Mortgages Open the Door to Diversification, Yield
Investment Ideas from the Mortgage Portfolio Team
Fixed income investors have a steep challenge to overcome in an environment of low yields and slow economic growth. However, BlackRock's mortgage market experts believe there are options for investors to consider. In this piece, they discuss the opportunities that an allocation to mortgage securities can provide an investor who is looking for enhanced diversification and yield.
- The agency mortgage-backed securities (MBS) sector provides investors with an opportunity to diversify and enhance the yield of their fixed income portfolios without taking on additional credit risk.
- The non-agency MBS sector currently offers attractive loss-adjusted yields of 6-8%†, presenting investors with an opportunity to add diversification to positions outside of high yield corporate credit.
- With the complexity and dynamism of the mortgage markets, we recommend relying on a professional active manager with the scale and expertise to make informed investment decisions.
What are Agency MBS?
Agency mortgage-backed securities (MBS) are pass-through securities issued by US Government federal housing agencies Federal National Mortgage Association (FNMA, commonly known as Fannie Mae), Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac) and Government National Mortgage Association (GNMA or Ginnie Mae). Ginnie Mae securities are explicitly backed by the full faith and credit of the federal government, while Fannie Mae and Freddie Mac are effectively backed. In the midst of the credit crisis in 2008, the federal government placed Fannie Mae and Freddie Mac under conservatorship run by the Federal Housing Finance Agency (FHFA), effectively guaranteeing these securities.
Why should investors add Agency MBS to their portfolio?
An investment in the Agency MBS sector provides investors with an opportunity to enhance the yield of their fixed income portfolios without taking the credit risk associated with spread sectors like corporate credit. By that virtue, the asset class may provide risk diversification to a fixed income portfolio since its primary risk is prepayment risk as opposed to credit risk. Prepayment risk is the risk that borrowers pay down their principal faster than anticipated, often via refinancing into a new mortgage. This can be viewed as the borrower exercising a call option, which would thereby reduce the return to investors. For investors in Agency MBS, the question is when, rather than if, you will get your money back (with the opposite being true in corporate credit). If a borrower defaults, the event is treated as a prepayment of principal that is guaranteed by the Agencies. Therefore, investors with a heavy weighting to corporate credit may improve the diversification of their fixed income portfolio by adding Agency MBS.
What is BlackRock's view on the Agency MBS sector?
We believe the Agency MBS sector is attractive, as strong supply/demand technicals and contained prepayment speeds due to refinancing barriers have resulted in an attractive yield over Treasuries. Supply is limited due to the moribund housing market while demand is strong, primarily among REITS, banks and money managers. In addition, the Federal Reserve is a significant source of demand through its reinvestment of mortgage paydowns on its balance sheet back into the sector. With the possibility of an additional future round of quantitative easing focused on the mortgage market, this demand could continue.
What are the challenges facing the housing market today?
The housing market overall continues to remain challenged by various factors (see Figure 1). A large overhang of "shadow" inventory remains and the mix of home sales to date has been heavily skewed toward distressed purchases. Additionally, while some policy efforts have been positive, home-buyer tax credits have failed to stimulate overall housing demand and long-overdue refinancing initiatives for borrowers have been less effective due to refinancing barriers. Overall, housing market credit availability is limited due to tightened underwriting standards, lower loan limits, and the continuing weak employment picture. As a consequence, prepayment speeds should remain relatively low as home sales and homeowner refinancing remain muted.
What risk does the Home Affordable Refinance Program (HARP) present to the Agency MBS market?
The HARP program was originally created in March 2009 to help homeowners with negative equity in their houses lower their payments by refinancing their mortgages at lower interest rates. The impact of this program on the housing market was fairly subdued as it was limited to homeowners with a loan-to-value (LTV) less than 105% and who were current on their monthly payments.
In an effort to improve effectiveness, in December of 2011 the program was expanded to include all Agency-backed mortgages regardless of LTV, issued on or before May 2009. The plan is still limited by the fact that mortgage holders must be current on their payments (i.e. only one missed payment in the last 12 months). While we anticipate that this expansion of the HARP program will increase prepayment speeds as the government puts pressure on firms to participate, we do not think any resulting rise would be overly damaging to the sector.
Indeed, we don't believe the Agency MBS market will likely return in the near term to the prepayment speeds seen prior to the credit crisis, when refinancing was extremely popular due in part to the ability to extract home equity via cash-out refinancing (see Figure 2). Moreover, while any government programs aimed at improving the housing market will have an impact on certain portions of the mortgage market, we believe active management can continue to uncover attractive opportunities with limited exposure to HARP risk.
Figure 1: Housing Activity Remains Weak
New housing starts and existing home sales
Why are Ginnie Mae securities less impacted by HARP?
Ginnie Mae securities trade at a premium compared to Fannie Mae and Freddie Mac securities in part because of their slower prepayment speeds. Ginnie Mae securities are typically backed by first-time home buyers with a low/medium income profile and a lower FICO score, thereby limiting their propensity to refinance. In addition, Ginnie Mae securities are not impacted by the HARP program, which is limited to loans guaranteed by Fannie and Freddie. Lastly, borrowing costs for most Federal Housing Administration (FHA) borrowers have actually increased recently due to rising insurance premiums, further dampening refinancing activity. Certain borrowers with older loans are exempt from this increase but could face other barriers to refinancing. Additionally, within the Ginnie Mae market, our team finds that certain pools offer call protection because they do not qualify for the exemption or because the insurance premium is not the major refinancing obstacle.
What is the future of the Agencies?
With roughly 95% of all mortgage issuance coming from agencies, the privatization of agency mortgages does not seem feasible at this time. The functionality of the mortgage market ultimately requires a government guarantee over the medium term, and while there are many ways this guarantee could be structured, the important point is that an agency presence will remain for quite some time.
Figure 2: Current Prepayments Remain Low Versus 2003
Conditional Prepayment Rate vs. interest rate savings from refinancing
Sources: CPR & CDR Technologies, Inc. The Conditional Prepayment Rate (CPR) is the proportion of the principal of a pool of loans that is assumed to be paid off prematurely in each period. Rate Incentive represents the interest rate savings from refinancing (in basis points).
How does an active manager add value in Agency MBS?
Active managers in the Agency MBS sector add value by positioning the portfolio across mortgages of differing characteristics in order to mitigate prepayment risk and maximize risk-adjusted returns. For example, in the current environment, the portfolio management team is underweight middle coupon issues, which are more susceptible to refinancing risk. Instead, the team is overweight low and high coupon MBS as well as 15-year low coupon MBS, which are better insulated from government-led refinancing initiatives.
What are non-agency MBS and why should investors consider them for their portfolio?
Non-agency MBS are securities issued by financial institutions, rather than government agencies, and are backed by residential mortgages that generally do not conform to the agencies' underwriting standards (i.e. loan size, documentation). The non-agency MBS sector, which recently has provided an attractive lossadjusted yield of 6-8%†, presents investors with an opportunity to add diversification to higher yielding positions outside of high yield corporate credit (see Figure 3). It is important to note that the loss adjusted yield is calculated using BlackRock's conservative assumptions for the US housing market. Therefore, there could potentially be greater upside to the sector if the housing recovery is better than our assumptions. In contrast, when looking at high yield corporate credit, there is no upside potential to yields but there is downside potential, since the quoted yields are not adjusted for losses. Defaults have been running just below 2% annualized for the past year.
Figure 3: Non-Agency Yields Are Attractive
Relative Yields within Fixed Income Sectors in 2011 vs. 2012
Sources: BlackRock, Bloomberg. Non-Agency MBS represented by Wells Fargo 6% CMO; HY Corporate represented by JP Morgan Domestic High Yield Index; IG Corporate represented by BoA ML 1-10 Year US Corporate Index. Past performance is no guarantee of future results. It is not possible to invest directly in an index.
A further important point is that the non-agency MBS market is in a unique position since it is effectively a disappearing market (see Figure 4). There is a limited opportunity for investors to capitalize on this market since the supply of distressed MBS credit is quickly diminishing.
Another reason to consider adding non-agency MBS to a portfolio is that the sector trades with significantly less duration (sensitivity to changes in interest rates) compared to corporate credit. This is particularly helpful for those investors concerned about a rising interest rate environment. The reason is that the sector trades on an absolute yield basis as opposed to a spread over US Treasuries. In fact, floating rate non-agency MBS are likely to rise in price should interest rates rise, an environment in which the prices of most fixed income assets decline.
What are the major risks in the non-agency MBS market?
When compared to high yield corporate credit, the non-agency MBS market carries a lower liquidity profile. In some cases, select securities may face the potential for legal settlement issues. Legal settlements may alter the cash future cash flows of certain securities negatively, as when principal is written down. On the other hand, legal recoveries due to violations of representations and warrants would likely benefit the sector. Therefore, credit analysis is important and the sector should be viewed as a buy and hold strategy, positioned to take advantage of attractive loss-adjusted yields.
How can investors access the mortgage market?
Having pioneered the structured securities markets, BlackRock is a recognized leader in the mortgage space, with over $150 billion managed in mortgages across fundamental fixed income and $19 billion in dedicated mortgage strategies. BlackRock offers several different ways to access the mortgage market, based upon the interests and needs of the investor and portfolio. With the complexity and rapidity of the mortgage securities markets, we recommend that investors rely on a professional active investor to oversee the allocations across yield curve, credit risk and other risks. Mutual funds are highly liquid and offer diversification (versus the chore of having to build your own portfolio of securities). Diversification among securities is very important in terms of managing risk, perhaps never more so than today. It should be noted, however, that diversification alone does not ensure profits in declining markets. Any investment decisions should be made in alignment with an investor's goals, risk tolerance and time horizon and in partnership with a professional financial advisor.
Figure 4: Dwindling Supply of Non-Agency Mortgages
Total outstanding by type
Investment involves risks. Bond values fluctuate in price so the value of your investment can go down depending on market conditions.The two main risks related to fixed income investing are interest-rate risk and credit risk. Typically, when interest rates rise, there is acorresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able tomake principal and interest payments. Investments in non-investment-grade debt securities (high yield or "junk" bonds) may be subjectto greater market fluctuations and risk of default or loss of income and principal than securities in higher rating categories.
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are those of the portfolio manager profiled as of April 27, 2012, and may change as subsequent conditions vary. Individual portfolio managers for BlackRock may have opinions and/or make investment decisions that may, in certain respects, not be consistent with the information contained in this report. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.
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Prepared by BlackRock Investments, LLC, member FINRA.
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