CIO WM Research 22 October 214 US fixed income enefits of investing in mortgage IOs Leslie Falconio, Senior Fixed Income Strategist, US FS leslie.falconio@ubs.com, +1 212 713 8496 James Rhodes, CFA, Fixed Income Strategist, US FS james.rhodes@ubs.com, +1 212 713 917 The agency interest only security is a AAA-rated mortgagebacked security that offers investors the opportunity to add yield to their fixed income portfolio, while at the same time mitigating potential losses in a rising rate environment and improving overall credit quality. Interest only securities have negative durations, which means that their prices are negatively correlated with the prices of other, more traditional fixed income securities. In fact, interest only bonds actually increase in price as rates rise, and fall as rates drop. Current opportunity Interest only securities are the rare fixed income security that appreciates in value when rates rise. Given that the US CIO WMR is that we are transitioning from the end of a decades long bull market in bonds to a secular bear market where interest rate will rise, we think this product can be an invaluable part of a fixed income investor's diversified portfolio. When used judiciously, IOs give investors that ability to reduce their duration risk. The fact that IOs currently offer relatively attractive yields means that investors may be able to increase overall portfolio yield at the same time that they reduce their interest rate risk profile. Further, agency IOs are AAA-rated, with zero credit risk. Investment considerations Interest only securities have a negative duration, so their valuations are negatively correlated with other, more traditional bond sectors, e.g., Treasury notes. Thus, as we've explained above, the opportunity is to mitigate a portfolio's interest rate exposure in a rising rate environment, because IO prices increase when rates rise. Conversely, if rates continue to fall, the IO price will drop. The fact that IOs represent a useful tool to reduce portfolio risk should not be misconstrued as a statement that they have no interest rate risk of their own. These securities will underperform as Treasury yields fall and outperform as Treasury yields rise. Figure 1: Treasury yields and IO prices IO price 23.5 23.3 23.1 22.9 22.7 22.5 22.3 22.1 21.9 21.7 21.5 2/14 3/14 4/14 5/14 6/14 7/14 8/14 9/14 1/14 FNMA 3yr 3% IO strip Source: US CIO WMR, loomberg Figure 2: IO supply Issuance (USD bn) 7 6 5 4 3 2 1 Treasury 1yr 2.9 2.8 2.7 2.6 2.5 2.4 2.3 2.2 2.1 2 199 1992 1994 1996 1998 2 22 24 26 28 21 212 214 IO Source: US CIO WMR, SIFMA Treasury yield (%) This report has been prepared by US Financial Services Inc. (US FS). Please see important disclaimers and disclosures that begin on page 7.
If you've ever financed your home with a mortgage loan, there's a good chance that your loan was collateral for a publicly traded mortgage backed security (MS). That's because a high percentage of the individual mortgages originated by lenders like banks are ultimately pooled as collateral that backs MS, which are then sold to investors all over the world. In the most basic type of MS, called passthrough securities 1, principal and interest are passed through to the investor, meaning that she receives monthly payments. Some other securities are "tranched" (i.e., mathematically "sliced and diced") to create collateralized mortgage obligations (CMOs) 2, which allow investors to customize both the risk and reward through sequential allocation of the underlying principal and interest payments. Another type of MS that we think deserves more attention in today's environment is the Interest Only (IO) security 3. Mortgage IOs, as the name suggests, consist of (only) the interest portion of the cash flows. That is, 1% of the interest is passed through to IO, but it receives % of the principal. There is, just in case you're wondering, a related Principal Only (PO) security, which receives the all principal and no interest. Together, an IO and PO on the same set of mortgage loans equates to the underlying passthrough, although they differ dramatically in terms of their risk characteristics. The IO is sold at a deep discount price, relative to the notional principal (e.g., an IO strip today might trade with a dollar price in the low 2s, versus a par amount of 1 on the notional principal). As the notional principal amount declines, because of either scheduled or unscheduled principal payments (e.g., loan amortization, borrower prepayments), the IO cash flows will likewise decline. Thus, faster prepayments are bad for the IO investor because they reduce the principal balance on which future interest payments are made; conversely, slower prepayments are good because they preserve the principal balance on which interest payments are made. This is an important distinction that makes IO securities very different than most other fixed income securities. That's because, all else equal, prepayment activity is negatively related to the level of interest rates (i.e., as rates fall, the incentive for a borrower to prepay a loan incrementally increases) and since IO valuations are also negatively related to prepayment activity the IO valuations are actually expected to increase as interest rates rise, unlike most other fixed income counterparts. In fact, IOs have negative durations. This means that not only do IO prices move in the opposite direction as, for example, Treasury notes; but do so in an asymmetrical fashion, with the IO showing price declines in Treasury market rallies. Figure 3: Mortgage loans collateralize myriad mortgage-backed securities, including IOs Different Risk and Return for Different Investors Source: US CIO WMR Pool of Mortgage Loans AAA/Aaa AA/Aa A/A /aa /a / Unrated Last Loss Loss position First Loss Lowest Risk Credit Risk Highest Risk Lower Expected Yield Higher Expected Yield Figure 4: Mortgage prepayment speeds and IO prices Prepay Speed (CPR) 6 5 4 3 2 1-3 -2-1 1 2 3 Interest rate shock (bps) CPR IO Source: US CIO WMR 35 3 25 2 15 1 5 IO Price (vs 1 par) [1] "Mortgage backed securities, Chapter One: Passthroughs," 4 July 214. [2] "Mortgage backed securities, Chapter Two: Agency CMO," 9 October 214. [3] "Mortgage backed securities, Chapter Three: Interest Only Securities," 21 October 214. US CIO WM Research 22 October 214 2
The fact that IOs offer a combination of relatively high yields, negative duration and AAA credit quality gives investors an opportunity to diversify their fixed income portfolios, while at the same time positioning for better total return performance in a rising rate environment. As a reminder, US CIO WMR believes that the FOMC will imminently end new QE-related bond purchases, then begin hiking overnight rates sometime mid-215. US CIO WMR expects both Fed policy and robust US economic growth to motivate higher interest rates going forward. We believe that fixed income investors should therefore, in turn, be motivated to find ways to mitigate the interest rate risk in their bond portfolios. We highlight some comparative rates of return for different fixed income securities, including a Treasury note, two corporate bonds, and an IO strip. Specifically, we project total returns over a six month horizon using option adjusted spread (OAS) analysis, assuming that US CIO WMR's rates forecasts are realized and prepayment activity evolves in a manner consistent with recent history. The results are presented on both an absolute and relative basis (i.e., for both the individual security and duration-weighted comparisons). As the chart shows, the IO strip is expected to outperform the more traditional fixed income securities in the rising rate environment that we expect to manifest. We think the comparative return profiles here look consistent with what a moderately conservator investor should find attractive. One final note about the analysis: while the effective durations of the paired trades (aka, comparison portfolios) are "zeroed out," please note that this is for the sake of analysis only. We are not recommending that investors completely avoid duration risk in their fixed income portfolios; rather, we are merely attempting to highlight the potential benefits of including IO securities in a diversified portfolio returns. Namely, those are yield enhancement and risk reduction, both with respect to duration risk and credit risk. Figure 5: Interest rate scenarios WMR 3mo WMR 6mo WMR 12mo Lower rates USD 3M Libor.4.5 1.2.1 USD 2Y Treasury.8 1. 1.6.1 USD 5Y Treasury 1.8 2. 2.3.91 USD 1Y Treasury 2.5 2.8 3. 1.7 USD 3Y Treasury 3.2 3.4 3.5 2.48 Source: US CIO WMR Figure 6: Interest rate scenarios Yield to maturity (%) 4 3.5 3 2.5 2 1.5 1.5 5 1 15 2 25 3 Interest rate scenarios WMR 3mo WMR 6mo WMR 12mo Lower rates Source: US CIO WMR Figure 7: Comparative total return analysis Security total return (%) 8 6 4 2 (2) (4) (6) (8) WMR 3mo forecast WMR 6mo forecast WMR 1yr forecast Lower rates Treasury 1yr IM 5yr IM 1yr FNMA 3yr 3% IO IO strip vs Treasury 1yr IO strip vs IM 5yr IO strip vs IM 1yr 1.2.9.6.3. -.3 -.6 -.9-1.2 Comp total return (%) Source: US CIO WMR, Yield ook US CIO WM Research 22 October 214 3
Glossary Callable bond: Allows redemption of the debt before maturity and therefore can be treated as an option. The issuer benefits from decreasing interest rates that allow cheaper debt refinancing. Accordingly, the investor expects the borrower not to call the bond and interest rates to at least stay stable or to increase slightly. If interest rates fall, the mortgage owners can refinance their debt at the lower rate, leading to asset loss by the agencies. Fannie and Freddie have been thought of as strategic issuers of callable debt because they issue structures that help to hedge the interest rate and cash flow risk characteristics of their retained mortgage portfolios. Issuance of callable bonds generates a natural hedge. Collateralized Mortgage Obligation (CMO): A security which pools together mortgages and separates them into short-, medium-, and long-term positions (called tranches). Tranches are set up to pay different rates of interest depending upon their maturity. Interest payments are usually paid monthly. In "plain vanilla" CMOs, principal is not paid on the final tranche until the other tranches have been paid off. This system provides interest and principal in a more predictable manner. Convexity (positive): A decrease in a bond's yield will raise the bond's price by an amount that is greater in size than the corresponding fall in the bond's price that would occur if there were an equal-sized increase in the bond's yield. Convexity (negative): When the shape of a bond's yield curve is concave. A bond s convexity is the rate of change of its duration, and is measured as the second derivative of price with respect to yield. Conditional prepayment rate (CPR): Equals the proportion of the principal that is likely to be repaid before maturity in every period. Several factors like historical prepayment rates are used in the analysis. Duration: A measure of the average maturity of the stream of payments generated by a financial asset. This is the weighted average of the lengths of time until the asset's remaining payments are made. Effective convexity: A measure of the sensitivity of a bond s price to an assumed shift in interest rates, which cannot be explained by the effective duration alone. Effective convexity takes into account the fact that the bond has embedded options. Effective duration: A duration calculation for bonds that have embedded options. Effective duration takes into account the fact that expected cash flows will fluctuate as interest rates change. Fannie Mae, Freddie Mac: constitute the so-called agency issuers, US CIO WM Research 22 October 214 4
since they are all in some way related to the US government (i.e., they are called "agents" of government public policy). Ginnie Mae: is government-owned and operates as a unit of the Department of Housing and Urban Development (HUD). The mortgage obligations of GNMA are backed by the full faith and credit of the US government. Interest Only Strip (IO): The interest portion of mortgage, Treasury or bond payments, which is separated and sold individually from the principal portion of those same payments. The periodic payments of several bonds can be "stripped" to form synthetic zero-coupon bonds. Also, an IO strip might be part of a larger collateralized mortgage obligation (CMO) structure. Modified duration: The approximation of the marginal shift of bond/mortgage price caused by a marginal change of the yield to maturity. Planned Amortization Class CMO (PAC): A class of tranche in a planned amortization class (PAC) bond that receives a primary payment schedule. As long as the actual prepayment rate is between a designated range of prepayment speeds, the life of the PAC tranche will remain relatively stable. This tranche of the PAC bond receives some measure of protection against prepayment risk. Principal Only Strip (PO): A type of fixed-income security where the holder is only entitled to receive regular cash flows that are derived from incoming principal repayments on an underlying loan pool. The loan is often a pool of mortgages in the form of a mortgage-backed security. Private label issuers (i.e. those not related to the US government): constitute the remaining part of the market. This segment of the market predominantly provides a secondary market for jumbo loans, which are those loans that do not qualify for involvement by Fannie, Freddie or Ginnie. Typically, this is because the loan amount is larger than the conforming loan limits set by the Federal Housing Administration (FHA). These loans are not backed by the government. Public Securities Association Standard Prepayment model (PSA): One of several models used for calculation and management of prepayment risk. This model includes the changing prepayment assumptions that might influence the lifetime of the security and its yield. The underlying assumption is that prepayments rise gradually until the 3th month. There are several real-world explanations for this: lower likelihood of moving to a different home or refinancing, or no financial means to allow for additional payments. The standard model, "1% PSA," goes from a month-zero annualized prepayment rate of % with.2% increases each month until reaching 6% after 3 months (see Fig. 12). US CIO WM Research 22 October 214 5
Sequential Pay CMO (SEQ): A type of collateralized mortgage obligation (CMO) in which there are several tranches. Each tranche's holder receives interest payments as long as the tranche's principal amount has not been completely paid off. The senior tranche receives all initial principal payments until it is completely paid off, after which the next most senior tranche receives all the principle payments, and so on. Z ond CMO (Z): The final tranche in a series of mortgage-backed securities that is the last one to receive payment. Used in some collateralized mortgage obligations (CMO), Z-bonds pay no coupon payments while principal is being paid on earlier bonds. Interest that would have been paid on Z-bonds is used instead to pay down principal more rapidly on the earlier series of bonds. Single mortality rate (SMM): In the context of MS, this is the proportion of the principal amount to be prepaid in a given month. The higher the proportion, the less interesting an investment becomes for financial investors due to lost future interest. This rate refers to prepayment risk. US CIO WM Research 22 October 214 6
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