May 18, 2017
Spreads at post-crisis lows and limited price tiering between lower- and higher-risk tranches warrant more cautious positioning, but we maintain a positive outlook for non-Agency RMBS due to improving credit fundamentals and constructive technicals. The supply shortage in non-Agency RMBS is not a new dynamic: Prepayments, defaults, and loan amortization have reduced the outstanding non-Agency MBS market from a peak of $2.5 trillion in 2007 to $750 billion today, creating reinvestment demand and support for bond prices. This runoff also has a dark side—without adequate new issuance, markets could lose institutional sponsorship. Fortunately, the non-Agency RMBS market resides in a Goldilocks-like middle ground, with sufficient runoff to create positive technical support while maintaining an institutionally accessible $40 billion to $50 billion annual supply of new issues, and outstanding balance comparable to the institutional leveraged loan market. New issuance has evolved to include performing (prime and non-prime) loans, distressed (non- and re-performing) loans, and the credit risk of “vanilla” government-sponsored enterprise loans through Credit Risk Transfer (CRT) deals. We view many of these segments as sustainable and poised for higher issuance in the future.
The non-Agency RMBS market resides in a Goldilocks-like middle ground, with sufficient runoff to create positive technical support while maintaining an institutionally accessible $40 billion to $50 billion annual supply of new issues, including prime, non-prime, non-performing and re-performing loans (NPL/RPL), and CRT deals.
Source: SIFMA, Wells Fargo, Guggenheim Investments. Data as of 12.31.2016.
Non-Agency RMBS tracked the broader rally in credit risk markets in the first quarter of 2017, posting a 2.2 percent total return. Trading volumes increased, as did dealer risk appetite, relative to the doldrums of the fourth quarter 2016. Housing data were generally positive and investors looked to potential pro-growth fiscal policies to extend the current economic expansion.
With the housing recovery maturing, we look for performance gains to come more from improved prepayments than from lower collateral defaults. Over time, loan pools have experienced positive selection: Weak borrowers defaulted, while remaining borrowers rebuilt their credit history, paid down their mortgages, and benefited from increased home prices. Even as default rates stabilize, prepayments continue to rise, an accretive trend for non-Agency RMBS priced at discounts to par. We currently favor a two-pronged investment approach of focusing on shorter maturity senior tranches backed by pre-crisis subprime, non- and re-performing loans, and selected discount-priced floaters that stand to benefit from improvements in credit performance and prepayments. We continue to avoid deeply subordinated or long maturity tranches with limited yield pickup and potential for heightened price volatility.
For both performing and reperforming loans, default rates have stabilized while prepayments have been improving, an accretive trend for non-Agency RMBS priced at discounts to par.
Source: Amherst Securities, Guggenheim Investments. Data as of 2.28.2017. CRR= Conditional repayment rate, which is an annualized rate of voluntary prepayments relative to the outstanding balance of loans. CDR= Conditional default rate, which is an annualized rate of defaults relative to the outstanding balance of loans.
—Karthik Narayanan, CFA, Managing Director; Eric Marcus, Director
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