Bond Investors' Next Big Trade Is Betting On U.S. Homeowners
DECEMBER 26, 2017 • CLAIRE BOSTON
One of the best bond trades of 2018 might be one of the top from this year: betting that U.S. homeowners won’t default on their mortgages.
Money managers piled into relatively new Fannie Mae and Freddie Mac bonds known as "credit risk transfer" securities in 2017 in part because they are floating rate, a boon when the Federal Reserve is projecting three rate hikes in the coming year. Investors who bought subprime mortgage bonds after the housing crisis for pennies on the dollar are now getting repaid about $80 billion of principal a year, and are looking to reinvest their funds somewhere.
The riskier credit-risk transfer debt returned more than 10 percent this year through Dec. 1, according to Bank of America Corp. data, outpacing 7.2 percent returns on U.S. high-yield bonds and 5.9 percent for investment-grade corporate securities. Next year, portions of the bonds could return 3 percent on top of government debt, according to Morgan Stanley analysts. They call CRT bonds “the place to be” in 2018, and list parts of the securities among their top buys for the year for structured finance globally.
Investors buying these securities are among the first to suffer losses when homeowners fail to make their payments. But with unemployment at just 4.1 percent in November and the U.S. economy growing at an annualized rate faster than 3 percent, it seems reasonable to bet that prime borrowers will continue to pay their home loans, Goodson said. He prefers the securities to commercial real estate or corporate debt, which may face downturns sooner.
There are also technical reasons for the bonds to perform well next year. Fannie Mae and Freddie Mac said they probably will sell around $13 billion of credit-risk transfer securities in their main programs next year. If even a fraction of the $80 billion of subprime mortgage bond principal that investors are expected to get back in 2018 goes into this market, prices could rise, said Michael Canter, who oversees mortgage bonds, asset-backed securities and related debt at AllianceBernstein, which manages $549 billion.
“As legacy RMBS winds down, there are more investors looking for assets they can purchase to get exposure to residential credit,” Canter said. “This is the most obvious way to do that.”
Fannie Mae and Freddie Mac began issuing credit risk transfer securities in 2013 as a way to offload some of their risk onto taxpayers. The two companies guarantee homeowners’ mortgage payments against default, and when the U.S. took over the failing enterprises in 2008 during the financial crisis, their obligations explicitly became the government’s. Previously, taxpayers backing was only implicit.
Here’s how it works: Fannie Mae and Freddie Mac sell CRT bonds tied to a pool of home loans that have been packaged into mortgage-backed securities they guarantee. The Fannie Mae notes are called Connecticut Avenue Securities, while Freddie Mac’s are Structured Agency Credit Risk notes.
If the underlying loans sour, CRT holders’ principal goes toward paying back mortgage bond holders. The way the deals are put together, Fannie Mae and Freddie Mac are usually the first to take losses, then bond holders take some portion of subsequent losses, and the two companies take whatever losses remain after that.`