RMBS market has been steadily shrinking since peaking at approximately $2.5 trillion in 2007. Pre-crisis RMBS now comprise a $750 billion market with over twenty thousand CUSIPs. This universe is paying down by approximately 12 percent per year, and new issuance of non-Agency RMBS—an eclectic mix of non-performing loan/re-performing loan (NPL/RPL) securitizations, prime loan securitizations, and credit risk transfer deals—should offset only about half of these paydowns. The resulting shortfall of reinvestment opportunities provides powerful technical support for prospective returns.

Our investment preferences are for pre-crisis Alt-A and subprime tranches, shorter maturity re-securitizations, and selected NPL/RPL deals. These subsectors offer yields of 2.7 percent to 3.8 percent above their corresponding benchmark rates and benefit from near-term amortization, positive optionality from improving housing prices and mortgage credit availability, limited structural leverage, and low interestrate sensitivity afforded by floating rate coupons or short maturities. We generally avoid highly-levered subordinated bonds, as well as tranches with long maturities due to possible idiosyncratic collateral performance, limited yield pickup, poor investor sponsorship, and heightened return volatility.

Strong Technical Support for Non-Agency RMBS

New issuance of non-Agency RMBS—which has consisted of non-performing and re-performing loan securitizations, prime loan securitization, and credit risk transfer deals—is only expected to offset about half of approximately $75 billion in annual paydowns. As long as fundamentals remain strong, the supply picture should continue to support a positive outlook for non- Agency RMBS.

Strong Technical Support for Non-Agency RMBS

Source: SIFMA. Data as of 12.31.2015.

—Eric Marcus, Director; Karthik Narayanan, CFA, 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, Transparent Value Advisors, LLC, GS GAMMA Advisors, LLC, Guggenheim Partners Europe Limited and Guggenheim Partners India Management.


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