by Tom Mansley – Investment Director
Evolving considerably since the Global Financial Crisis (GFC), Mortgage-Backed Securities (MBS) make up almost a quarter of the US fixed income market and offer a less volatile source of returns. New regulations and tighter lending standards following the GFC have improved mortgage credit quality.
For investors seeking to establish a truly diversified global fixed income portfolio, there are some aspects of the US mortgage-backed securities (MBS) market which could make it an appealing asset class to non-US investors. While the MBS market played a central role in the GFC, the asset class has evolved considerably in the years since, when we have seen the issuance of a range of different instruments. The concept of non-qualifying mortgages was created after the GFC and is an area with a large number of opportunities. The developed market definition is loans made to borrowers whose financial and / or property profiles fall outside of defined guidelines set by a government agency. In addition, a whole specialist area in troubled loans has emerged, such as reperforming loans, where the borrower has been delinquent but has resumed making payments.
It may be surprising to find that MBS is actually the second largest segment of the US bond market after treasuries, accounting for almost a quarter of the US fixed income market. In our view, there are a number of reasons why an investor may consider US MBS. With mortgages accounting for such a sizeable part of the US bond market it is difficult to have a representative exposure to this market without including mortgages. MBS may offer higher yields than treasuries with similar maturities; this includes higher-quality agency, as well as non-agency, issuance. One reason for this enhanced yield is the risk of prepayment and the associated reinvestment risk that comes with MBS. In the case of Ginnie Mae, Freddie Mac and Fannie Mae, this enhanced yield comes with little or no additional credit risk. The combination of high credit quality, large size and a diverse range of investors mean the US MBS market is generally highly liquid.
What does the US mortgage market look like in 2022?
Our latest paper examines the dramatic change undergone this year in the US mortgage market. Higher mortgage rates are contributing to declining home sales, which have now fallen to levels consistent with pre-Covid home sales. The price of houses in the US have stabilised after rising dramatically during the pandemic. In June, house prices increased by +0.6% from May, and +18% year-on-year, according to Case-Shiller. We believe that the lack of inventory and strong household formation should continue to provide relative stability for house prices for the foreseeable future. Further points expanded on in the report include rising interest rates, mortgage originations and tighter lending standards.
Despite concerns about strong inflation and the prospect of a recession, we believe that MBS has the potential to weather the storm. This is because we believe the US consumer will likely remain resilient due to the tight labour market and the high savings rate during the pandemic. The unemployment rate in August was 3.5%, which we believe should allow the Federal Reserve to act aggressively without crushing the labour market and leaving consumer credit relatively unscathed. Further, the MBS market continues to be supported by strong housing demand and low vacancy rates which, in our view, are unlikely to fall significantly while there is a shortage of homes.
