PM Perspectives: Looking Ahead with Mortgage-Backed Securities
Portfolio Manager John Kerschner discusses why mortgage- and asset-backed securities may present active managers with opportunities in varying market environments.
- While some investors remain concerned with the potential for a slowdown in the U.S. housing market, market conditions can provide opportunities within agency mortgage-backed securities.
- We have seen over time that interest rate volatility has continued to move lower, which we believe is a result of more transparency from the Federal Reserve.
- Many investors are concerned about spreads being relatively tight. What many investors don’t realize is that asset-backed securities actually recovered from the Global Financial Crisis much later, and because of that spreads on those assets are much wider than you would expect given how far we are into the cycle – potentially allowing for more income.
John Kerschner: The U.S. housing market actually has been very strong recently. A lot of people are concerned about what happens with mortgage-backed securities if this housing market does slow down. In actuality, because agency mortgaged-backed securities are guaranteed by the U.S. Treasury we can actually find opportunities no matter what is going on with the U.S. housing market. In fact, if the housing market does slow, that might mean more volatility in the agency mortgage-backed securities market and more opportunities.
Mortgage-backed securities actually have a lot less interest rate risk than the general fixed income indices or corporate credit indices in the market today. Now as far as volatility, yes, volatility is not good for markets, in general, and definitely not good for mortgage-backed securities because of the prepayment option. However, what we have seen over time is that interest rate volatility keeps going lower and lower. People forget about what happened back in the ’90s and 2000s – interest rate volatility was much higher with the range on the U.S. 10-year, usually 100 to 200 basis points on an annual basis. Those type of ranges we just haven’t seen for many years. Now why is this? In general, we believe it’s because the Federal Reserve has become much more transparent about their goals, giving press conferences, doing dot plots, and basically communicating with investors on a much more ongoing basis. All of this has allowed interest rate volatility to be dampened over the last few years.
One of the nice things about asset-backed securities is they actually are securitized. That means they actually have assets backing them. It’s right in the name.
So for example, let’s just assume you’re a person with an auto loan. If you have that loan, you’ll be making monthly payments on your auto. Those auto loan payments will be then transferred into the income of securities. Now what’s nice about these securities is if a certain number of people don’t make their payments, you have security in the form of an actual car that you can use to offset those payments that aren’t being made.
What we saw during the Global Financial Crisis in asset-backed securities is actually people were paying their car payment first. A lot of times what researchers said that people make their housing payments first, but what it really comes right down to is, in the United States in particular, people need their cars to go to work and they prioritize their payments for those things that they need first and foremost. In general, that is their auto payment. In fact, and a lot of people don’t realize this, there’s never been an auto ABS that is defaulted, and for the first time one got downgraded to CCC, but even that security we do not think will enter a default.
What a lot of investors are concerned about these days is when they talk about higher-yielding, or securities that may offer investors income, is that spreads are relatively tight, and this is pretty much true. Spreads have been tightening since the Global Financial Crisis started to come to a halt back in 2010 with a slight blip in late 2015, 2016. What a lot of investors don’t realize is ABS, asset-backed securities, actually recovered from the crisis much later. In fact, some sectors in ABS only started coming back around 2015, and because of that spreads on those assets are much wider than you would expect given how far we are into the cycle, because they’re really only two or three years into their cycle, not eight or nine like other asset classes. So, these wider spreads allow us more income and we think they will end up with being a better risk-adjusted return.
Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.
The principal on mortgage- or asset-backed securities may normally be prepaid at any time, which will reduce the yield and market value of these securities. Investing in derivatives entails specific risks relating to liquidity, leverage and credit and may reduce returns and/or increase volatility.
Credit Spread is the difference in yield between securities with similar maturity but different credit quality.
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