A number of factors are set to influence agency mortgage-backed securities (MBS) in 2019. John Kerschner, Head of US Securitized Products, discusses the market dynamics and the risks and opportunities on the horizon.
Agency mortgage-backed securities (MBS) comprise roughly $7 trillion1 of the US fixed income market and represent nearly 30% of the Bloomberg Barclays US Aggregate Bond Index, a popular proxy for that market. Given the asset class’ size, and its weighting in many core fixed income portfolios, we think investors need to be mindful of the factors set to influence agency MBS in 2019. In the Q&A that follows, Head of US Securitized Products John Kerschner discusses the market’s dynamics and the risks and opportunities on the horizon.
The mortgage market stirs up negative connotation for many; why should investors consider agency MBS?
There is often a perceived riskiness to the asset class that investors associate with the Global Financial Crisis; however, agency MBS carry the same credit rating as the US government. The widening in agency mortgage spreads during the crisis was largely due to uncertainty as to whether the government would let the Federal National Mortgage Association, or Fannie Mae, and the Federal Home Loan Mortgage Corporation, or Freddie Mac, fail. They were ultimately placed under conservatorship of the Treasury, confirming the previously implicit government guarantee. Thanks to the government’s backing, the asset class has offered spread over US Treasuries with little to no credit risk.
At approximately $7 trillion, the mortgage market is vast. Agency MBS is the most liquid and efficiently traded fixed income market after US Treasuries, trading over $200 billion per day. Even during the crisis, this market remained accessible1.
Investors are growing increasingly concerned with the drawn-out credit cycle. How should investors expect agency MBS to fare versus corporate credit in these later stages?
Agency MBS may actually offer a compelling opportunity for investors seeking to garner income but mitigate drawdown in the late stages of the credit cycle. Regardless of market activity, borrowers generally make their monthly mortgage payment. Timely payment of the principal and interest on agency MBS is also effectively government guaranteed. This has traditionally resulted in a less volatile return stream relative to corporate credit, particularly in periods of market stress.
In contrast to corporate credit spreads, which we expect to widen from here as investors demand greater compensation for holding riskier securities, risks in agency MBS appear relatively benign and valuations relatively attractive. The primary risk in the asset class stems from the uncertainty associated with mortgage holders’ ability to prepay their principal at any time. Due to a multi-year period of historically low interest rates, the majority of mortgage holders have little to no incentive to refinance now that rates are rising. Further, the Fed’s methodical and well-telegraphed approach to hiking typically dampens interest rate volatility. Refinancing risk is highest when rates are falling and in volatile rate environments when fluctuating rates provide borrowers with a greater number of opportunities to prepay. Therefore, agency MBS tend to unperform in periods of higher interest rate volatility. Given the Fed is likely to continue its transparency on future interest rate moves, we expect minimal volatility in coming months and a favourable environment for agency MBS.
Now that rates are rising off of historic lows, US borrowers have little to no incentive to refinance their mortgage, reducing MBS prepayment risk.
Chart 1: MBS Refinanceable Index
Source: Bloomberg, as at 23 November 2018.
Note: Morgan Stanley Truly Refinanceable Index. Morgan Stanley Truly Refinanceable Index is a proprietary measure of the percentage of the mortgage universe that has the incentive and equity available to refinance.
The Fed amassed more than $1.7 trillion in MBS securities from 2009 to 2017. What do investors need to know now that it’s trimming its balance sheet?
The Fed is shedding around $10 billion to $20 billion in MBS per month, and that roll-off is generally priced in to valuations. In our view, the reduction in asset purchases will be most impactful for passive investors. Agency MBS comprise 100% of the Bloomberg Barclays US MBS Index and are the second-largest constituent in the Bloomberg Barclays US Aggregate Bond Index. The Fed purchased agency MBS without discrimination, often buying the securities with the worst prepayment risks, creating a tailwind for passive investors who had exposure to better-quality assets as a result. Now those poorer quality loans are available in the float, accessible to investors and indexing products. Passive investors will be exposed to greater convexity risk as a result, extending duration as yields rise and decreasing interest rate risk as yields fall. Essentially, there will be fewer prepayments to reinvest at higher yields and a greater number of prepayments to reinvest at lower yields. Active managers, that seek to understand borrower behaviour and mitigate prepayment risk, may be better suited to navigate the influx of lower quality assets.
What is the Single Security Initiative?
The Single Security Initiative, set to go live in June, will combine the to-be-announced (TBA) markets (or forward-settling MBS trades) of Fannie and Freddie to create one Uniform Mortgage-Backed Security (UMBS). Both enterprises have been under conservatorship of the Treasury since September 2008, bringing into question the need for two issuing enterprises. Additionally, Freddie securities continue to be less liquid than Fannies despite multiple attempts to increase investor appetite, including a shorter payment delay - cash flows passed to investors on these securities are delayed to allow time to process mortgage payments. UMBS will maintain a 55-day delay, and investors trading in Freddies will be compensated for the increase. A 55-day delay means principle and interest payments for April, for example, would be paid on 25 May, which is 55 days from the start of April.
Overall, the UMBS will result in a smaller opportunity set, but we expect this to have minimal impact given the limited relative value to be gained between Fannies and Freddies in recent years. With approximately 75% of the market moving to the UMBS, we do anticipate enhanced liquidity in an already very efficient market.
What does the new appointment of Mark Calabria as director of the Federal Housing Finance Agency (FHFA) mean for the US housing and mortgage markets?
Mr Calabria has historically been a proponent of less involvement by government-sponsored enterprises (GSE) in mortgage financing, so he’s likely to push for reforms at Fannie and Freddie. However, the TBA market is working, and Congress is unlikely to agree to measures that would jeopardise the efficiency of the system. Further, given that the government has already intervened once, we believe that any reform would still include the implicit government guarantee.
We anticipate reforms that will cause a gradual reduction in the number of mortgages qualifying for GSE approval, such as a cap on the size of conforming loans. Conforming loan limits have historically been lifted with home price appreciation but held steady when home prices fall. For 2019, the FHFA limit for most of the US is $484,350; it’s $726,525 for more costly locales.
We also expect policy that mitigates the amount of capital for which the government is responsible, such as enhancements to the credit risk transfer (CRT) program. CRTs transition a significant portion of credit risk from the GSEs to private investors. They have grown to represent roughly one-third of agency MBS, and we expect that number to continue increasing.
New and existing home sales generally declined in the latter half of 2018 and home price appreciation has slowed; what impact will a housing market slowdown have on agency MBS?
Housing prices are neither good nor bad for MBS. However, market dynamics do impact the relative attractiveness of certain securities. MBS with a high loan-to-value (LTV) ratio may be compelling in an environment where home prices are appreciating and rates are rising. The ability to take cash out often generates the incentive to refinance and those prepayments could then be reinvested at higher yields. Those opportunities will be less robust and higher LTV securities less attractive as home price appreciation slows. In our view, it is critical for MBS investors to understand the impact of market dynamics on borrower behaviour and how different loans will perform as a result.
1Securities Industry and Financial Markets Association (SIFMA), Janus Henderson Research, as of 12/31/17