Lower Rates Create Opportunities in Today’s Mortgage Market
While mortgages have underperformed U.S. Treasuries year to date, lower rates have sparked a refinancing wave that is creating tailwinds in the housing market. Portfolio Manager Nick Childs explains why we believe active management is key to uncovering opportunities in the space.
- With mortgage rates low and a large percentage of loans refinanceable, we are seeing tailwinds in today’s housing market.
- Understanding the nuances of borrower behavior and taking advantage of volatility in the space should enable active managers to capitalize on opportunities.
- We believe future changes in the interest rate regime and increased volatility may present further opportunities.
Nick Childs: So why mortgages, why now? Mortgages have struggled versus Treasuries year to date. In Q4 2018, we were around 150 basis points higher in mortgage rates. So, what we are seeing today is, back in Q4, around 7% of the universe was refinanceable; now, [it’s] around 70%. So, from a risk perspective, mortgages have refinancing risk. In this environment, given the volatility, mortgage spreads are close to the wides we have seen over the last five years. So, they do look attractive from a spread perspective, on a standalone basis, historically.
A lot of our clients are asking, “What’s going on with the housing market? How are mortgage rates affecting the housing market?” You know, [in] Q4 we were fairly bearish on the housing market broadly. Mortgage rates were high, affordability was constrained. Today, a lot of those headwinds have lifted, with mortgage rates as low as they are. In fact, we are seeing a lot of tailwinds, and we are becoming fairly optimistic on the housing market.
The mortgages that were taken out over the last 18 months are most refinanceable, because they haven’t had an opportunity to refinance in their lifetime. When you think about the mortgage space in aggregate, and you kind of think about that in total return space, while there’s a top-level total return number, there are thousands of nuances beneath the surface. So the dispersion beneath that surface in total return is significant.
So, while mortgages are underperforming U.S. Treasuries year to date, as an active manager, you still can outperform because of the thousands of nuances.
It’s making it a very interesting market for active managers. Whereas the mortgage space generically on a passive basis has a lower preference for volatility, we are encouraged by it. And if you think about, kind of, how the borrower universe is made up, really the most negatively convex or refinanceable borrowers have taken out their mortgages over the last 18 months.
So why active and mortgages? Volatility is good for us, right? And investing in mortgages, it’s a very quantitative space in general. So, think basic statistics, mean reversion, etc. Every time you see a change in interest rate regime, it allows for further opportunity, right? It is a modeling space, so we are understanding borrower behavior – so effectively why and when people prepay their mortgage – and every change in interest rate and every increase in volatility allows us to do more of that. So we are pretty excited about that.
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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.
Mortgage-backed securities (MBS) may be more sensitive to interest rate changes. They are subject to extension risk, where borrowers extend the duration of their mortgages as interest rates rise, and prepayment risk, where borrowers pay off their mortgages earlier as interest rates fall. These risks may reduce returns.
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