Mortgage-backed securities (MBS) traditionally offer higher nominal spreads than other fixed income asset classes because of uncertainty in their cash flows. In a simple MBS pass-through structure, investors receive the scheduled principal and interest from a pool of mortgages. Investors also receive the return of principal from loans that prepay any additional principal in part or in full by various methods, including refinancing, sale or principal curtailment.
The additional return of principal is commonly known as “prepayment.” Mortgagers typically exhibit faster prepayments when interest rates fall (as they refinance into lower mortgage rates) and slower prepayments when interest rates rise. Prepayment risk results in negative convexity for the investor. When rates fall and prepayments rise, investors have their principal returned more quickly and must reinvest at lower rates. Consequently, as rates rise, prepayments slow and the investor has less cash flow available to invest at higher rates.
Since the global financial crisis (GFC) of 2007-08, the government-owned Ginnie Mae and government-sponsored entities (GSEs) Fannie Mae and Freddie Mac have dominated issuance in the MBS market. MBS issued by these entities are referred to as agency MBS and carry — explicitly (Ginnie) or implicitly (Fannie, Freddie) ― the full faith and credit of the U.S. government. Issuance in non-agency MBS, which are not government-guaranteed, came to a halt after the GFC but has been steadily increasing. In 2015, issuance was $62 billion, with estimates for 2021 reaching $160 billion.
In this week’s chart, we are looking at two fast-growing sectors in non-agency MBS: private-label securitizations of prime jumbo and agency-eligible investor collateral. Prime jumbo deals securitize large, high-balance loans that may (conforming) or may not (non-conforming) meet the size limits for the GSEs. Borrowers must have pristine credit (765-plus FICO), with loan-to-value (LTV) ratios between 65% and 75%. Agency-eligible investor deals contain loans for investment properties that are eligible for a guarantee if sold to Fannie or Freddie. Average credit scores for these borrowers are north of 760, with 60%-70% LTV.
There are several reasons for the increasing volume of issuance in these two sectors. For prime jumbo, non-conforming loans are ineligible for agency MBS so the non-agency MBS market is a main outlet for originators to realize a gain on sale. The growth in agency-eligible investor securitizations, particularly in the second half of 2021, is likely attributable to a January announcement by the U.S. Department of the Treasury that limits Fannie and Freddie’s purchase of second-home and investor loans to 7%. In addition, the tightening of credit spreads has made private-label securitization more economical than sale to the GSEs.
Investor demand has been robust for recent private-label securitizations. Both prime jumbo and agency-eligible investor super-senior pass-through AAA-rated bonds are available at a significant discount to their agency MBS counterparts. Agency MBS 2.5% coupon investor-specified pools have been trading at a 0.5 to 1 point premium to generic (TBA, to-be-announced) 2.5% agency MBS compared with private label, which has been pricing around a 1.5-point discount.
Investor collateral trades at a premium in agency MBS because this collateral has demonstrated more favorable prepayment characteristics. Prime jumbo collateral exhibits inferior prepayment characteristics compared to both TBA and investor collateral. Prime jumbo 2.5% super-senior pass-through bonds are pricing at a little more than a 2-point discount and are roughly 1 point cheaper than their agency jumbo counterparts.
When investing in private-label securitizations of prime jumbo and agency-eligible investor collateral, investors forgo the volumes and government guarantee found in agency MBS. In return, investors receive more spread and lower dollar prices, which improves the convexity on premium-priced bonds. Investors looking for a cheaper form of call (prepayment) protection may find better relative value in the recent supply of private-label agency-eligible investor deals compared with investor-specified pools.
For other MBS investors looking to take on more prepayment risk in return for higher spreads and low dollar prices, prime jumbo issuance continues to remain robust. The pricing of the super-senior classes in new deals and the relative collateral performance will impact the relative value between sectors for investors looking at both.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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