Residential mortgage-backed securities are having a fortuitous moment. Notes have higher yields, better liquidity, and lower duration than A/BBB corporate credit, making them potentially better purchases, say industry professionals. Those dynamics could change rapidly, however, they say, so it's better to be in this trade today.
Agency mortgages are very cheap compared with investment-grade U.S. corporates, and represent a huge opportunity, according to Mike Nowakowski, director, structured products at Conning, especially now that major backstop buyers have retreated from the market, leaving a lot of supply.
The Federal Reserve is currently in run-off mode and is allowing up to $35 billion per month in RMBS to roll off its System Open Market Account (SOMA) portfolio without reinvestments. This eliminates a significant backstop buyer that was active in the market, which also took out a meaningful amount of supply, particularly during 2020 and 2021, Nowakowski said.
The central bank is not the only institution in run-off mode. Banks are not big RMBS buyers either. One reason is overstock, a legacy of the COVID era when they invested heavily in RMBS rather than uncertain consumer, commercial, and industrial loans.
"They bought a lot of bonds at very low coupons - e.g. 1.5%-2% coupons," Nowakowski said. "As the Fed raised rates, these bonds went really out of the money."
After such losses on the 2020 and 2021 purchases, banks have not been as active since.
Accounts in retreat
Additionally, lower interest rates offered by banks have resulted in money going into money market funds, leaving banks with less capital to invest in bonds or securities.
The absence of foreign buyers is another factor. Historically, a lot of foreign demand is from Chinese, Japanese and U.K. buyers who hedge their currency. "On a currency-hedged basis, the opportunities for RMBS haven't been compelling, especially versus the yen," said Nowakowski.
"If you're a large Japanese life insurer that typically buys 30-year RMBS, after you've dealt with hedging costs, the yield isn't that compelling compared to European sovereign debt or Japanese securities."
After warnings of rating agency downgrades in March forced regional banks Silicon Valley Bank and First Republic Bank to liquidate their mortgage holdings through the FDIC, a lot of unexpected supply came back into the market. , Money managers that were already overweight required an additional spread to take on that extra supply.
"You can see a significant wider gap in spreads after the March episode," Nowakowski said.
Once a catalyst occurs such as Fed rate cuts, banks will resume their borrowing and lending activities. The bonds on their portfolios should get closer to at the money or in the money, so bank purchases will likely return and spreads in RMBS may tighten rapidly, Nowakowski predicts.
"I don't know that banks will do a massive number of investments, but they will, at minimum, stop letting bonds roll off their books and start to reinvest," he said.
Jack Kahan, a KBRA senior managing director of RMBS research, also predicts that, as the market gains clarity on interest rates, this will lead to tighter spreads in general.
2024: hardly a booming reset
RMBS issuance is expected to be relatively low for 2024, another potential factor in tightening spreads.
KBRA estimates that RMBS will end 2023 at $52 billion, down 50% year-on-year from 2022 and comparable to 2020. It says 2024 conditions are expected to be more favorable compared to 2023, although issuance volumes will likely remain modest.
Total 2024 issuance will rise 8.6% from 2023 to $56.5 billion, KBRA predicts. Issuance in Q1 2024 is projected to fall 12% year-on-year to $12 billion, it says.
Commenting on RMBS collateral performance, KBRA's Kahan said he expects delinquencies to be stable, with a modest degree of credit deterioration in 2024 continuing the trend seen in 2023.
