David Thornton, senior investment manager, Premier Asset Management
Mortgaged-backed securities may have been unfamiliar to many investors prior to the global financial crisis in 2008 but since then, simply uttering the words ‘mortgage backed securities’ was enough to cause many investors to baulk. Throw the term ‘subprime’ into the mix and it would bring on a cold sweat.
These were deemed toxic assets, and indeed that was true for a particular section of the mortgage market, but it is easy to forget that much of the mortgage market stood up well during the turmoil, and that there are securitisations of perfectly sound mortgages that were issued well before the crisis.
The attention of the Premier multi-asset team is often drawn to an unloved asset class, as it often means that there are opportunities that have been overlooked and oversold, as the investment crowd rushes for the exit. The complexity premium in analysing these vehicles is significant too.
Our preference is for legacy, non-agency deals that have benefitted from a recovering housing market, thus improved loan-to-value, and are now in a position to refinance. The non-agency mortgage space is a shrinking market with banks unlikely to be re-entering the market, in any significant way, soon. This offers us good value access to high credit quality yield, something that we feel unable to achieve from traditional government bond markets.
Damian Barry, senior investment manager, 7IM
A mortgage-backed security is a bond that is backed by a pool of mortgages. The mortgage pool is then divided into ‘tranches’ with varying characteristics and risk levels. The popularity of these securities is motivated by investors search for yield, liquidity and diversity. Downside risks of mortgage-backed securities were highlighted in 2008 when the value of US properties plummeted and mortgage holders defaulted in huge numbers.
US property prices are rising gradually and US banks have better mortgage standards in place than 2008. The US economic expansion continues and the possibility of income tax reductions from the Trump administration should provide further support for the US residential and mortgage market.
Today the US mortgage-backed securities market is a highly liquid, diversified market with approximately $8trn (£6.4trn) in assets and accounts for about 25 per cent of the US fixed income market. Mortgage-backed securities are much more liquid than US corporate bonds, and offer a diverse choice of securities.
Mortgage-backed securities offer attractive yields but are in general insulated from rising rates. Corporate bonds by comparison are not protected from rising rates. In addition corporate bonds can be more highly correlated to equites than mortgage-backed securities. Corporate bonds may well struggle to deliver past returns, particularly in a rising interest rates environment. In which case it may be worth considering a role for mortgage-backed securities in a multi-asset portfolio.
Solomon Nevins, senior investment manager, Architas
The outlook for mortgage-backed securities looks attractive. The floating-rate cash flows that are a feature of the underlying mortgages position them to perform well in an environment where base rates and Libor are rising.
If we focus on the US market, the fundamental outlook is supportive: unemployment is low and falling, home prices have risen sharply since the great financial crisis, and mortgage costs are far lower than the long-term average. If the US economy continues its recovery, with an added boost from Trump’s fiscal policies, then the housing market and mortgage servicing should remain robust.
Spreads have tightened over the past year along with other credit asset classes but mortgage-backed securities, particularly in the non-government agency private segment where prime floating rate indices are yielding Libor+200bps. From the current low interest rate level, mortgage rates can increase by a modest amount resulting in higher cash flows before affordability becomes a problem.
The change in inflation perception and the prospect for higher rates may also spur homeowners to re-finance their mortgage to lock-in a low rate whilst they are still cheap and consequently there may be pre-payment penalties to be earned by the mortgage-backed securities holders.
Despite being a diverse asset class, asset-backed securities still carry a poor reputation due to its key role in the global financial crisis. But for investors that are willing to look beyond this generalisation and partner with asset class specialists there are attractive opportunities in the current environment.