Most fixed-income instruments promise stable contractual principal and interest cash flows. For RMBS, borrower behavior (voluntary prepayments and involuntary defaults) is the primary driver of bond cash flows; contractual cash flows play a secondary role. In today’s environment of improving borrower equity, increasing prepayments, and falling default rates, this variability can tilt returns in investors’ favor by increasing a bond’s cash flows above what the market expects. For example, consider the performance of a floating-rate option ARM RMBS purchased in January 2015 and held until December 2016. Spreads over Libor started and ended the period at approximately 230 basis points. Basic bond math suggests the total return during the two-year holding period would be approximately 5.5 percent (two years of 230 basis points plus two years of one-month Libor, which averaged 35 basis points). Due to better-than-expected credit and prepayment performance, however, the actual return would have been 8.7 percent, according to JP Morgan research, as investors benefited not only from receiving more cash than expected, but also from increased expectations for future cash flows, which elevated bond prices despite unchanged spreads.
RMBS tracked the broader rally in credit risk markets in the fourth quarter 2016, posting a 2.4 percent total return, and bringing full-year 2016 total return to 8.4 percent. More credit-sensitive, longer maturity, and subordinated tranches performed the best.
With spreads so low, we look to upgrade to shorter maturity and more senior tranches for a relatively small spread concession. However, we believe opportunities exist to earn returns in excess of quoted spreads due to the nature of discount-priced RMBS in today’s favorable credit environment. Our outlook favors short maturity subprime RMBS, nonperforming loan/reperforming loan (NPL/RPL) senior tranches, and senior re-securitizations, as well as option ARM and subprime floaters with potential upside from ongoing credit improvements. We would look for a widening of spreads on longer maturity and more deeply subordinated securities to deploy capital to those subsectors.
—Eric Marcus, Director; Karthik Narayanan, CFA, Director
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.
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