Housing Rebound and Investor Demand Buoy Mortgage-Backed Securities Market

Transcription

1 December 2013 Updated February 2014 Housing Rebound and Investor Demand Buoy Mortgage-Backed Securities Market Jose Pluto Fixed Income Analyst The U.S. housing market has improved markedly since hitting post-crisis lows in late 2011, representing a key point of support for the world s largest economy. Mortgage finance channels are gradually becoming unclogged as bank lending standards ease and the Federal Reserve continues to support housing, which exerts an outsized 3 to 6% impact on U.S. economic growth, by keeping mortgage rates low. These favorable trends have combined to fuel demand and push valuations to levels that increasingly reflect optimism for continued housing market strength, despite still-sluggish labor markets and weak income trends. An integral component of housing finance is the mortgage-backed securities (MBS) market. Currently $8.7 trillion in residential MBS are outstanding, an amount almost equal to all U.S. corporate bond market debt. A key feature of mortgage-backed securities the ability for the borrowers backing these bonds to refinance can cause investor cash flow expectations to vary significantly with the level of interest rates and affect broader fixed income market returns. So the housing sector s rebound has wide economic significance, and it is clearly underway. The widely followed S&P/Case-Shiller Home Price Index, for example, is up 13.7% for the year ended November 30, and overall the index is up 20.8% from post- collapse lows. All 20 metro areas that comprise the index have seen price rises over the past year, with 13 of the 20 experiencing gains over 10% and three markets in which price increases have topped 20%. The National Association of Realtors Pending Home Sale Index is almost 20% above the 2010 lows, and inventories of both existing and new homes continue to fall (Chart 1). Census Bureau data show rental housing vacancy rates have also fallen to 8.2% today from the 2009 peak of 11.1%, and are approaching levels not seen since the late 1990s. Chart 1: Monthly Supply of Single-Family Homes Months of Supply New homes Existing homes With this improvement in housing market fundamentals, the U.S. residential mortgage-backed securities markets remain well supported by investor demand. The U.S. MBS component of the Barclays U.S. Aggregate Bond Index, a broad representation of the agency-backed mortgage market, is up 0.75% over the last twelve months and has outperformed the broader index by 112 basis points. Similarly, average prices for generic non-agency-guaranteed MBS issuance are at the same levels as where they began There is also strong demand for new issues: according to recent data from Deutsche Bank, 2013 non-agency MBS issuance volumes were over 200% higher than Several factors have contributed to this strength. First, despite rising prices and higher interest rates, housing affordability is still very good. According to

2 2 February 2014 the National Association of Realtors Homebuyer Affordability Index, which represents the affordability of a median-priced home to the median-income buyer, home prices remain affordable relative to longer-term averages (history in Chart 2). Investor purchases of single-family homes have also been very strong. In an effort to take advantage of still favorable affordability as well as the falling home ownership rate, several large high-profile investors, such as private equity firm Blackstone s Invitation Homes unit and REIT American Homes 4 Rent, have been acquiring single-family homes for conversion into rental properties. Single-family home rental has historically been a fragmented, highly localized business that these investors believe is ripe for consolidation. Invitation Homes, for example, has built their business at an unprecedented pace and scale. According to the company, they have acquired approximately 40,000 single-family homes since April 2012 and are the largest owner of these properties in the country. Second, the Federal Reserve has focused its monetary policy efforts on supporting the housing market, given its historical contribution to growth. From the late 1990s through 2007, housing investment contributed 5 to 6% to total annual output; today housing is only 3% of GDP. However, recent economic growth has Chart 2: Homebuyer Affordability Index (higher = more affordable) Chart 3: 30-Year Agency MBS Yield 6.0% 5.5% 5.0% 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% Nov-08 May-09 Nov-09 May-10 Nov-10 May-11 Nov-11 May-12 Nov-12 May-13 Nov-13 seen a heavy contribution from housing activity; during the year ended September 30, 2013, 0.4% of GDP growth was attributable to housing. This represents 20.3% of the total economic growth seen over the period. MBS purchases have been a key contributor to mortgage rates remaining near historically low levels.

3 U.S. Housing Market Rebound 3 Since QE3 began in September 2012, the Fed has purchased 51% of all agency MBS issuance, helping to keep mortgage rates near all-time lows, despite the recent backup (MBS yield history: Chart 3). 7.75% 7.25% 6.75% 6.25% 5.75% 5.25% 4.75% 4.25% Chart 5: Mortgage Market Delinquencies Delinquencies as % of Total Loans Third, the availability of mortgage credit has been gradually easing. Over the past four quarters, the Fed Senior Loan Officer Survey has shown moderate loosening in credit standards for prime borrowers. Mortgage rates for jumbo borrowers have fallen significantly since 2008 and are now in line with those for conforming mortgages (history in Chart 4). Chart 4: Bankrate.com National Average 30-Year Jumbo Mortgage Rate 3.75% Sep-08 Mar-09 Sep-09 Mar-10 Sep-10 Mar-11 Sep-11 Mar-12 Sep-12 Mar-13 Sep Chart 6: Refinancing Activity and 30-Year Mortgage Rates % 2.25% 2.75% 2000 MBA Refinance Index (left-hand scale) 1000 Federal National Mortgage Association 30-Year Rate (right-hand scale, inverted) % 3.75 % Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Delinquency rates have improved significantly, helping to reduce foreclosure-related inventory that weighs on prices. With improvement in broader economic conditions, availability of refinancing alternatives such as the government s Home Affordable Mortgage Program, and house-price appreciation, delinquencies have fallen 36% from their peak (history in Chart 5). Finally, there is scope for continued improvement in household formation rates that help drive demand for housing. According to a recent Federal Reserve study authored by Andrew Paciorek 1, a weak labor market has in large part driven the 60% drop in household formation experienced during 2006 to 2011, as compared to the prior five years. This study also suggests that improving labor market fundamentals could lead to a significant pickup in household formation rates that would in turn provide a structural boost to housing market demand. Another key aspect of mortgage-backed securities returns is the impact of borrower refinancing activity on the timing of cash flows or duration. As interest rates fall, borrowers move to refinance, resulting in MBS receiving principal repayment more quickly and shortening duration. The opposite occurs when interest rates rise; refinancing activity falls and principal is repaid more slowly, resulting in longer duration. This phenomenon is known as negative convexity and results in MBS price returns that underperform similar non-refinanceable bonds in both rising- and falling-interestrate environments. As seen in Chart 6, the rise in interest rates over the summer has resulted in significantly slower refinancing activity. With the average conforming 30- year fixed-rate standing at 4.23% today, approximately 2/3 of these borrowers have little or no incentive to refinance. This has translated into slower repayment and a longer duration for much of the mortgage-backed securities market. One widely watched index that covers a broad swath of the mortgage-backed securities, the U.S. mortgage-backed securities component of the Barclays U.S. Aggregate Bond Index, saw its expected average duration increase from 3.93 years in early May to 5.37 years on February 7. This lengthening in duration results

4 4 February 2014 Chart 7: Monthly Supply of Single-Family Homes $100 $95 $90 $85 $80 $75 $70 $65 Jumbo Fixed Super-Senior 2007 Vintage Alt-A Fixed Super-Senior 2007 Vintage $60 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Chart 8: 30-Year Agency MBS Spread over Treasuries Spread in Basis Points Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13 Oct-13 Nov-13 Dec-13 Jan-14 in MBS behaving like longer-maturity, more price-sensitive bonds. Despite the selloff and lengthening duration, the impact of robust housing fundamentals and accommodative monetary policy targeting mortgage rates has been reflected in resilient residential mortgage-backed securities markets. While mortgage-backed securities initially experienced a broad pullback from May through July on Fed tapering concerns, both agency and non-agency MBS (non-agency MBS prices in Chart 7 and 30-year agency MBS/Treasury Spreads in Chart 8) have remained strong and are performing well relative to the broader interest rate increase. Most notably, MBS markets are increasingly pricing in favorable scenarios for the housing market recovery. Current prices for non-agency MBS now reflect default rates that will continue to fall as houseprice appreciation gives incentive to marginal borrowers to stay current on their mortgages and lowers losses associated with defaults. The recent price performance for agency risk transfer transactions most directly epitomizes this optimism. Under a regulatory mandate from the Federal Housing Finance Agency, Fannie Mae and Freddie Mac have undertaken a series of transactions to distribute credit risk from their conforming-mortgage guarantee books into the bond markets. Since the first transaction closed this past July, the cost to the agencies for selling this risk to the markets has fallen by almost 49%. Demand for these issues has been white hot; the most recent Freddie Mac (FHLMC) deal saw investor subscription levels over 7 times the total size of the deal, which is an unthinkably high level for MBS markets. Other segments of the mortgage-backed securities markets are also benefitting from the strong tone in housing. One prime example has been the market for mortgage-backed securities collateralized by defaulted residential mortgages. These bonds, known as non-performing loan securitizations, receive repayment through two primary means: 1) loan modification and rehabilitation of the borrower, or 2) sale of the property. Key considerations for investors in this market are yield levels and the assumed recovery rates on the defaulted loans. Demand for these securities remains strong. According to issuance volume data from Bank of America, $12.3 billion of these securities were brought to market in 2013, a 150% increase over This issuance has been readily absorbed despite yields that have fallen by over 20% since the summer s highs, progressively weaker bondholder protections, higher assumed recovery rates and lower-quality collateral. Even new products with unproven business models, such as securities backed by the aforementioned single-family home rental business, have seen significant demand. Invitation Homes recently brought a transaction which gives them financing at an all-in cost and loan-tovalue ratio that is far more favorable than that achievable through traditional residential and commercial mortgage finance channels. While the risks to bondholders of providing large amounts of inexpensive financial leverage to building an operation of this magnitude in what has traditionally been a fragmented, low-margin business is real, investors appear undaunted. Factors Driving Future MBS Performance Given the policy and housing market backdrops discussed above, four main factors will be central to MBS performance going forward: federal reserve policy expectations If economic growth continues, the conundrum facing Fed policy makers will be how to remove policy accommodation without significantly disrupting housing s contribution to growth. Given the impact of Fed purchases on mortgage rates, policy normalization could have a disproportionate impact on both housing and MBS markets depending on the timing, pace and composition of stimulus. During last summer s Fed tapering bond market scare, mortgage-backed

5 U.S. Housing Market Rebound 5 securities were the greatest laggards in high-grade fixed income, on investor concerns that the exit from quantitative easing could lead to eventual MBS sales. Yields rose by over 150 basis points, and underperformed alternatives such as investment-grade corporate bonds and Treasuries. Key factors to watch will be the strength of the housing market recovery and its contribution to growth as well as policy maker choices around the path to interest-rate normalization. the housing market For non-agency mortgage-backed securities, delinquency and house-price trends must continue to improve in line with expectations and translate into stronger default and recovery experiences for bondholders. If performance fails to deliver results that meet what are becoming increasingly optimistic investor expectations, a correction could be in order. duration and negative convexity With a significant majority of borrowers having no refinancing incentive, risks to further lengthening in duration have fallen and negative convexity has been greatly diminished. This comes with a caveat: if yields continue to fall (the FNMA 30- year MBS rate is now approximately 50 basis points below the early-september peak) or rise dramatically, negative convexity will once again become a concern for mortgage-backed securities investors. investor risk appetite Demand for both traditional MBS products and innovation has been strong and shows no sign of abating over the near term. How long can this continue in the face of falling return expectations, less favorable transaction structures, and lower quality collateral? The summer selloff notwithstanding, mortgage-backed securities have delivered strong performance for the year to date, and investor demand will likely remain robust over the near term. Tailwinds from improved housing market fundamentals and thawing lending markets should continue to support performance for non-agency MBS. Given the importance of housing to the broader economy, Fed policy will likely remain accommodative and favorable to mortgage-lending conditions. Despite these positive indicators, significant longer-term challenges remain. Here at Thornburg, we will pay close attention to changes in Fed policy expectations, housing market fundamentals, duration, convexity, and broader risk sentiment as we navigate the mortgage-backed securities landscape. 1 The Long and The Short of Household Formation, Andrew D. Paciorek, April 1, 2013

6 6 February 2014 Past performance does not guarantee future results. The views expressed by the portfolio managers reflect their professional opinions and should not be considered buy or sell recommendations. These views are subject to change. Bonds are subject to certain risks, including interest-rate risk, credit risk, and inflation risk. The principal value of bonds will fluctuate relative to changes in interest rates, decreasing when interest rates rise. The performance of any index is not indicative of the performance of any particular investment. Unless otherwise noted, index returns reflect the reinvestment of income dividends and capital gains, if any, but do not reflect fees, brokerage commissions or other expenses of investing. Investors may not make direct investments into any index. Glossary Alt-A home loans are a type of mortgage considered riskier than an A or prime loan, and less risky than a subprime loan. Agency MBS are mortgage-backed securities issued by government-sponsored enterprises or government corporations such as Ginnie Mae, Fannie Mae or Freddie Mac. The Barclays U.S. Aggregate Bond Index is composed of approximately 8,000 publicly traded bonds including U.S. government, mortgage-backed, corporate and Yankee bonds. The index is weighted by the market value of the bonds included in the index. Basis Point (bp) is a unit equal to 1/100th of 1%. 1% = 100 basis points (bps). Duration is a bond s sensitivity to interest rates. Bonds with longer durations experience greater price volatility than bonds with shorter durations. The Federal Housing Finance Agency is A U.S. government agency created by the Housing and Economic Recovery Act of 2008 that regulates the secondary mortgage market by overseeing the activities of Fannie Mae, Freddie Mac and the 12 federal home loan banks. Fannie Mae (FNMA) is a government-sponsored enterprise (GSE) that was created in 1938 to expand the flow of mortgage money by creating a secondary mortgage market. Freddie Mac, or the Federal Home Loan Mortgage Corp (FHLMC) is a stockholder-owned, 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. Gross Domestic Product (GDP) equals a country s income minus foreign investments: the total value of all goods and services produced within a country in a year, minus net income from investments in other countries. The Home Affordable Mortgage Program was established to help eligible homeowners with loan modifications on their mortgage debt. Jumbo Mortgages refer to home loans in amounts above conventional conforming loan limits set by Fannie Mae and Freddie Mac. Mortgage-Backed Securities (MBS) are a type of asset-backed security that is backed by a mortgage or collection of mortgages. These securities must also be grouped in one of the top two ratings as determined by a accredited credit rating agency, and usually pay periodic payments that are similar to coupon payments. Furthermore, the mortgage must have originated from a regulated and authorized financial institution. The Mortgage Bankers Association (MBA) Mortgage Refinance Index covers all mortgage applications to refinance an existing mortgage. It is considered to be the best overall gauge of mortgage refinancing activity. The Refinance Index includes conventional and government refinances, regardless of product (FRM or ARM) or coupon rate refinanced into or out of. The National Association of Realtors Housing Affordability Index is based on the relationship between median home price, median family income and average mortgage interest rate. Negative Convexity is a bond characteristic such that the price appreciation will be less than the price depreciation for a large change in yield of a given number of basis points. For example, a fixed-rate mortgage may lose value as rates go down because of prepayments. The National Association of Realtors Pending Home Sales (PHS) Index measures housing contract activity. It is based on signed real estate contracts for existing single-family homes, condos and co-ops. Quantitative Easing (QE) refers to the Federal Reserve s monetary policy used to stimulate the U.S. economy following the recession that began in 2007/08. QE3 is the third round, announced in September 2012 and revised in December 2012, during which the Fed has purchased $85 billion in mortgage-backed securities and Treasuries each month. A Real Estate Investment Trust (REIT) is a security that sells like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages. REITs receive special tax considerations and typically offer investors high yields as well as a highly liquid method of investing in real estate. The S&P/Case-Shiller Home Price Indices are the leading measures of U.S. residential real estate prices, tracking changes in the value of residential real estate both nationally as well as in 20 metropolitan regions. Super Senior refers to the status of a lender who is in seniormost position for repayment because of first claim to unsecured assets. Before investing, carefully consider the Fund s investment goals, risks, charges, and expenses. For a prospectus or summary prospectus containing this and other information, contact your financial advisor or visit thornburg.com. Read them carefully before investing. 2/19/14 Thornburg Securities Corporation, Distributor 2300 North Ridgetop Road Santa Fe, New Mexico TH2978