A Playbook for a Changing Mortgage Market

The U.S. securitized mortgage market has performed well since the 2008–’09 financial crisis. Agency mortgage-backed securities (MBSs) have generally benefited from accommodative monetary policies, which have suppressed volatility, and from the Federal Reserve’s MBS purchases. Both residential and commercial MBSs have profited from the sharp recovery in real estate fundamentals, a limited new supply — especially on the residential side — and investor demand for yield. Whereas performance across the mortgage sector has generally been quite strong, PIMCO’s outlook in “The New Neutral” calls for tempered return estimates across asset classes. PIMCO’s mortgage opportunities strategy thus focuses on three key themes: selective offense, targeted defense and investing in the future of real estate finance.

A selective offense: nonagency residential MBSs. Despite strong performance in recent years, we believe that legacy, or precrisis, nonagency RMBSs remain attractive. Prices are higher, but housing fundamentals have also improved materially since U.S. home prices bottomed out in early 2012. Although PIMCO expects home price appreciation to slow, we feel that legacy nonagency MBSs provide value with less interest rate risk than traditional core fixed-income sectors. Idiosyncratic risks, such as litigation, servicing transfers and securities that have largely amortized, present further opportunities.

European MBSs. An accommodative European Central Bank has helped reduce much of the tail risk in European credit markets. As a result, both European (Irish, in particular) residential and commercial MBSs may provide attractive return profiles in PIMCO’s base-case scenarios, which include a gradual improvement in broader European economic conditions.

Structured agency MBSs. While valuations are rich, unique return opportunities may be available in select structured agency MBSs. In “The New Neutral,” we expect a lower future federal funds rate than the market is currently pricing in. Consequently, we have targeted agency MBSs with inverse coupon structures, which move counter to short-term interest rates. Our prepayment analytics identify opportunities in which prepayment risks can be mitigated, potentially resulting in an efficient vehicle to position against a realization of the forward yield curve.

We have also targeted interest-only (IO) securities that can provide positive returns when interest rates are rising. Less refinancing activity means that investors receive interest payments for longer than the market may be pricing in. Whereas not all IOs are attractively priced, select bonds with collateral attributes that are designed to provide downside-risk mitigation from faster prepayments may provide stable current yields and potential price appreciation if interest rates rise.

Targeted defense: agency MBSs. Despite Fed tapering, the Barclays fixed-rate agency MBS index has outperformed like-duration U.S. Treasuries year-to-date. In many cases, valuations have reached extremes as the Fed’s demand continues to outpace issuance. Agency MBS issuance has been much lower than the market expected this year. Although a short position in MBSs sacrifices some yield today, we believe such a position is prudent from a value perspective. Furthermore, we think valuations in certain coupons are so expensive that the yield pickup relative to Treasuries will not be sufficient if these bonds revert toward long-term fair value over the next 18 to 36 months (depending on the timing of the coupon). Notably, according to our analysis, there has been no 18-month period over the past 20 years in which the current coupon mortgage has not reverted to fair value or cheaper. With the Fed exiting this market and private investors seemingly hesitant to add significant exposure, we expect MBSs to get cheaper in the months ahead.

Buying optionality. We believe one of the most underutilized opportunities in a low-volatility environment is the ability to purchase optionality in an attempt to hedge your portfolio from adverse market events. We utilize options on both interest rates and MBSs for this purpose in the mortgage opportunities strategy.

Investing in the future of real estate finance: Fannie Mae and Freddie Mac risk reduction. A strategic initiative of government-sponsored enterprises (GSEs) during the past 24 months has been to reduce the risk they hold on their balance sheets. As a result, we have observed more than $6 billion in “risk sharing” transactions, in which GSEs sell off first-loss positions on mortgage pools that they have previously guaranteed to reduce credit risk and draw private capital back into mortgage credit. So far, we have found that transaction volumes have been minimal, and initial pricing has been fairly expensive (and remains so, even after recent cheapening) relative to similar credit opportunities within legacy nonagency MBSs. PIMCO expects spreads to widen as the GSEs look to reduce significantly larger amounts of risk, creating opportunities for private investors.

Private label securitizations. Policymakers are focusing on igniting growth in private label securitization channels to help reduce the government’s footprint in housing finance. Nevertheless, this market is not likely to entice investors, such as PIMCO, without material improvements in investor protections. Whereas valuations on these securities have been unattractive, we would expect spreads to widen if issuance increases materially, similar to GSE risk sharing. If private label securitizations return in size, at the right price and with proper alignment of incentives, we believe they will provide more options for today’s mortgage investors.

Buy-to-rent securitizations. The Federal Reserve Bank of Atlanta estimates that institutional investors have deployed $15 billion to $20 billion of capital to purchase 90,000 to 150,000 single-family homes and that many of these investors have started to utilize securitization for financing. Although we see this option as unattractive at this stage, if residential credit availability does not improve, growth in renting will likely continue and could result in a greater than expected increase in single-family rental securitizations.

A strategy for an evolving market. MBS investing requires flexibility and the willingness to broaden your opportunity set. Whereas future returns in securitized mortgages are unlikely to match those in recent years, mortgage credit risk and prepayment risk are highly complex, often misunderstood and have historically presented attractive risk-adjusted return opportunities.

Daniel Hyman is an executive vice president and co-head of the agency mortgage portfolio management team, and Jason Mandinach is a senior vice president and product manager responsible for mortgage-related strategies, both at PIMCO’s headquarters in Newport Beach, California.