Today's RMBS opportunity deconstructed
WyeTree Asset Management, April 2017
US RMBS continue to rally, supported by robust labour and housing markets, cheap credit and increasingly high-quality collateral. In this Q&A article, WyeTree ceo and cio Judith Sciamma explains that since RMBS also have several portfolio characteristics that institutional investors continue to search for in today's investment environment, the sector offers compelling value.
Q: Why are real money investors looking at US-based RMBS strategies?
A: RMBS portfolios can provide a number of attributes that institutional investors continue to seek, such as stable yield, diversification and inflation protection. Since returns are a function of the underlying performance of the mortgage collateral - i.e., borrowers repaying their mortgages - they provide diversification from and low correlation to traditional asset classes. RMBS-based portfolios can also protect from inflation and rising interest rates by investing predominantly in floating rate securities.
The asset class is also now accessible to a broader range of investors in more liquid, UCITS-compliant vehicles. Investors can achieve cost-effective and diversified exposure to the RMBS market in a portfolio backed by a highly analytical and thorough investment process.
Q: What are the drivers of RMBS performance?
A: Returns on RMBS are a function of both ability and incentive to pay by borrowers holding the underlying mortgages. The strength of the US economy, and its potential for further growth, continues to be highly supportive of both these factors and augments the investment case for RMBS.
The US labour market is increasingly robust, with close to full employment and continuing wage growth. Pro-growth government policies are expected to further bolster job creation and should be particularly beneficial to subprime borrowers.
Demand and supply dynamics in the housing market are also very positive. Healthy demand for homes is being driven by the formation of new households and, in particular, by millennials who are seeking houses to buy or rent. As the largest cohort in history, it's likely that their need for housing will continue to grow for some time.
Access to cheap credit for many borrowers supports this trend, and expected deregulation should further increase lending levels. Alongside this, the availability of spare homes is thin, with housing inventory at only 3.6 months - the lowest recorded since at least 1999 - and construction levels too low to fill the gap.
The combination of these factors has caused a 35% increase in US house prices since the end of 2012, according to CoreLogic. This is also a boon for RMBS, since higher house prices reduce loan-to-value rates (which, for US subprime borrowers, were at 74% in December 2016, compared to their peak of 117% during the financial crisis).
This makes it easier for borrowers to refinance and further incentivises them to repay their home loans. House price appreciation and low interest rates have also encouraged loan prepayments, further reducing the likelihood of borrower default.
These dynamics are borne out in the strength of key mortgage market indicators. Loan default rates are stable and delinquency rates have dropped by more than 25% since their peak during the crisis. When repossessions do occur, overall losses are now lower for two reasons: higher house prices have improved resale values, and liquidation is quicker because of excess demand.
Q: Many borrowers defaulted during the financial crisis, affecting the performance of RMBS investments. Is there still reason for concern?
A: These securities are considerably more robust now, for several reasons. When weaker borrowers defaulted during the crisis, the subordinated tranches - which are exposed to losses first - were written off, leaving only the senior tranches that hold mortgages from borrowers less likely to default. These borrowers had continued to repay their mortgages when interest rates were higher and during difficult economic conditions.
In addition, their houses are now worth more than before the crisis and their loans have fewer years remaining. Not only are the deals that survived the financial crisis therefore structurally more robust, but - given the time that has now passed - there is also substantially more information available on the cashflow of the underlying mortgages, allowing greater insight into the likelihood of default.
Deals issued since the crisis - although relatively limited in number - have benefited from the tougher underwriting criteria put in place after the crisis, meaning the collateral quality in these securities is also stronger.
Q: Investors can receive higher returns by investing in subprime mortgage pools, but this also means the potential for higher risk. How do you mitigate against this?
A: We believe that it's important to always take a bottom-up, analytical approach to looking at both bonds and transaction structures. This is particularly true in today's investment environment, where it's harder to identify strong top-down investment themes. By combining detailed quantitative analysis with extensive stress and scenario testing and independent qualitative research to construct a portfolio, it is better insulated from a less stable political and economic environment, and more able to provide stable returns from investment in high quality securities.
Q: What is the outlook for this asset class?
A: We expect positive sentiment for the asset class to continue, bolstered by further strengthening in the US economy, a healthy job market with room for more growth and supportive housing market dynamics. Stability in these factors gives borrowers confidence, better ensures they are willing and able to repay their mortgages and drives the performance of mortgage-backed bonds.
This article was published in Structured Credit Investor on 10 April 2017