Despite the unaffordability of U.S. homes for first-time buyers, there is a unique opportunity emerging in the mortgage bond market. The Federal Reserve’s decision to increase interest rates has had a significant impact on the $8.9 trillion agency mortgage-bond market, which serves as the main source of financing for the housing industry.
Investors have witnessed historically wide spreads, referring to the compensation they receive. This is particularly remarkable considering that these mortgage bonds are backed by home loans that adhere to stricter government standards implemented after the subprime-mortgage crisis.
As a result of these shocks, bond prices have dropped sharply, falling from a peak above 106 cents on the dollar to below 98. Despite this decline, investors are guaranteed full repayment at 100 cents on the dollar.
Although the agency mortgage-bond market has struggled recently, some investors, like portfolio manager Nick Childs from Janus Henderson Investors, see significant opportunities on the horizon. The slowdown in the housing market is expected to create scarcity in these bonds. Consequently, this scarcity may help revitalize the sector which has experienced a two-year slump.
Not only have prices fallen due to rate shocks but also because the Federal Reserve has been reducing its presence in the mortgage-bond market to restore economic stability. Additionally, banks burdened with underwater securities have also scaled back their involvement. In fact, the repricing of similar bonds contributed to the collapse of Silicon Valley Bank earlier this year.
Childs notes that banks have not only stepped away from the market but are also actively selling. He oversees the Janus Henderson Mortgage-Backed Securities exchange-traded fund JMBS, a $2 billion fund that focuses on highly rated securities with minimal credit risk.
However, despite current challenges, Childs believes that as supply continues to dwindle due to low refinancing activity and a lack of new home loans, the sector may experience improvement. This is especially true as 30-year fixed mortgage rates have increased above 7%.
In conclusion, while the U.S. housing market poses challenges for first-time buyers, the mortgage bond market offers unique opportunities for investors. Despite recent struggles, the shrinking supply and potential scarcity of these bonds may help revive the sector. With careful maneuvering and strategic investment, mortgage bond investors can take advantage of the current market conditions.
The Evolving Landscape of U.S. Mortgage Bonds
Over the past two decades, the bulk of U.S. mortgage bonds has been dominated by housing giants Freddie Mac, Fannie Mae, and Ginnie Mae. These bonds, supported by government guarantees, have effectively transformed the sector into a market similar in size to the $25 trillion Treasury market. However, unlike Treasury investors, those investing in mortgage bonds earn an additional spread to compensate for the primary risk associated with these instruments: early repayments.
While homeowners typically opt for 30-year loans, the pandemic-driven rush to secure record-low interest rates led many to refinance their mortgages instead of continuing payments on more expensive loans. Consequently, this trend introduces an element of uncertainty for bond investors when borrowers refinance, sell, or default on their homes.
In light of this evolving landscape, Sam Dunlap, the Chief Investment Officer at Angel Oak Capital Advisors, points out that the biggest risk to mortgages has largely dissipated. Despite this positive development, spreads on mortgage bonds remain historically wide.
Presently, these spreads exceed the long-term average and surpass those offered by corporate bonds deemed relatively low-risk in comparison. Notably, agency mortgage bonds are commonly included in low-risk bond funds and are also available through exchange-traded funds. Although they encountered significant losses due to the sharp selloff in long-dated Treasury bonds, there is optimism that the worst of the storm might be behind them.
Goldman Sachs credit analysts express a favorable view of the sector; however, they caution that it still grapples with high rate volatility and a lack of institutional demand.
One unmistakable sign of the U.S. bond selloff is reflected in the iShares 20+ Year Treasury Bond ETF (TLT), which recently reached its lowest level in over a decade. FactSet data indicates that TLT is on course for a negative 10% total return this year. Similarly, Janus Henderson’s JMBS ETF is projected to record a negative 2.7% total return by the end of the year.
The attractiveness of agency mortgages lies in their inherent credit risk mitigation. As Childs asserts, the government backing associated with these bonds eliminates credit risk. In the event of borrower default, investors can still expect the full repayment of principal.
In summary, the landscape of U.S. mortgage bonds continues to evolve, driven by unprecedented factors such as refinancing surges and historic spreads. Yet, with the government providing crucial support, agency mortgage bonds continue to find a place in portfolios due to their credit risk resilience.
