As volatility increases, US fixed income investments backed by high-quality mortgage and consumer loans may potentially provide strong risk-adjusted return outcomes.
Aggregate U.S. consumer fundamentals remain strong and stable for the time being, even as the effects and risks of COVID-19 continue to grow rapidly. The ratio of consumer financial obligations relative to disposable income has declined meaningfully, and currently stands at 20-year lows. While the overall level of mortgage and consumer debt has grown since the great financial crisis (GFC), the debt burden to the consumer continues to decline, specifically due to falling interest rates and the rise in disposable income, both of which have supported the deleveraging process (Exhibit 1).
Exhibit 1: Consumer Balance Sheets Have Improved Along With Default Rates
Source: Bank of America Merrill Lynch, Federal Reserve, Western Asset. As of 30 Sep 19. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
From a consumer stimulus perspective, with mortgage rates continuing to decline, most US homeowners have an incentive to refinance. Given the rapid moves in Treasury rates, mortgage rates have lagged in adjusting as originators’ capacity for processing refinance and purchase applications has been constrained. Lenders are aggressively staffing to address the growing demand from mortgage borrowers; however, lockdowns and social distancing associated with the response to the virus complicate business decisions. As capacity constraints improve and rates remain low, more borrowers will take advantage of historically low mortgage rates, which will manifest in higher prepayments and supply for agency mortgage-backed securities (MBS) investors, while at the same time improving consumer credit fundamentals.
We are constructive on agency MBS given our view that monetary policy will be accommodative for an extended period. On Sunday March 15, 2020, the Fed eased monetary policy by an additional 100 bps and authorized $700 billion in Fed purchases across US Treasury and agency MBS markets ($500 billion in US Treasury and $200 billion in agency MBS). These additional measures are designed to smooth functioning of markets for Treasury securities and agency MBS that are central to the flow of credit to households and businesses. We believe conventional MBS offer better relative value and a liquidity advantage over Ginnie Mae issued MBS, focusing on coupons and collateral stories with more predicable prepayment profiles. Exhibit 2 highlights that agency MBS spreads have largely discounted the surge in refinancing applications.
Exhibit 2: Refinancing Activity and Mortgage Spreads
Source: Bloomberg, Mortgage Bankers Association. As of 06 Mar 20. *MBS spread represents Bloomberg Barclays US MBS Index Zero Volatility Spread. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
The housing market has notably lower leverage today based on low loan-to-value ratios and high quality underwriting. Additionally, we have observed low levels of new construction, limited inventory of existing homes and increasing demand from low mortgage rates. We expect home prices to remain steady with limited downside risk, given the lack of supply and leverage in the system. Against this backdrop, fundamentals for securities that are backed by residential credit are favorable. Additionally, the structural features embedded in securitization markets today are far superior to ones we saw pre-GFC, and are built to withstand significant stress. To the extent individuals face quarantines related to COVID-19, we expect servicers to act sympathetically and provide forbearance on loans in affected areas. Similar to what occurs in areas of natural disasters, Fannie and Freddie guidance allow servicers to provide forbearance up to a cumulative term of 12 months with additional forbearance possible if approved by the government-sponsored enterprises (GSEs). We have seen these programs work effectively recently in times of natural disasters such as wild fires and hurricanes. Troubled loans are typically kept in pools for a lengthy period with principal and interest advancement for investors, which is followed by buyout programs.
Commercial real estate has also benefited from a lack of construction and improved demand. However, we are mindful of areas in the commercial MBS (CMBS) market that will be more exposed to COVID-19 risks, most notably hotels and retail properties. These deals are also more soundly structured today, and our focus is on Class A properties with well-capitalized sponsors capable of withstanding short-term disruptions. We would express significant caution on lower quality Class B/C properties and more levered properties that you typically see in CRE-CLOs and Conduit CMBS. We would be cautious in these subsectors.
Asset-backed securities (ABS) markets also vary in exposure from high quality to lower quality borrowers, and asset classes that are more exposed to travel and US recession risks. The areas of primary concern are lower quality consumer ABS such as subprime auto loans and unsecured consumer credit. These borrowers are more susceptible to near-term income disruption. Travel- and trade-related assets such as aircraft ABS, timeshare ABS and container shipping are also under significant pressure. We would be cautious in these sectors as well.
In our view, as volatility in financial markets increases, US fixed-income investments backed by high quality mortgage and consumer loans are expected to provide better risk-adjusted return outcomes. Agency MBS offer a liquidity advantage and an explicit/implicit government guarantee of underlying cash flows for investors, while non-agency structured credit has strong fundamentals.
During the month of February as volatility picked up, performance in our strategies supports our conviction. With that said, a severe and prolonged global economic slowdown will certainly impact most spread sectors negatively and we may see increased levels of delinquencies and write-downs that will start negatively affecting the bottom tranches of different transactions. However, this is not our base case scenario at Western Asset. The Fed’s proactive reduction of its target rate by 150 bps will have little effect to correct a supply shock due to COVID-19 but it will certainly be a positive development for the demand side of the equation. Furthermore, from the consumer point of view, lower prices at gas stations combined with money saved from refinanced mortgages and potential payroll tax cuts will free up some cash, improve balance sheets further and make the fundamental macro picture more attractive.
COVID-19 is the World Health Organization's official designation of the current coronavirus disease.
The financial crisis of 2007–08, also known as the Great Financial Crisis (GFC), global financial crisis and the 2008 financial crisis, was a severe worldwide economic crisis considered by many economists to have been the most serious financial crisis since the Great Depression of the 1930s, to which it is often compared.
The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
One basis point (bps) is one one-hundredth (1/100, or 0.01) of one percentage point.
U.S. Treasuries are direct debt obligations issued and backed by the "full faith and credit" of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.
Debt service ratio is the ratio of its debt service payments (principal + interest) to earnings.
The MBA Refinance Index is a weekly measurement put together by the Mortgage Bankers Association, a national real estate finance industry association. The index helps to predict mortgage activity and loan prepayments based on the number of mortgages refinance applications submitted.
Agency mortgage-backed securities (MBS) are asset-backed securities secured by a mortgage or collection of mortgages issued by federal agencies like Fannie Mae, Freddie Mac and Ginnie Mae.
Government National Mortgage Association (GNMA) obligations are pass-through mortgage-backed securities consisting of a pool of residential mortgage loans. All payments of principal and interest are passed through to investors each month.
A conduit loan - also known as a CMBS loan (Commercial Mortgage Backed Security) - is a type of commercial mortgage that is packaged into a pool with other similar type commercial loans and securitized and sold in the secondary market to institutional investors.
A conduit bond is a type of municipal bond sold by a governmental entity for the purpose of making proceeds available to a private entity usually in furtherance of a public purpose. An example would be bonds in connection with not-for-profit hospitals or affordable housing.
An Asset-Backed Security (ABS) is a financial security backed by a loan, lease or receivables against assets other than real estate and mortgage-backed securities.
A Commercial Mortgage-Backed Securities (CMBS) is a type of mortgage-backed security that is secured by the loan on a commercial property.
A Mortgage-Backed Security (MBS) is a type of asset-backed security that is secured by a mortgage or collection of mortgages.
A spread is the difference in yield between two different types of fixed income securities with similar but not identical characteristics, with the possible differences including creditworthiness, maturity date, or other factors.
Bloomberg Barclays US MBS Index Zero Volatility Spread measures the spread of MBS securities, adjusted for volatility set at zero percent.
Government-sponsored enterprise (GSE) includes the Federal Home Loan Mortgage Corp (FHLMC), also known as Freddie Mac; and the Federal National Mortgage Association (FNMA), also known as Fannie Mae. GSEs were chartered by Congress in 1970 to keep money flowing to mortgage lenders in support of homeownership and rental housing for middle income Americans.
The Federal Housing Finance Agency (FHFA) regulates Fannie Mae, Freddie Mac, and the 12 Federal Home Loan Banks.
The Federal National Mortgage Association (FNMA), also known as Fannie Mae, is a government-sponsored enterprise (GSE) founded in 1938. Its purpose is to expand the secondary mortgage market by securitizing mortgages in the form of mortgage-backed securities (MBS), allowing lenders to reinvest their assets into more lending.
The Federal Home Loan Mortgage Corp (FHLMC), also known as Freddie Mac is government-sponsored enterprise (GSE) chartered by Congress in 1970 to keep money flowing to mortgage lenders in support of homeownership and rental housing for middle income Americans. The FHLMC purchases, guarantees and securitizes mortgages to form mortgage-backed securities.
Commercial Real Estate (CRE) is defined as any property owned to produce income.
A CRE CLO is a securitization vehicle for commercial real estate bridge loans. CRE CLOs serve as an alternative to other forms of financing such as traditional bank warehouse lines. The vehicles are primarily collateralized by first lien loans on transitional assets.
A subprime auto loan is a type of auto loan that is normally made out to borrowers with lower credit ratings who the lender views as having a larger-than-average risk of defaulting on the loan.
Risk-adjusted return is a measure of performance relative to its level of risk exposure over a given period of time.
Spread sectors refers to sectors of the bond market, such as taxable bonds that are not Treasury securities, and includes securities such as agency securities, asset-backed securities, corporate bonds, high-yield bonds and mortgage-backed securities.