US agency mortgage-backed securities (MBS), one of the largest segments of global fixed-income markets, still bear the stigma of the 2008 financial crisis, but investors in search of yields in 2017 should give this asset class a fresh hearing.
What are asset-backed and other mortgage-related securities?
Asset-backed securities are financial market instruments that are backed by pools of assets such as loans. The loans have been bundled into tradeable securities which the provider of the loans sells to investors for refinancing purposes. In other words, the issuer of asset-backed securities turns the debt it is owed into cash that they can use for other (banking) products.
In the US, most home mortgages are pooled into securities and guaranteed by US government-sponsored entities (GSEs). These securities are called agency MBS. They have been issued by US Treasury-guaranteed – and thus top-rated – issuers such as the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac) and the Government National Mortgage Association (GNMA).
We believe today that a strategy investing in high-quality agency MBS – and not, I must emphasise, the sub-prime mortgages that were the root cause of the financial crisis in 2008 – can be an attractive proposition. Many investors are looking for yield and positive total returns in an environment where many asset classes are offering paltry returns.
Exhibit 1: The creation of a mortgage
Source: BNP Paribas Investment Partners
Why MBS can appeal to investors in 2017
There are a number of reasons. We believe this is a market that by itself offers an attractive return. Over the past 10 years, a strategy investing in agency mortgage-backed bonds generated an annualised return of more than 6.5% (in USD net of fees). Even when you look at a period of only three years, the return was still 4.7% annualised*. For an investor holding cash, where yields are negative in a number of countries, or government bonds, with yields close to zero in many countries, MBS represents an attractive asset allocation opportunity.
Relative to other asset classes, agency MBS can offer a substantial yield pick-up. Compared with similar duration US Treasuries, which have the same AAA credit quality, the pick-up is currently 94bp. This partly reflects characteristics such as the strict underwriting criteria applied to mortgage takers’ finances and employment records. Other conditions include limits on the size of the mortgage and the requirement to make a large down-payment.
One of the other attractive characteristics is that agency MBS offer investors diversification benefits versus traditional US and European fixed-income markets due to a unique risk: prepayment risk. Since there is no default risk in the agency MBS market, the risk is WHEN you get paid back, not IF. The low correlation with other fixed-income segments makes agency MBS attractive to investors looking to diversify risk away from large concentrations in credit and duration risk. In such a context, MBS can be used as a high-quality, high-yielding portfolio diversification tool.
Looking at diversification opportunities – and opportunities to generate excess returns through active security selection – investors should realise that not all pools of mortgages are equal and thus active fund managers can add value for investors. Not all issuers are of the same quality: are we dealing with major banks or start-up mortgage lenders? Different US regions have different characteristics: housing markets in the north east, California and Florida are not the same. The California market has been strong and seen a run-up in home prices: are we seeing a bubble there? The New York State market has a unique profile in that there is a tax on refinancing which acts as a disincentive, mitigating prepayment risk. Specialists with considerable experience in the MBS field can exploit such opportunities.
While within the agency MBS sector we believe in focusing on the highest-quality issuers, we also see room in an MBS portfolio for small, opportunistic investments in non-agency MBS and commercial mortgages – for offices, hotels, retail properties and multi-family homes – with an investment-grade rating or higher.
Exhibit 2: US agency mortgage-backed securities – an attractive risk-return profile (10 years to 30 September 2016, based on monthly returns in USD*)
Defining prepayment risk and the other main risks
This is the risk that the investor gets their money back earlier than expected. In the agency MBS market, mortgagors can prepay their mortgage at any time for any reason and often at no penalty. Prepayments typically occur when a mortgagor moves, defaults (the government entities must then pay the investor) or refinances. Refinancing is particularly interesting because this is what typically leads the sector to perform well when interest rates rise.
When interest rates rise, prepayment risk is reduced as mortgagors are not incentivised to refinance. This means that compared to other types of fixed-income investments, agency MBS can still have strong total returns in a rising rate environment. Historically, there is clear evidence for this: mortgage-backed securities have outperformed other fixed-income securities and notably US government bonds in markets where interest rates have risen.
In the current macroeconomic environment, we believe prepayment risk is low and is likely to stay so for the foreseeable future. It is worth noting that investors do get handsome compensation for prepayment risk: the 94bp yield pick-up over Treasuries.
When it comes to credit risk, the US Treasury guarantee means that effectively, there is no risk of agency MBS defaulting. There has never been a default to an investor in the agency MBS market since its inception in the 1970s, including in the 2008 crisis. The agency MBS market also benefits from strong liquidity: with a size of around USD 5 trillion, it is the second-largest market in the world (second only to the size of the US Treasury market). Other fixed-income sectors are becoming less liquid due to bond scarcity and increasing bank regulation. The agency MBS market, on the other hand, has not suffered from this and in fact, new regulations incentivise banks to own agency MBS over riskier market sectors.
A segment with broad appeal
We believe agency MBS can offer investors an attractive yield pick-up versus government bonds. Investing in agency MBS can provide a diversifying high credit-quality portfolio with a low duration and the ability to generate positive total returns in both slowly rising and falling interest-rate environments.
This is a market segment that offers many opportunities and one that is liquid and transparent compared to the corporate bond market. Investors such as pension funds and sovereign wealth funds, and to a lesser extent, insurance companies have been active in this segment for many years, but we believe it can also appeal to other investors. This includes fixed-income investors concerned about rising rates, those looking to diversify portfolio risks as well as those looking for yield without having to accept lower credit quality. As awareness of its attractiveness builds, we expect to see broader interest in US mortgage-backed securities.
Written on 1 February 2017 in New York
*A strategy investing in US mortgage-backed securities and run by BNP Paribas Investment Partners; for illustrative purposes only; for details, go to www.bnpparibas-ip.com or investors-corner.bnpparibas-ip.com